You have heard it before. Owning a home is a great tax deduction. It is one thing to make a general statement. It is another to understand the specifics of how owning a home may lower your tax liability. Below is a list of important points that every homeowner should know. Note that this is not a complete list of allowable deductions.
Itemizing deductions. In order to deduct your mortgage interest, you must itemize deductions rather than take the standard deduction. As a general example, if your allowable standard deduction is $14,000 and you only have $7,000 in itemized deductions, you will be better off taking the standard deduction. However, if the home gives you an “extra” $10,000 in itemized deductions, you are better off itemizing. Note that the “excess” $7,000 ($14,000 minus $7,000) will not garner any benefit because you are now itemizing. The standard deduction changes most years because it is indexed to inflation.
The housing payment. The housing payment is generally comprised of four segments: Principal, interest, taxes and insurance (PITI). Generally, you can deduct two of these—mortgage interest and taxes. The good news is in most cases these two items comprise the greatest majority of the total payment. For example, here are some fictitious numbers given to illustrate this point:
$450 Principal
$2,000 Interest
$500 Taxes
$50 Insurance
$3,000 Total Payment (PITI)
Of this example, $2,500 out of $3,000 is deductible, or approximately 80% of the payment. Note that, depending upon your income, monthly mortgage insurance may be deductible as well.
Again, using fictitious numbers, if the above homeowner was in a 25% tax bracket, the home payment would actually be reduced by approximately $625 per month after taxes. There are a few exceptions or requirements with regard to this rule—
- The deduction is only allowable for principal residences and second homes. Homes which are rented out (investor properties) have additional tax benefits.
- The maximum deduction for state and local taxes is $10,000 (including state/local income taxes). Thus, if you have a higher income and/or live in a high-tax state, not all of the real estate taxes may be deductible.
- You cannot deduct interest on any loan amount above $750,000.
You can only deduct interest on a mortgage which is taken out to purchase, build or improve a property.
Points. A point is a cost charged by a mortgage company for originating a mortgage and/or buying the rate down on that mortgage. Generally, points can be deducted in the year that they are paid when they are used to purchase a primary residence. If the purpose of the mortgage loan is to refinance an existing loan, then the points may still be able to be deducted, but the deduction must be spread out over the life of the loan, unless the refinance was to improve the present home. There are additional restrictions regarding the deducting of points which are not delineated herein.
Investment properties. Those who own properties for the purpose of generating income can deduct the cost of expenses of carrying the property against the income of that property. Allowable expenses would include interest, insurance, taxes, maintenance, depreciation and more. Rental losses can be claimed up to $25,000 annually if your income is below $100,000. Again, using a fictitious example …
$2,000 Rental Income (monthly)
-1,600 Interest, taxes and insurance
-100 Maintenance
-100 Depreciation
$200 monthly “net” income or $1,200 for the year.
Sale of the home. Another major tax benefit is achieved when someone sells their home. The profits of the sale of a principal residence are excluded from income up to a maximum of $500,000 for joint filers, including married couples, and $250,000 for individuals. You must have owned the home at least two years and used it as your primary residence at least two out of the past five years. Any amount above these are treated as capital gains, which are taxed at lower rates than ordinary income.
The tax benefits of owning a home are “great” as advertised. You are advised to get with your tax advisor for greater clarification with regard to these general rules. Note that tax laws now allow for inflation indexing of standard deductions and tax brackets.
