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Welcome to Your New Shelter |
There are many reasons to buy a home rather than rent one. Owing your own home improves your lifestyle, provides you with pride of ownership and starts you on a path to real wealth building. Because of the stabling effect property ownership has on its citizens, the government has a vested interest in making sure that most Americans have the opportunity to become home owners. It is to this end that they have made home ownership one of the best tax shelters available. From the time of its purchase to the time of its sale, your home can provide you with substantial savings on your tax bill.
The Mortgage Interest Deduction
In the early years of a loan, most of your monthly mortgage payment will be going to the payment of interest. Regardless of where you have gotten your loan, your lender will send you a Form 1098, Mortgage Interest Statement at the end of each year. It will usually be sent to you in January. This form will list all of the interest you have paid on your home loan for the previous year.
You are allowed to deduct interest on loans that are secured by either your primary residence or a second home up to a loan amount of $1,000,000. If a loan is not secured by your home, it is considered a personal loan and its interest would not be deductible. The IRS considers a home to be a house, condominium, mobile home, boat, recreational vehicle or a similar property as long it has sleeping, cooking and bathroom facilities. The deduction is limited to first and second homes.
You can qualify for the interest deduction on your second home even if you rent it out for most of the year. The rule for qualifying is that you must occupy the home for at least 14 days out of the year.
As a new home owner be sure to hold onto the HUD-1 Form that was given to you at your closing since it is possible in the first year your 1098 may not be adequate to give you the entire interest amount. Let’s say you have closed on your home in the middle of July. That usually means your first mortgage payment will not be due until September 1. This payment will include an interest payment for August. Many lenders, however, will charge you interest from the middle of July to the beginning of August and you will need a record of this amount when you file your taxes. You can use your Hud-1 statement to provide you with a record of the additional interest payment for your first partial month of home ownership.
With home ownership, you can decide which will give you the largest tax deduction, the standard deduction or your total amount of interest payments for the year. If you find that the standard deduction will give you more of a write-off you may decide to stay with it. If the situation changes and the interest deduction is more, you may later use the interest deduction. You can alternate between the two options every year or itemize for a few years and then return to the standard. The key is to make sure that you choose the method that will give you the most tax savings for each year.
In order to claim the interest deduction, you will need to itemize and file a Schedule A, Form 1040 which will allow you to take deductions such as medical expenses, real estate taxes and charitable contributions as well as the mortgage interest deduction.
Real Estate Taxes
Along with your mortgage payment, you will also be paying property taxes which go to your town. The town uses this revenue to fund its schools, pay for police and fire protection, to maintain roads and to fund other services that are needed by its residents.
Real estate taxes are based on two factors: 1) property assessments, and 2) property tax rates.
A property’s assessment is based on its market value or how much it would sell for under normal circumstances. The assessor estimates the market value of a property based on the sales prices of similar properties. Comparable sales are used as well as the appraisal method of adding and deducting monetary values according to the property’s square footage, number of bedrooms, bathrooms and other features of the home.
Value is also added for upgrades to your property. The town is made aware of an upgrade when you file for a building permit. In most towns a permit is necessary whenever a significant improvement is made to your home such as an addition or remodeling.
The town’s tax rate is determined by the amount of the tax levy. The tax levy is based on a budget that has been set by the town. First, the revenue from all sources other than property tax (sales tax revenue, user fees, state aid, etc.) is determined. This amount is then subtracted from the budget and what is left must be collected through property taxes. In order to ensure that the correct amount is collected, the town decides on an appropriate tax rate. An example of a tax rate would be 12.66 or $12.66 per thousand.
In your home search, you will find the tax assessment, tax rate and annual property taxes in the public record and on the MLS listing sheets of homes that you are viewing. Your bank or other lending institution will need this information to calculate your monthly payment. Tax payments are usually divided into monthly amounts and are escrowed and paid with your mortgage and insurance payment.
You may deduct real estate taxes in the year paid. They are also reported on the Form 1098, that you will receive from your bank annually. In addition, you can deduct any prorated taxes that were collected from you at your closing.
Items you may not deduct include:
- Special assessments or betterment charges;
- Trash collection services, even if these are included on your tax bill;
- Home owners’ association assessments.
Home Office
Do You Work at Home?
If you own your own business, you may be able to take advantage of the home office deduction. Although the potential is an attractive one, before you take this deduction, you should make sure that you meet with all of the requirements.
To qualify as a home office for the purpose of the IRS, you must comply with the following:
1. Your use of the Business Part of your Home must be Exclusive, Regular and for your Trade or Business.
This usually means that it should be a separate room in your home that you use both regularly and exclusively for your business. A common area that you use in this way can comply—as long as you use it exclusively for business.
If you have an additional business with another location, you cannot perform any of that work in your home office. For example, if you are claiming a home office as a real estate agent and you have another job as a teacher, grading papers in your home office would invalidate your use of the office for the real estate business.
Exclusive use also means that your children cannot use your office computer to play computer games or do research for their school papers. An exclusion to this would be if you run a daycare center and let the children use the computer for games and applications.
Regular use means that you should be using the room on a continuing basis whether that is daily or weekly and you should be able to back this use with logs of phone calls or invoices on your computer that show how you used the office. Be sure to keep any and all records that prove your use of the office on a regular basis.
2. Your Home Office must be Your Principal Place of Business.
You must be able to show that you use your home as your principal place of business. To qualify you will need to prove one of the following:
- You meet patients, clients or customers at your home,
- You use a separate structure on your property exclusively for business purposes.
