When you purchase a home, you can take advantage of a number of lucrative tax benefits, thereby cutting the real cost of homeownership. Getting to know your tax advantages, and keeping track of home improvements, will pay off handsomely in the long run.
For home mortgages totaling up to $1 million, taxpayers are allowed to deduct their annual mortgage interest payments from their income. Homeowners are allowed to deduct mortgage interest for primary residences, vacation homes and rental properties, one way or another.
For your primary residence, of course, interest payments are fully deductible under the $1 million mortgage limit. Your mortgage company will send you a statement at the first of the year showing the total interest paid during the previous year. If you’re in the 15% tax bracket, a mortgage interest payment of $8,000 for the year would reduce your taxes by $1,200. The savings would be $2,200 if you fall into the new 27.5% bracket.
For rental properties, interest payments are counted as part of deductible rent expenses. If an overall loss results because total rent expenses (including interest expense) exceed rent income, the loss is deductible against other income such as wages, but only up to $25,000 in losses. The property owner must be an active participant to qualify and the $25,000 amount is reduced when total income goes over $100,000.
For vacation homes, overall losses are not deductible, but all mortgage interest and property taxes are deductible, either as rent expenses or as additional itemized deductions. A residence is a vacation home if it was used personally more than 14 days or 10% of the days it was rented (if rented more than 140 days).
On home equity loans (loans secured by a primary or second home), interest is fully deductible for loans up to $100,000, regardless of how the proceeds are used. When added to other debt secured by the residence, the total cannot exceed the fair market value of the property. (In other words, you can’t deduct all the interest on a 125% loan-to-value mortgage.)
In addition to mortgage interest, homeowners also get to deduct property taxes from their income on annual federal returns. You’ll receive a statement of property taxes paid from your lender early in the year. If you purchase a home this year, check your settlement papers when completing your return next year to see if you paid prorated taxes, which would be a deductible item.
Don’t forget to deduct any loan discount points that may have been paid at settlement — by you or the seller. You can deduct loan discount fees in the year you paid for financing to purchase a home, as long as you intend to occupy the residence.
A point equals 1% of the amount of the loan, i.e., one point would equal $1,000 on a $100,000 loan. (Be careful not to confuse loan discount points with mortgage service fees that are sometimes expressed as points — mortgage service fees are not deductible.)
Even if the seller pays the points, you can still claim the deduction. If you choose this alternative, however, you must reduce the cost basis of the property (discussed later) by the deducted amount when you sell the home. However, with current capital gain exclusion levels — $250,000 (single filers), $500,000 (married, filing jointly) — the basis reduction will usually have no tax effect.
|Points Paid At Refinancing|
Should you ever refinance your home, the rules for deducting discount points are different. In this case, you may not deduct the points in full the year you refinance your home. Instead, you must amortize them over the life of the loan. For instance, if you refinanced to a 20-year loan and paid $1,000 in points, you would deduct 1/20 of the points ($50) for each year of the term of the loan. (Note: If the home is refinanced again or sold, the remaining balance of points from the earlier refinancing is fully deductible.)
If any of the funds from the refinanced loan are used for home improvement, the percentage of the points paid for the part of the funds used for improvements may be deducted in full in the refinance year.
|Track Home Improvements|
It may be difficult to focus on selling a home when you’re just purchasing one, but you should be vigilant about keeping financial records related to your home from the outset. Bear in mind that when you sell your home, you could have a capital gains tax liability on your home-sale profits. Keeping track of your purchase and improvement costs will help reduce (or eliminate) your tax bill at sale time.
Capital gains. The profit you make when selling a home qualifies as a “capital gain.” Uncle Sam may be able to get a some of those gains if they exceed exclusion limits or you don’t meet the “time and use” tests.
Currently, you can exclude from taxable income home-sale profits up to $500,000 (for married taxpayers) or $250,000 (for singles). There are, however, a few rules:
- You must have owned the home for at least two of the five years prior to the sale.
- You must have used the home as your principal residence for a total of two of the previous five years. Any two years qualify, including intermittent, non-consecutive periods of time.
- You must wait two years between home sales that claim the exclusion.
If you must sell a principal residence before the two-year qualification is met due to a change in place of employment, health, or unforeseen circumstances, you may take a prorated portion of the exclusion. (Consult with a tax professional if this applies to you.)
To compute your capital gain, you must first know your home’s “basis value” — your costs to acquire the home plus or minus any “adjustments.”
Acquisition Costs. The starting point of your home’s basis value is the price you paid for it. But purchasing costs also include most settlement or closing costs you paid, such as fees for title insurance, legal service, recording fees, surveys, transfer taxes, abstract of title, and more. You cannot, however, include fire insurance premiums, rent to occupy the home prior to settlement, mortgage insurance premiums or loan-acquisition costs (such as discount points or credit reports). Nor can you include escrowed amounts for future payment of taxes or insurance.
Adjustments To Basis. You may add certain items to your home’s cost basis and you must subtract certain other items from it. The higher the basis value, the lower your capital gains tax liability will be.
Increases to basis include: the cost of “capital” improvements to your home (e.g., putting on an addition, replacing the entire roof, paving the driveway, installing air conditioning, etc., but not home maintenance or repair expenses); assessments for local improvements; amounts spent to restore damaged property.
Items that decrease your basis include: insurance reimbursement for casualty losses; deductible casualty loss not covered by insurance; payment received for granting an easement or right-of-way; depreciation deduction for use of your home for business or as a rental property; value of energy conservation subsidy; points paid by the seller; gains deferred on sale of a home before May 7, 1997.
For detailed information on these basis issues, consult a tax professional or refer to IRS Publication 523, Chapter 2.
Home-Sale Proceeds. Next, you’ll need to compute the proceeds from your home sale, which equal the sales price minus your selling expenses. Note that selling expenses include broker’s commissions and legal fees. They also include expenses that would otherwise be considered repairs providing they were incurred to make the home more saleable and were completed within 90 days of the sale.
The Calculation. Now you can do the math. Subtract your home’s adjusted basis value from your home-sale proceeds. The answer is your capital gain amount. If it’s over the $250,000 or $500,000 limits, you’ll have some taxes to pay.
If you never sell your home for more than $250,000 or $500,000, you might never have to compute your home’s cost basis. Still, there’s no telling how much your home might be worth in the future, or whether you’ll need to know its cost basis for other reasons (such as depreciating the home as a rental for a period of time). Keeping good records of your home improvements could save you thousands of dollars in taxes later on.