This is my third and final post about first-time homebuyer savings accounts, a tax dodge that seems to have swept the nation a few years ago, with several states setting up similar-but-not-identical versions of the gambit, with vastly varying value based on income restrictions, time and contribution limits, investment options, and of course the state income tax rate itself. It may help to read part one and part two of the series first, unless you’re only interested in your own state’s deduction.
Alabama: deductible contributions and earnings with low limits
As in the case of Oregon, Alabama requires what they call a “First-Time and Second Chance Home Buyer Savings Account” to be a separate account opened specifically for that purpose and designated as such “contemporaneously” with the account opening. Banks and credit unions in Alabama are presumably familiar with this process, but in principle I think you could probably designate almost any newly-opened account, either by adding “First-Time and Second Chance Home Buyer Savings Account” on the account’s name line, having a declaration notarized, or possibly even by sending yourself an e-mail “contemporaneously.” I would consult with an Alabama tax attorney if you plan to use an out-of-state account or your bank won’t let you add an additional entry on the name line of your account.
First, the good news: both deposits and earnings in your new savings account are deductible from your Alabama state income tax, and there’s a $5,000 annual/$25,000 total contribution limit for single filers and $10,000/$50,000 limit for joint filers.
Unfortunately, Alabama’s state income tax just isn’t that onerous, maxing out at 5% for taxable incomes above $100,000, so the maximum value of the account is $1,250 or $2,500, plus whatever negligible interest you earn on the account. Furthermore, the accounts have a punishingly short lifespan of 5 years, half the 10 years provided for by most other states. That means the only way to maximize the value of the deduction is to make the maximum contribution every year, which rules out the technique I described for married filers to maximize the value of Oregon’s accounts by focusing deposits on high-tax years.
There’s also a 10% penalty for non-eligible withdrawals (in addition to any taxes owed). It’s unclear to me from the Alabama state income tax instructions whether this penalty still applies if the account is allowed to expire after 5 years. If so, that would spoil the opportunity accounts in Oregon offer to borrow money at 0% or even negative interest rates, although the amounts involved in Alabama are so low I doubt it would be worth it for most high-income Alabamans anyway.
Overall, Alabama did a good job spotting the most obvious opportunities for abuse, and good for them. One question I wasn’t able to easily answer was whether these accounts can be opened sequentially, so that after the first 5-year period expires, you can open a second account and claim the deduction for an additional 5 years, or whether there is a 5-year lifetime limit on deductions.
Mississippi: no lifetime limits and unlimited deductible earnings
Mississippi is the first state I’ve come across with two added twists to their accounts. First, there are no lifetime limits on deductible contributions, so once you’ve got an account set up (as in Alabama, it does have to be a new, segregated account), single filers can deduct up to $2,500 and joint filers up to $5,000 per year forever (or at least until they change the law or repeal their income tax, as their legislature mooted this year).
Second, as far as I can tell (see page 13 of these instructions, and this “technical bulletin“), all earnings in the account are deductible above and beyond the annual cap on deductible contributions.
Additionally, according to the Mississippi code, there’s no requirement that your account be a “savings” account as traditionally defined. The definition in the law is simply that a “‘First-time home buyer savings account’ or ‘account’ means an account with a financial institution for which the account holder claims first-time home buyer savings account status.” And in fact, unlike in Alabama, there’s no need for the financial institution to make any kind of notation on your account (although it couldn’t hurt for record-keeping purposes), so virtually any kind of account, including brokerage accounts, should be eligible.
While Mississippi has a low top marginal income tax rate of 5%, over a long enough time period the unlimited earnings deduction could still eventually amount to an even more valuable benefit than the capped deduction of contributions.
Montana: unlimited deductible earnings and an astonishing loophole
I can’t say I’ve been saving the best for last since I’ve been going through these states in a roughly random order, but Montana’s version of these accounts has the most bizarre feature I’ve seen yet.
Before we get there, the basics: $3,000 (single) or $6,000 (joint) in contributions are deductible each year from your Montana state income tax, which has a top marginal tax rate of 6.75%, for a maximum annual value of $202.50 or $405. You can designate most accounts, including brokerage accounts, and balances have to be used for eligible purposes within 10 years or be added back to your state income, plus a 10% penalty. All earnings in the account are deductible, to the extent they’re attributable to deductible contributions (this sounds like a pain to keep track of, I’d recommend exclusively making deductible contributions).
Note that while accounts “expire” after 10 years, as in Mississippi there do not appear to be any limits on the length of time you can claim the deduction (as long as you remain an eligible first-time homebuyer).
Now for the loophole: withdrawals made on the last business day of the year are not subject to the 10% penalty. This is unrelated to the 10-year deadline for using the funds — it’s a pure trick of the calendar, so wealthy Montanans can withdraw their balances, compounded tax-free for up to 10 years, penalty-free. But this can be done in any year, not just in the 10th year the account is open, and the fact the withdrawal has to fall on exactly the last business day of the year is the clue that this loophole was drilled for people who are trying to precisely dial in their tax liability.
The possibilities for arbitrage here are obvious, since you have an opportunity for a deductible contribution and a penalty-free withdrawal each year: you can make a deductible contribution each January, and then see what tax bracket you fall into at the end of the year to decide whether to make a penalty-free withdrawal, up to your entire balance! The withdrawal is added to your taxable income, but the point is to “fill up” your low marginal tax rate buckets during low-income years, and then let your balance ride free of state income taxes during high-income years.
Finally, Montana provides for the absurdity of “rolling forward” contributions that are ineligible for deduction (in excess of the annual limit) to future years, so a $60,000 contribution in the first year can be deducted, $6,000 at a time, over the next 10 years, then the final balance withdrawn on the last business day of year 10 penalty-free.
I’m genuinely unclear on what the history of these deductions is. It appears to me most of them went into effect between 2017 and 2019, when states were experiencing budget surpluses they may have been struggling to find ways to spend. They differ in key ways (caps, time limits, investment options, etc.) but are similar enough to each other for me to intuit that a single lobbying hand was behind them all. I follow the activities of the American Legislative Exchange Council somewhat closely, and didn’t see anything coming from their policy shop, and besides, the states that fell for this gimmick are fairly diverse: Democratic Oregon, Colorado, and Virginia, Republican Idaho, Mississippi, and Alabama. And indeed, the Democratic states did put stricter limits on the accounts to keep them from being an infinite drain on their state budgets.
But I feel confident pointing the lobbyist finger at the National Association of Realtors. Realtors have a curious position in American politics, since like car dealers there are realtors in every state, but unlike car dealers they don’t have any obvious partisan valence. They’re paid when homes are bought and sold, so they want as many homes to be bought and sold as possible each year. Realtors sell free-standing houses, rowhouses, rental units, and condominium units alike, so their role in the housing shortage is complicated as well.
But if, during boom times, states found they had some extra cash lying around, the first-time homebuyer tax deductions are exactly the kind of crazy scam I’d expect realtors to come up with.
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