This must be the place where you perform the most important part of your work and you cannot perform a substantial portion of your administrative activities at any other location. Some of these activities would include:
- Billing customers
- Keeping books and records
- Ordering supplies
- Writing reports
- Setting appointments
You could perform some of these activities elsewhere but your home office must be where you perform your most substantial administrative activities.
Expenses you can deduct for an office in your home may include the business portion of real estate taxes, mortgage interest, utilities, insurance, depreciation, painting and repairs.
Even if you do not qualify for the home office deduction, you can still deduct the expenses you pay for your business such as the business telephone bill, your on-line services and any other business expenses that are generated from home.
Home Improvements
If you take out an equity loan to make substantial improvements to your home, you can deduct the interest paid on the amount borrowed for the improvement. You can also add this amount to your tax basis for the purpose of the capital gains exclusion when you sell. The IRS defines improvements as those items that “add to the value of your home, prolong its useful life, or adapt it to new uses.”
The following are examples of home improvements that may qualify:
Additions: bedrooms, bathrooms, a deck, a garage, a porch or patio.
Lawn & Grounds: landscaping, walkway, fence, retaining wall, sprinkler, swimming pool.
Heating and Air Conditioning: heating system, central air, a furnace, duct work a central humidifier, a filtration system.
Miscellaneous: storm windows, doors, a new roof, central vacuum, wiring updates, a security system.
Plumbing: a septic system, water heater, water softening system.
Interior Improvements: built-in appliances, kitchen modernization, flooring, wall-to-wall carpeting, insulation, attic, walls, floors, pipes, duct work.
Work that does not qualify as home improvements includes repairs such as repainting, plastering, patching your roof, repairing broken windows, replacing cracked tiles and fixing minor leaks.
Additional Home Equity Loans
College Tuition, Car Loans and Debt Consolidation
You may decide to take out a home equity loan for reasons other than home improvements. You can generally claim an itemized deduction for interest on up to $100,000 (married couple filing jointly) worth of home equity debt.
These loans may be used to finance your son or daughter’s college education, pay off a car loan or consolidate credit card debt. You could even use the money to buy furniture. As long as the loan is secured by your residence, its interest is deductible.
Be careful that you don’t create an upside down mortgage by ending up owing the bank more than the value of your home. Your own good judgment must come into play whenever you borrow against your home’s equity. However; if you have plenty of equity and were going to incur these expenditures anyway, you may want to make the choice to secure an additional tax write-off by financing them through your home.
Points
Remember Those Extra 2 or 3 Points You Paid to
Make Your Interest Rate Lower?
In your mortgage application, you will have the option of paying points to help you to get a lower interest rate. A point is 1% of the principal and is usually considered pre-paid interest. For example, one point on a $100,000 loan would be $1,000.
To be treated as pre-paid interest the points have to be paid solely for your use of the money and not for services performed by the lender. Even if the lender calls this amount a loan origination fee, as long as it is a charge for the use of the money, the fees are deductible on your income taxes.
To qualify for deduction of points on your income tax, you must meet the following criteria:
- Your loan is secured by your main home.
- Paying points is an established business practice in the areas where the loan was made.
- The points paid were not more than the points generally charged in your area.
- You use the cash method of accounting. Most people use this.
- Points were not paid in place of normal settlement costs, such as appraisal fees, etc.
- The funds you provided at closing were at least as much as the points charged.
- You use your loan to buy or build your main home.
- The amount is clearly shown on the settlement statement (Form HUD-1).
Points can be deducted from your taxes by filing them through a Schedule A, Form 1040 along with your other itemized deductions.
The Capital Gains Exclusion
This Will Apply When You Sell Your Home
Prior to May 7, 1997, home sellers needed to use the proceeds from the sale of their home to buy a more expensive home in order to avoid paying taxes on capital gains. The Taxpayer Relief Act of 1997 changed all that. Now, rather than having to roll over into another residence, home owners only need to comply with the following:
When you sell your home, provided you have occupied it for at least two out of five years, you have a $250,000 exclusion from capital gains taxes on this amount if you are single or a $500,000 exclusion as a married couple. The property you are selling must be your principal residence, not an investment property. However; if you hold a property for five years, rent it out for the first three, and then live in for the last two, you qualify for the tax exemption. Also, your habitation of the home does not necessarily have to be sequential. You could live in the home for a year, rent it out for three and live in it for the final year. It is also not necessary for you to be residing in the home at the time of sale. So, you could live in the house for a year, rent it out for two, move back into it for another year and rent it out in the final year. The rule is you must live in the home two out of any five years of ownership.
With regard to the married couple exclusion, you must both pass the use test and that is that each of you must have lived in the residence for two years. If you own a home for two years and your significant other marries you six months before the two year time period, you can qualify for the $500,000 tax exclusion, as long as you file jointly and your significant other has lived in the property with you for the last two years. If he has not lived in the property for the two year time period, or, if he owned and sold his own property and claimed the exclusion within the two year period, then, you do not qualify for the married couple exclusion.
These capital gains rules are a vast improvement over the previous ones since you can now use the proceeds from your home to travel, buy clothes or embark on a completely new venture. Also, there is no limit on the number of times you can use the home-sale exemption. In fact, you can have a tax-free profit of $250,000 (or $500,000 if married) every time you sell a home provided that each sale is at least two years apart.
These are brief descriptions of the some of the possible tax savings with home ownership. Before taking any deductions on your taxes, check with your tax accountant, attorney or appropriate IRS publication which may be found at www.irs.gov.
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