Congratulations, you’ve just taken another step up the American-dream ladder and are a homeowner. Along with the joy of painting, plumbing and yardwork, you now have some new tax considerations.
The good news is you can deduct many home-related expenses. These tax breaks are available for any abode — mobile home, single-family residence, town house, condominium or cooperative apartment.
The bad news is, to take full tax advantage of your home, your taxes will likely get more complicated. In most cases, homeowners itemize. That means you’re not living on “EZ” Street anymore; you’ve moved to the 1040 long form and Schedule A, where you’ll have to detail your deductible expenses.
For many homeowners, the effort of itemizing is well worth it at tax time. Some, however, might find that claiming the standard deduction remains their best move. How do you decide? First, find your standard deduction amount, based on your filing status: $5,450 for taxpayers who are single or married but filing separately; $8,000 for heads of households; and $10,900 for married couples who file joint returns. Then compare it to the total expenses you can itemize and file using the method that gives you the larger deduction.
To help you figure your possible Schedule A tax breaks, here’s a look at homeowner expenses you can deduct, ones you can’t and some tips to get the most tax advantages out of your new property owning status.
Your biggest tax break is reflected in the house payment you make each month since, for most homeowners, the bulk of that check goes toward interest. And all that interest is deductible, unless your loan is more than $1 million. If you’re the proud owner of a multimillion-dollar mortgaged mansion, the Internal Revenue Service will limit your deductible interest.
Interest tax breaks don’t end with your home’s first mortgage. Did you pull out extra cash through refinancing? Or did you decide instead to get a home equity loan or line of credit? Either way, that interest also is deductible, again within IRS guidelines.
Generally, equity debts of $100,000 or less are fully deductible. But even then, the remaining amount of your first mortgage could restrict your tax break. This could be a concern if you excessively leverage your house.
When a homeowner takes out an equity loan that, when combined with his first mortgage amount, increases the debt on the house to an amount more than the property’s actual value, the homeowner faces additional deductibility limits. In these cases, the IRS says you can deduct the smaller of interest on a $100,000 loan or your home’s value less the amount of your existing mortgage.
For example, say you bought your home three years ago with a minimal down payment. Your mortgage balance is $95,000 and the house is now worth $110,000. Your bank says you qualify for a 125 percent loan-to-value equity line, or $42,500 ($110,000 x 125 percent = $137,000 – $95,000 left on your first mortgage). To pay for your daughter’s college tuition and buy her a car to get to school, you take the bank up on the offer, thinking the interest deduction on the loan would be icing on the tax-break cake.
However, you’re not going to get to deduct all that interest. Instead, your deduction is limited to interest on just $15,000 of the loan; that’s the amount your home’s value exceeds your first mortgage. Interest payments on the other $27,500 are not deductible, even though the equity line is secured by your home. So don’t automatically assume you can deduct all interest on home equity debts.
What if your real estate circumstances are a bit brighter? Say, for instance, you’re able to swing a vacation home on the lake. You’re in tax luck. Mortgage interest on a second home is fully deductible. In fact, your additional property doesn’t have to strictly be a house. It could be a boat or RV, as long as it has cooking, sleeping and bathroom facilities. You can even rent out your second property for part of the year and still take full advantage of the mortgage interest deduction as long as you also spend some time there.
But be careful. If you don’t vacation at least 14 days at your second property, or more than 10 percent of the number of days that you do rent it out (whichever is longer), the IRS could consider the place a residential rental property and ax your interest deduction.
Did you pay points to get a better rate on any of your various home loans? They offer a tax break, too. The only issue is exactly when you get to claim them.
The IRS lets you deduct points in the year you paid them if, among other things, the loan is to purchase or build your main home, payment of points is an established business practice in your area and the points were within the usual range. Make sure your loan meets all the qualification requirements so that you can deduct points all at once.
A homeowner who pays points on a refinanced loan is also eligible for this tax break, but in most cases the points must be deducted over the life of the loan. So if you paid $2,000 in points to refinance your mortgage for 30 years, you can deduct $5.56 per monthly payment, or a total of $66.72 if you made 12 payments in one year on the new loan.
