Now that the housing market is several quarters into a full-fledged recovery, home ownership is once again looking like the American Dream. Owning a home provides an opportunity to build equity and establish roots in your community.
Owning a home also provides some powerful tax benefits, even beyond the well-known deduction for mortgage interest. If you are a home owner, make sure you take advantage of all the possible tax breaks you’re entitled to, and if you’re considering buying a home, make sure you’re factoring in the true after-tax cost of buying vs. renting.
What is deductible: Many of the expenses associated with owning and financing a home can be used as deductions from your taxable income. To claim these, you must itemize your deductions, rather than claiming the standard deduction.
Mortgage interest: The most important of the tax breaks for homeowners is the deduction for qualified mortgage interest. This adds up to major savings, especially during the first years of owning a home (or in the years right after refinancing an existing mortgage) when the vast majority of your monthly mortgage payment is applied to interest. You only get to claim this deduction for the amount of interest on mortgages of up to $1 million.
Mortgage interest on vacation homes: The good news, however, is that you can also include a second home or a vacation home in that $1 million limit. For example, if the original loan value of your primary home is $700,000 and the original loan value of your vacation home is $500,000, then you would get to deduct the interest on all but $200,000 of the total principal you owe. For a vacation home, the rules on how much interest you get to deduct can get complicated if you rent out the vacation home for more than 14 days a year, generally speaking. (It’s actually more complicated than this, so if you do rent out your vacation home, be sure to let your tax professional know about it.)
Mortgage points: Points that you pay on a mortgage are fully deductible. Points paid on a refinancing are also fully deductible, but they are amortized (an accounting word for “spread out”) over the life of the mortgage.
Home equity line of credit: For a home equity line of credit (HELOC), interest on up to $100,000 of the loan is tax deductible. This is in addition to the $1 million limit for mortgage interest.
Real estate taxes: Often the second-biggest cost of owning a home after the mortgage payment is real estate taxes. The sting of real estate taxes is lessened by the fact that these taxes are deductible. One important caveat to keep in mind is that real estate taxes get added back to taxable income when calculating the alternative minimum tax, so in some cases you won’t get the full benefit of this deduction.
Private mortgage insurance: The premiums paid for private mortgage insurance (PMI) are fully deductible in 2013. PMI is insurance that you’re required to purchase if your down payment is less than 20% of the purchase price. This deduction was eliminated for 2012, but the fiscal cliff legislation reinstated it retroactively for all of 2012 and 2013. This deduction begins phasing out rapidly at fairly low income levels ($100,000 for individuals and $150,000 for joint filers).
Energy-efficient home improvements: While most improvements to your home don’t provide any immediate tax benefits, installing energy-efficient appliances, windows, roofs, doors, and HVAC equipment can qualify for tax credits of up to $300 per item. Geothermal heat pumps, solar panels, and wind turbines can generate even larger credits.
What’s not deductible: It’s also important to realize what aspects of owning a home are not deductible.
Some of the most common items include:
Home owner’s insurance premiums
Assessments or home owners association fees
Home improvements or repairs (except for the qualifying energy-efficient upgrades described above)
Transfer taxes and other closing costs
Although these items are not generally deductible for home owners, they can be partially deductible if you have a qualifying home office. Furthermore, several of these items add to your tax basis on the house, which can reduce the amount of capital gains when you sell the house. Fortunately, Congress gives home owners a break when selling a home because the first $250,000 of gain on the house ($500,000 for joint filers) is excluded from capital gains tax. On the flip side, unfortunately, if you sell your house for a loss, you don’t get to recognize any of that as a capital loss.
Calculating the after-tax cost of home ownership: If you are trying to decide between renting and buying or are trying to figure out how much house you can afford, it’s important to consider the net, or after-tax, cost of owning a home. To do that, you have to figure out how much those tax benefits are really worth.
Let’s consider the case of Eddie, who owns a $200,000 home that he purchased last year with a 20% down payment and a mortgage at 4.5%. The property taxes on the house are $3,000 a year. Eddies earns $180,000 a year, so he’s in the 28% marginal tax bracket and he itemizes on his taxes.
In the second year of owning the home, Eddie will pay about $7,000 in interest. When added to the $3,000 he pays in real estate taxes, the total amount of deductions he’ll get from his home are $10,000. Because he’s in the 28% tax bracket, those deductions are worth $2,800 when he goes to file his taxes next year.
However, if Eddie earned less and did not itemize in the past, he would take the standard deduction of $6,100 for an individual in 2013. To find the true value of Eddie’s mortgage and real estate tax deductions, you only consider the incremental deductions he would get to take beyond the $6,100 standard deduction. In this case, the incremental value of his mortgage interest and real estate tax breaks alone would be $1,092 or ($10,000 – $6,100) x 28%. Now that Eddie is itemizing his deductions, he will also get to claim deductions for state income taxes and charitable donations, which will provide additional tax savings.
Don’t go reducing that withholding just yet: You’ll notice that in this example we used the second year that Eddie owned the home. Why didn’t we use the first year? That’s because calculating the tax benefits in the first year is extremely complicated because of the timing of when you close on the house, prorated real estate taxes, tax credits, and all sorts of strange items. This is why it’s important to talk to your tax professional before assuming that you can reduce your W-2 withholding or count on a giant refund during that first year of owning the home.
Personal exemption phaseout–another complicating factor: Further complicating the calculation of your tax benefits for owning a home is the reinstatement of limitations on itemized deductions for high-income taxpayers. For individuals earning more than $250,000 and married couples earning more than $300,000, the amount of itemized deductions that the taxpayer can claim–including the home ownership deductions mentioned above and charitable contributions–is reduced by $3 for every $100 of income above those levels. The total reduction is capped at 80% of the deductions, so no matter how much someone earns, they will still get to claim at least 20% of the deductions.
Owning a home can be a tremendous source of pride and financial security. It can also be a great source of tax benefits. But as is the case with any financial question, don’t make the decision purely for the tax benefits. The tax breaks are just one piece that should be factored into the overall costs and benefits of owning a home.
If you have any questions about maximizing the tax benefits of your home, contact us at email@example.com or 773.525.6171 to set up a time to talk with us about your tax situation. At Eilts & Associates, we work closely with our clients to help them understand the tax implications of buying, owning, and selling a home.