Your changing tax life: Owning a home

Congratulations, you've just taken another step up the American dream ladder and are a homeowner. Along with the joy of painting, plumbing and yard work, you'll now have an added dimension to your taxes.

The good news is that you can deduct many home-related expenses. These advantages apply to any type of residence -- mobile home, single-family, townhouse, condominium, or cooperative apartment.

The bad news is that to take full tax advantage of your home, you need to itemize your deductions on Schedule A. You're not living on "EZ" Street anymore; you've moved to the 1040 Long Form.

What expenses can you deduct as a homeowner? The major ones are reflected in your house payment, which you probably are making to a bank. When you got the loan, you learned that the check you send in each month pays for a lot more than just the structure. Each January, your lender will send you a statement, usually Form 1098, detailing just how your payments were allocated.

Mortgage interest
If that annual statement were presented as a pie, you'd see that the actual paying down of your loan principal is the smallest slice. And the biggest piece is the interest your lender collects. That's why it's going to take you 30 years to own your home, but during that time you'll be able to use the interest paid on that to reduce your tax bill.

Mortgage interest is one of the last remaining personal interest deductions that our tax laws allow, so use it. You enter the amount your lender reports to you on line 10 of Form 1040, Schedule A.

Points
Also mentioned on this part of Schedule A are points. A point is a percentage of your loan amount and is a one-time fee paid to obtain a loan or reduce the loan rate. Points also are called loan origination fees, maximum loan charges, loan discount or discount points.

The IRS lets you deduct points in the year you paid them if:

• The loan is to purchase or build your main home.
• Payment of points is an established business practice in your area.
• The points charged were within the usual range.
• And the points were not paid in place of other fees (appraisal, inspection, title) or property taxes.

Points may be listed on the 1098 form you get from the bank. But more likely you'll have to dig out the documents you received when you closed on the house to find the amount you paid.

Using taxes to reduce taxes
The other major deduction in connection with your home is your property taxes.

If your house payment includes an escrow amount for payment of taxes, the annual information you get from the bank is a good way to check that those property taxes were paid. You certainly want to ensure that the state or local tax collector doesn't come looking for you. But you also want to keep tract of this amount so that you can include it as a deduction on Schedule A.

These taxes will be an annual deduction as long as you own your home. But if this is your first tax year in your house, dig out that settlement sheet given to you when you closed the deal. You will find additional tax payment information there. When the property was transferred from the seller to you, the year's tax payments were divided so that each of you paid the taxes for that portion of the tax year during which you owned the home. Your share of these taxes is fully deductible.

A word of caution: if your settlement statement shows any money you paid into an escrow account for future taxes, this amount is not deductible. You can only deduct the taxes when your lender actually pays them from the escrow account to the property tax collector.

For example, you buy your house on July 1. Your property taxes are due on Jan. 1 each year. When you closed, the seller had already paid the year's taxes of $1,000 in full so you reimburse the seller half of his annual tax payment since you are the owner for the last six months of the year. Your $500 reimbursement to the seller is shown on your settlement documents.

The closing document also shows you prepaid another $500 to the lender as escrow for the coming year's taxes due next Jan. 1. The $500 you reimbursed the seller at closing is deductible on this year's tax return, but the $500 held in escrow is not deductible until it is paid the next year.

Home equity loans
Personal interest is no longer deductible -- unless it's the interest you pay on a home equity loan. However, there is a restriction on the amount of these loans for which the interest is deductible.

The IRS limits the home equity debt for which you can deduct interest to the smaller of:

• $100,000 ($50,000 if married filing separately), or
• The total of the home's fair market value reduced by the amount of the existing home mortgage debt.

For example, you bought your home in five years ago, your mortgage balance is $95,000 and the house's fair value is $110,000. To pay for your daughter's college tuition and buy her a car so she can get to school, you take out a home equity loan of $42,000. In this case, your interest deduction would is limited to $15,000. This is the smaller of the $100,000 limit or $15,000 -- the amount that your home's fair market value of $110,000 exceeds the existing mortgage debt of $95,000.

The IRS considers the interest on the $27,000 of the loan that is over the home equity debt limit ($42,000 - $15,000) as nondeductible personal interest. So while you generally can get some tax benefit here, you need to keep in mind what your loan deductibility limits are when you consider a home equity loan.

When you sell
When you decide to move up to a bigger home, you'll be able to avoid some taxes on the profit you make. Tax law now allows you to exclude up to $250,000 of gain you make on the sale or exchange of property. Married taxpayers filing a joint return can exclude up to $500,000.

You can only take this exclusion every two years. And the IRS requires that you have owned and lived in the house as your principal residence for at least two of the five years before you sold it.

If you must sell before you meet the IRS ownership and residency requirements, you can still get a partial exclusion on any profit. To qualify for prorated tax relief, your home's sale must be because of a change in the your health, employment or unforeseen circumstances.

What's not deductible
With all the possible tax deductions you can get from your house, there are still a few things for which you have to bear the full cost.

You've probably noticed that a portion of your house payment goes into escrow so your bank can pay your property insurance bill. Unfortunately, that insurance fee is not tax-deductible. Neither are FHA mortgage insurance premiums, homeowner association fees, any additional principal payments you make, maid service costs, depreciation of your home or your utility charges.

So even though you still have to pay the electric bill and hire the kid down the street to mow the lawn, it's a small price to pay to have your own place and get all the tax breaks that come with it.