Realtors are quick to point out that home ownership allows a lot of tax advantages in the form of tax deductions not available to someone who merely pays rent. The advantages are different depending on whether you are buying a home vs. already owning a home and then selling your home. Below is an outline that addresses all three situations.
Buying a Home -- What’s Deductible?
A homeowner can deduct points used to obtain a mortgage when buying a home, mortgage interest paid during the year, and property taxes.
What are Points?
When most people buy a home, they generally obtain a mortgage. Mortgages have costs and one of those costs is the "loan origination fee." The loan origination fee is usually a percentage of the loan amount, generally expressed as "points."
For example, one "point" on a $150,000 loan would be $1500. One and a half points on the same loan amount would be $2250.
On VA and FHA loans, points are often broken down into two categories: loan origination fee (which is usually one point) and discount points (which are also a percentage of the loan balance). Both are deductible.
The loan origination fee must be expressed as points in order for it to be tax deductible.
When buying a home, points are deductible in the year they are paid, providing they meet certain conditions. The main conditions are that the mortgage is secured by the home you live in most of the time and that you used this mortgage to either purchase or build your home.
However, there are other conditions.
Your lender cannot inflate the points to include other items you would normally be charged. When buying a home, there are normally other charges such as appraisal fee, title insurance fee, property taxes, settlement fees, and so on. If by some miracle you are not charged these fees but your "points" are higher than normal…
In that case you can’t deduct the points. Sorry.
The cash you put into the deal must also exceed the amount charged in points. In other words, if your points were $3000, but you only had to put in $2000 to close, the IRS knows something is up. Your lender is inflating your loan amount to cover your points. Although a lender can technically do this, you wouldn’t be allowed to deduct the points.
The only other major condition is that the points must be clearly stated on the HUD1 Settlement Statement. This is a document you receive after closing that clearly lays out all the costs involved in buying the home. The seller also receives a HUD1.
When purchasing a home, sometimes the buyer negotiates for the seller to pay some closing costs, including the points. Since the seller pays them and not the buyer, one would assume they could not be deductible, right?
Wrong.
If the seller pays the buyer’s points, the IRS allows the buyer to deduct this as an expense on their federal tax returns. However, the seller cannot deduct them, too. Paying the buyer’s closing costs, including points, merely reduces the net gain on the home for purposes in calculating capital gains taxes (which are usually deferred).
Points paid to finance the purchase of a second home must be deducted over the life of the loan, not in the year in which they are paid.
If you make too much money, there are limits on what you can deduct based on your “adjusted gross income”, and for that you should see a Certified Public Accountant as the figure changes annually.
With two exceptions, other closing costs are not deductible. Those exceptions are pre-paid interest and pro-rated property taxes.
When you buy a home, you may close on any day of the month. However, most lenders want their mortgage payment due on the first of each month. So if you close on the 20th, for example, you "pre-pay" ten days of interest as part of your closing costs. The ten days of interest pays you up to the end of the month. Your first mortgage payment will not be on the first of the following month, but the month after that. Unlike renting, where you pay in advance, mortgages are paid in arrears.
Since interest is a deductible expense, prepaid interest is also deductible.
A similar thing happens with property taxes. The seller’s last property tax payment may have covered part of the time where you will actually be the owner of the home. The settlement agent will calculate how much of that last bill you should pay and charge it to you as a closing cost called "pro-rated property taxes." This is also deductible.
Certified Public Accountants
Whenever you reach a point where you begin itemizing deductions, it is best to have your tax returns prepared by a Certified Public Accountant as IRS rules and regulations are complex, confusing and constantly changing.
Owning a Home -- What’s Deductible?
Your Biggest Deduction – Interest
If you have a mortgage on your home, the loan is probably "fully amortized." This means a portion of your monthly payment actually repays the debt and another portion pays the interest. After a scheduled period of time your mortgage is paid off.
If you itemize deductions using a Schedule A, the interest portion of your mortgage payment is usually tax deductible.
There are conditions.
The first condition is that your primary residence or a second home must be collateral for the loan.
Defining "Home"
Your home can be a house, co-op, condominium, mobile home, trailer, or even a houseboat. For trailers and houseboats, one requirement is that the home must have sleeping, cooking, and toilet facilities.
Even a rental can be considered a second home, provided you live in it either fourteen days out of the year or at least ten percent of the number of days you rent it for, whichever is greater.
At the end of each year, your lender should send you a form 1098. This form tells you how much you paid in interest and points during the year. This is your deductible interest, provided you meet certain conditions.
If you obtained the loan prior to October 13, 1987, the loan is considered "grandfathered." All interest paid on grandfathered loans in a given year is fully tax deductible. After that, there are conditions, but most conditions won’t apply to most homeowners.
An important IRS term is "home acquisition debt." Any first or second mortgage used to buy, build, or improve your home is considered to be home acquisition debt.
Acquisition debt can be a first or second mortgage used to buy your home. If you get a second mortgage and use it all for home improvement, that is also considered acquisition debt. If you do a "rate and term" refinance and don’t get any "cash out" – since you are just refinancing your acquisition debt – that also can be considered acquisition debt.
For any of the above types of loans that aren’t "grandfathered" -- you can still deduct all the interest -- but only if the total mortgage debt for married couples filing jointly does not exceed $1,000,000. For married couples filing separately, the limit is $500,000 each.
