As most of us are already aware, homeowners get significant tax breaks that are not available to renters; however, tax laws are continually changing. While accurate at the time of this writing, it is critical that the taxpayer verify the information provided herein with either the Internal Revenue Service or an accounting professional for advice on your particular tax situation.
Mortgage interest rates are still near record lows, and home prices are still well off the peak prices of just a few years ago, so if you do not currently own your own home, now is an excellent time to become a homeowner.
Mortgage Interest and Points Deduction
The U.S. tax code allows homeowners to deduct mortgage interest from gross income, which results in lower taxable income. Additionally, some of the closing costs you paid when you purchased your home (e.g., origination points or discount points), may be deductible as well. This may apply to mortgages on first and second homes as well as home equity loans, regardless of how the proceeds from the home equity loan are spent.
Property Tax Deductions
The U.S. tax code also allows homeowners to deduct real estate property taxes from gross income, which, like mortgage interest, results in lower taxable income.
Increasing total deductions to the point where it is advantageous to itemize them is another advantage that often results from home ownership. When you file your taxes, you have two options when claiming deductions that will lower your taxable income. You can claim a standard deduction, which is a flat amount determined by your filing status, or you can itemize your deductions. If you are a homeowner, itemizing your deductions, including your mortgage interest and property taxes, often results in a lower amount of income that is subject to taxes. This is especially advantageous during the first few years of your mortgage when you are paying significantly more each month in interest than you are in principal. This can save you a substantial amount each year in federal and state income taxes.
If your mortgage payment consists of principal, interest, and property taxes of $1,200 per month, you will pay $14,400 in total payments over the course of a year. If annual property taxes of $1,800 ($150 per month) are included in that payment, the remaining $1,050 monthly payment consists of principal and interest. Since the majority of your house payment is interest in the first years, you will have easily paid at least $8,600 in interest during that year. This interest payment, combined with the property tax paid, gives you $10,400 in home ownership-related deductions. If you are in the 28% incremental tax bracket, this will either reduce your taxes by or provide you with a refund of more than $2,900 as a result of owning a home. You could easily have paid $1,200 each month in rent during that same period and would have no tax advantage whatsoever. Any tax advantages as a result of being able to deduct some of the closing costs when you purchased your home would be in addition to this.
Preferential Tax Treatment Upon Selling
Another major advantage of home ownership is that, in most cases, you don’t have to pay taxes on any capital gains (profit) you make when you sell your principal residence, provided you (and your spouse, where applicable) have lived in that house for at least two of the previous five years. The law, which was introduced by President Clinton, allows you to exclude from taxes up to $500,000 in capital gains (profit) from the sale of your principal residence for married taxpayers filing jointly and up to $250,000 for single taxpayers or married taxpayers who file separately. This exclusion also covers the sale of a parcel of land adjacent to your house, unless it’s used for business.
These full exemptions can only be claimed once every two years. Even if you don't meet the requirements for the above full exemptions, you may still be able to claim a partial exemption if you are forced to sell before you meet the two-year residency requirement due to some qualifying unforeseen event such as a job change, illness, death of a spouse, divorce, disaster, war or some other hardship.
For qualifying unforeseen circumstances, you can prorate the $500,000/$250,000 exclusion (not your specific gain) if you are forced to sell early. For example, if you only live in your home a year (half the two-year requirement) before you are forced to sell because of some qualifying unforeseen event, you can exclude from taxes up to $250,000 (half the exclusion) in capital gains if you are married and file jointly or $125,000 for separate and single filers.
If you are fortunate enough to receive more profit on the sale of your home than the allowable exclusion, that "excess" profit will be considered long term capital gains, provided you owned your home for more than one year. Long term capital gains receive preferential tax treatment compared to ordinary income or short-term capital gains.
The New 2013 Real Estate Tax
A new 3.8% tax, which was passed in the final days of negotiating the Affordable Care Act that has come to be known as Obamacare, took effect at the beginning of 2013, and is intended to help fund the costs that will be incurred as a result of Obamacare. It’s a 3.8% tax on certain profits made on selling real estate.
This new tax will NOT affect all Real Estate transactions, but it may effectively impose a tax on some interest, dividends and rents (less expenses), and capital gains (less capital losses). The tax will only be applicable to married couples filing jointly with Adjusted Gross Income (AGI) higher than $250,000 and to single taxpayers and married couples filing separately with AGI higher than $200,000, although being in those high income brackets does not necessarily mean that you will be paying this tax. Certain investment income above these income levels might be subject to the 3.8% tax on a portion of that income. Whether the tax applies or not depends on many factors having to do with the kind and amount of the total income the taxpayer(s) receives.
The $500,000/$250,000 exemption on capital gains from the sale of a primary residence is still in effect. This means that profits from the sale of a primary residence under $500,000 for most married couples filing jointly and under $250,000 for most single taxpayers or married taxpayers filing separately are still exempt from the capital gains tax. Just to be clear, it's capital gains (profits), not the sale proceeds.
The new tax adds an additional 3.8% surtax to those transactions if you exceed those exemption amounts for all applicable capital gains, but only for those taxpayers whose AGI exceeds the $250,000/$200,000 AGI levels outlined above, and only for the amount that exceeds the $500,000/$250,000 exemption.
Again, tax laws are continually changing. While accurate at the time of this writing, it is critical that the taxpayer verify the information provided herein with either the Internal Revenue Service or an accounting professional for advice on your particular tax situation.
When you consider that you can often finance a home and keep your monthly payments to approximately the same amount you pay in rent each month, it's still true that you can really come out ahead with home ownership.