Due to a combination of low interest rates and improving household balance sheets, the housing market is heating up. For example, in the San Francisco Bay Area, it isn’t uncommon for final sale prices to end up to 25% over asking prices. Due to this competitive environment, it pays to understand home financing and not get tripped up by these common misconceptions:
Common misconception #1: All gifts except the annual exclusion are currently taxable.
Not true. If a generous relative is willing to give you a gift of cash to help fund the down payment or closing costs, even if it is over the annual gift tax exclusion of $14,000 (2013 amount) you probably don’t have to worry about anyone paying taxes now or later. Why? Because each of us has a lifetime gift tax exclusion of $5,250,000 (2013 amount) – very few people will come close to maxing out this amount in lifetime gifts. Note: The gift amount over the annual exclusion must be reported to the IRS on Form 709 the year the gift is given for reporting and tracking purposes. In addition, lenders will require a gift letter from the donor.
What to remember: We each have an annual gift tax exclusion and a lifetime gift tax exclusion amount. Besides some reporting requirements, most people will never pay tax on gifts.
Common misconception #2: Lenders will qualify you for a loan based on how much money you have in your bank or brokerage accounts.
Not true. Banks qualify borrowers on income first, not savings.The general rule is that not more than 40% of your pretax income can go to PITI: principal, interest, taxes and insurance plus any monthly debt obligations such as a car loan, student loans or credit card debt. Lenders will also document that you have enough savings for the down payment, closing costs and a minimum two to three months of cash reserves covering your PITI plus debt obligations.
Note: There is an exception to this rule and it’s called an asset dissipation loan. However, you must be retired, over age 59 1/2 and not receiving any employment income. Lenders use a formula to calculate how much your assets could produce in income and it would still need to meet the 40% requirement. It’s very difficult to qualify for this type of loan unless you have sufficient assets in the bank to yield enough income to qualify.
Common misconception #3: Believing that the “replacement residence rule” still applies. This rule, which expired in 1996 allowed sellers to avoid taxes on their profit as long as they spent that profit on the purchase of a new home within two years of the sale. If you had any of your profit left over after buying the new home, you had to pay taxes on that remainder.
Not true. This rule no longer applies. Since 1997, the rule is called the principal-residence tax break. Now, if you sell your principal residence you can skip tax on a large chunk of the gain-up to $500,000 for married couples filing jointly and up to $250,000 for singles. Profits above those cutoffs are usually taxed as long-term capital gains.
Common misconception #4: It is difficult for self-employed people to qualify for a mortgage loan just because they are self-employed.
Not true: If you report enough income to qualify for the loan, there is no discrimination to being self-employed. But income must be documented on two years of tax returns and be deemed stable by the lender. “Stable” means that your income stays the same or is increasing year over year. The amount of income must meet the general rule outlined in Misconception #2.
Common misconception #5: Your loan agent/officer can change the rules and make it easier for you to qualify.
Not true: While your loan agent needs knowledge and expertise to present your loan properly to a lender the actual underwriting guidelines are written by Fannie Mae and Freddie Mac and apply to everyone.
There are some lenders that will offer portfolio loans and can set the guidelines themselves but this is much less common than it used to be.
Common misconception #6: Your credit score is excellent; your income is stable and adequate; you have money in the bank – so applying for a loan and getting approved will be a piece of cake.
Not true: Since the credit crisis of 2007-2008 lenders have tightened their standards and leave nothing to chance. Stated-income and no-doc or low-doc loans are a thing of the past. Expect to provide a lot of detail about items you think aren’t important. For example, any deposit in your recent bank statements that is not a payroll deposit or other recurring deposit like social security income, must be explained and paper-trailed.
Please note: This blog post provides general information for home buyers. Consult your tax and financial advisers and/estate planning attorney regarding your specific situation.
Additional Reading:
From the Wall Street Journal: Will Your Home Sale Be Tax-Free?
From the Consumer Finance Protection Bureau: What Happens After I Apply For a Loan?