It gets more complicated with refinances and second mortgages.
The IRS has another term called "home equity debt." Basically, this is any loan amount in excess of what was spent to purchase, build, or improve your home.
If you get "cash out" when refinancing your home, the amount in excess of your original loan amount is considered "home equity debt" – unless some of it was used for home improvement. Anything in excess of the home improvement cost is considered "home equity debt."
For second mortgages, it works the same way – anything not used to improve the home is considered "home equity debt."
For the interest to be fully deductible, home equity debt for married couples filing jointly cannot exceed $100,000 and the total mortgage debt on the home must not exceed its value. For married couples filing separately, the limit is $50,000 each. This can create a problem for those using 125% loan-to-value second mortgages to consolidate debt. That portion of the loan amount that exceeds the value of your home is not tax deductible (unless you used it for home improvement).
Points paid during refinancing must be deducted over the life of the loan. For a thirty-year loan, you divide the points by thirty and get to deduct that amount each year.
However, there is an exception.
If you did a "cash out" refinance and used some of the funds to improve your primary residence, a portion of the points are deductible in the year you paid them. That portion is related to how much of the loan was used for home improvement. If you obtained a $200,000 loan and $50,000 was used for home improvement, then one-fourth of the points are deductible in the year you obtained the loan.
Save your receipts.
Most homeowners pay property taxes to a local, state or foreign government. In most cases, property taxes are deductible. They must be charged uniformly against all property in the jurisdiction and must be based on the assessed value.
Many states and counties also impose property taxes for local improvements to property, such as assessments for streets, sidewalks, and sewer lines. These taxes cannot be deducted. Local property taxes are deductible only if they are for maintenance or repair, or interest charges related to those benefits.
Many mortgages have impound or escrow accounts. The borrower’s payment exceeds the amount necessary to pay the principal and interest. The excess goes into an account used to pay property taxes, homeowner’s insurance and mortgage insurance.
When calculating your property tax deduction, don’t deduct what you pay into that account. Only deduct what is paid from the account to the taxing authority.
Limits on Deductions
You may be subject to a limit on some of your itemized deductions. For 2000, this limit applies if your adjusted gross income is more than $128,950, or $64,475 if you are married filing separately.
Certified Public Accountants
Whenever you reach a point where you begin itemizing deductions, it is best to have your tax returns prepared by a Certified Public Accountant. Internal Revenue Service rules and regulations are complex, confusing and constantly changing.
Selling a Home -- What’s Deductible?
If you sold your main home and made a profit, you may be able to exclude that profit from your taxable income. Here's how it works.
$250,000 Exclusion on the Sale of a Main Home
Individuals can exclude up to $250,000 in profit from the sale of a main home (or $500,000 for a married couple) as long as you have owned the home and lived in the home for a minimum of two years. Those two years do not need to be consecutive. In the 5 years prior to the sale of the house, you need to have lived in the house for at least 24 months in that 5-year period. In other words, the home must have been your principal residence.
You can use this 2-out-of-5 year rule to exclude your profits each time you sell or exchange your main home. Generally, you can claim the exclusion only once every two years. Some exceptions do apply.
Exceptions to the 2 out of 5 Year Rule
If you lived in your home less than 24 months, you may be able to exclude a portion of the gain. Exceptions are allowed if you sold your house because the location of your job changed, because of health concerns, or for some other unforeseen circumstance.
Change in the Location of Your Job
If you lived in your house for less than two years, you can exclude a part of your gain on the sale of your house if your work location has changed. This exception would apply if you started a new job, or if you are moved to a new location with your employer.
Health Concerns
If you are selling your house for medical or health reasons, be ready to document those reasons with a letter from your physician. Such a letter does not need to be filed with your tax return. Instead, keep the documentation in your personal records just in case the IRS wants further information.
Unforeseen Circumstances
If you are selling your house because of unforeseen circumstances, be ready to document what those reasons are. IRS Publication 523 defines an unforseen circumstance as "the occurrence of an event that you could not reasonably have anticipated before buying and occupying your main home." The IRS has given specific examples of unforeseen circumstances:
- natural disasters,
- acts of war,
- acts of terrorism,
- change in employment or unemployment that left you unable to meet basic living expenses,
- death,
- divorce,
- separation, or
- multiple births from the same pregnancy.
Partial Exclusion
You can exclude a portion of your gain if you are selling your home and lived there less than 2 years and you meet one of the three exceptions. You calculate your partial exclusion based on the amount of time you actually lived in your home.
Count the number of months you actually lived in your home. Then divide that number by 24. Then multiply this ratio by $250,000 (if unmarried) or by $500,000 (if married). The result is the amount of gain you can exclude from your taxable income.
For example: you lived in your home for 12 months, and then sold the home because your employer asked you to relocate to a different office. You are an unmarried person. You calculate your partial exclusion: 12 months divided by 24 month (for a ratio of .50) times your maximum exclusion of $250,000. The result: you can exclude up to $125,000 in gain. If your gain is more than $125,000, you include only the amount over $125,000 as taxable income. If your gain is less than $125,000, then your gain can be excluded from your taxable income.
Loss on the Sale of a Home