But if the refinancing frees up cash you then use to improve your house, you can fully deduct points on that money in the year you paid the points. The same rule applies to home equity loans or lines of credit. When the loan money is used for work on the house securing the loan, the points are deductible in the year the loan is taken out. If you use the extra cash for something else, such as buying a car, you still can deduct the points, but not completely, on one tax return. The point deductions must be parceled out over the equity loan’s term.
Remember: It’s only the portion of the points related to refi money you used for home improvement that is eligible for immediate tax-deduction purposes. The points attributable to the refinanced existing mortgage balance still must be amortized over the life of the refinanced loan.
And points paid on a loan secured by a second home or vacation residence, regardless of how the cash is used, must be amortized over the life of the loan.
The other major deduction in connection with your home is property taxes.
A big part of most monthly loan payments is taxes, which go into an escrow account for payment once a year. This amount should be included on the annual statement you get from your lender, along with your loan interest information. 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 the settlement sheet you got at closing to find additional tax payment data. 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 in the year your lender actually pays them to the property tax collector.
For example, say you bought your house July 1. Your property taxes are due each Jan. 1. 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 to cover your ownership of the property 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.
Property taxes usually must be deducted as an itemized expense on Schedule A. However, a new tax law allows homeowners who use the standard deduction to add at least some of their property tax payments to their standard amount. A single homeowner can add up to $500 of property tax payments to the $5,450 standard deduction. Married taxpayers filing a joint return can add up to $1,000 to their $10,900 amount.
This option helps homeowners who don’t have enough deductions to itemize, but who pay property taxes on their personal residence. This additional standard deduction amount is in effect through the 2009 tax year.
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.
Years ago, to avoid paying tax on the sale of a residence, a homeowner had to use the sale proceeds to buy another house. In 1997, the law was changed so that up to $250,000 in sales gain ($500,000 for married joint filers) is tax-free as long as the homeowner owned the property for two years and lived in it for two of the five years before the sale.
If you sell before meeting the ownership and residency requirements, you owe tax on any profit. The IRS provides some tax relief if the sale is because of a change in the owner’s health, employment or unforeseen circumstances. In these cases, the tax-free gain amount is prorated.
A ruling by the IRS in late 2002 could put more dollars in homeowners’ pockets when they must sell before they qualify for the full tax break. The Treasury has defined the unforeseen circumstances that often force homeowners to sell and under which they now can get some tax relief.
- Divorce or legal separation.
- Job loss that qualifies for unemployment compensation.
- Employment changes that make it difficult for the homeowner to meet mortgage and basic living expenses.
- Multiple births from the same pregnancy.
A partial exclusion can be claimed if the sale was prompted by residential damage from a natural or man-made disaster or the property was “involuntarily converted,” for example, taken by a local government under eminent domain law.
Second home sales also can provide some tax benefits, but not as much as they did in the past, thanks to a law that took effect in 2008. Previously, you could move into your vacation property, live in the home as your primary residence for two years and then sell and pocket up to $250,000 or $500,000 profit tax-free. Now, however, you’ll owe tax on part of the sale money based on how long the house was used as a second residence.
What’s not deductible
While many tax breaks are available to a homeowner, don’t get too carried away. There are still a few things for which you have to bear the full cost.
One such expense is insurance. If you pay private mortgage insurance, or PMI, because you weren’t able to come up with a large enough down payment, that’s a cost you probably won’t be able to deduct — unless you meet the requirements of a special PMI law. The tax-law change, first passed in December 2006 and extended in December 2007, allows some homeowners to deduct PMI for loans that are originated or refinanced after Jan. 1, 2007, and through Dec. 31, 2010, and which meet certain loan amount limits.
The other big home-related insurance cost, property hazard insurance premiums, still remains nondeductible for all, even though the coverage generally is required as part of the home loan and is included as a portion of your monthly payment.
Other nondeductible residential expenses include homeowners association dues, any additional principal payments you make, depreciation of your home, and general closing costs and local assessments to increase the value of your neighborhood, such as construction of new sidewalks or utility connections.
What about all those repairs that seem to crop up the day after you move in? Surely they’re tax-deductible. Sorry. While they’ll make your house much more comfortable, you’re on your own here, too.
But hold onto the receipts. Some long-time homeowners may find their property has appreciated beyond the $250,000 ($500,000 for married couples) amount the IRS will let you keep tax free when you sell. If that happens, the records of property improvements could help you establish a higher basis for your house and reduce your taxable profit.