One of the pillars of the American Dream is the ability to purchase one’s own home. Whatever your dream home may be — a rustic cabin in the woods, a Cape Cod with a white picket fence in the suburbs, or a high-rise apartment in the city—there is something very unique about making the transition from renter to owner. However, it may be challenging and costly to make the change. It’s not easy to put save money for a down payment and then make mortgage payments on time every month. Buying a home, reducing home-related expenses, and selling a home tax-free are all possible thanks to a few of Uncle Sam’s tax tactics. Although not everyone will be able to take advantage of these opportunities, those who do may find that the effort is well worth it. In addition, if your finances are already tight, every bit of assistance is greatly appreciated. Without further ado, here are thirteen tax deductions that can assist you in purchasing a home and increasing your wealth as a result.
List of contents
- Tip 1: Making a Purchase Using Retirement Savings
- Tip 2: Mortgage Points Deduction
- Tip 3: Mortgage Interest Deduction
- Tip 4: Mortgage Interest Credit
- Tip 5: Home-Office Expense Deduction
- Tip 6: Credits for Energy-Saving Improvements
- Tip 7: Credit for Electric Vehicle Charging Equipment
- Tip 8: Deduction of Medically Necessary Home Improvements
- Tip 9: Deduction of Rental Expenses
- Tip 10: Property Tax Deduction
- Tip 11: Forgiveness of Debt on a Foreclosure or Short Sale
- Tip 12: Capital Gain Exclusion When Selling Your Home
- Tip 13: Increased Basis When Selling Your Home
Tip 1: Making a Purchase Using Retirement Savings
Homeownership requires saving enough for a down payment. You might be allowed to use the money saved in your 401(k) or individual retirement account (IRA) toward a down payment on a house. Anyone under the age of 59½ who has saved in a regular IRA can take up to $10,000 to use toward the purchase, construction, or restoration of a primary residence without incurring the 10% early withdrawal penalty. It’s possible to take out a total of $20,000 from your IRAs after tax-free withdrawals if you and your spouse are married. You and your spouse cannot be current homeowners within the last two years for this to count as your first home. The withdrawal amount is still subject to taxation, but the penalty is waived.
Contributions to a Roth IRA are tax and penalty-free at any time or for any reason. Income tax withholding was completed long ago. Earnings up to $10,000 can be withdrawn tax-free before age 5912 to put toward a down payment on a first house. (Likewise, your better half is free to do the same.) After five years, profits are also exempt from taxation in this account.
Borrowing from a 401(k) plan is the only way to access the funds needed for a down payment. Your 401(k) plan may allow you to take out a loan of up to half of your balance, with no taxes or penalties applied, but the maximum borrowing amount is $50,000. Although 401(k) loans are typically due (with interest) after five years, the payback time may be extended for loans used to buy a primary residence. If you lose your job or quit, you’ll have to pay back the loan by the next tax deadline. If you take money out of a retirement account before you turn 55, you’ll owe taxes on the remaining balance plus a 10% early withdrawal penalty.
Tip 2: Mortgage Points Deduction
You typically have to pay “points” to the lender when getting a mortgage. Points paid on loans used to purchase, construct, or significantly improve a principal property are generally fully deductible in the year they are paid. While there are stipulations, such as the loan being secured by your primary residence, in most cases, you can deduct points paid immediately at closing on a conventional mortgage.
However, the loan points paid on a second house are not tax deductible in the year they are paid. Still, you can deduct them in installments during the loan. If you have a 30-year mortgage, you can remove one-thirtieth of the points each year. The annual return on your investment of 1,000 points is $33; it’s not a lot of money, but it’s also not something you should throw away.
Any points paid when refinancing must commonly be amortized over the remaining loan term. Refinancing mortgage points are generally not tax deductible, but if you utilize a portion of the funds to make significant improvements to your primary residence, you may be able to deduct the amount of the points linked to the repair in the year you paid them (you can remove the rest of the points over the life of the loan). All remaining points on a refinance loan are tax deductible in the year the loan is paid off, whether through the sale of the home or another refinance. If you refinance twice with the same lender, the points paid on the second loan will be added to any unused points from the first refinance and deducted from the new loan balance throughout the loan’s term.
The last caveat is whether you subtract points in the year you paid them or spread them out over the life of the loan. You must use the itemized tax filing method to qualify for this deduction. Most individuals do not bother to itemize their deductions but instead claim the standard deduction.
Tip 3: Mortgage Interest Deduction
Mortgage interest deductions are the primary source of tax savings for most homeowners. Mortgage interest on up to $750,000 in debt ($375,000 if filing separately) used to acquire, construct, or significantly improve either a primary residence or a single secondary residence is deductible if you itemize your deductions. Mortgage interest on loans made before 2018 is deductible for up to $1 million. Modifications are considered “significant” if they increase the home’s worth, lengthen the home’s useful life, or make it suitable for new purposes. Renovations and extensions are considered “significant,” but routine upkeep is not.
The mortgage interest you paid last year will be itemized on a Form 1098 that your lender will mail to you at the beginning of the new year. Calculate that sum on Schedule A. (Form 1040). Be sure that any interest payments made between the date of closing and the end of the month in question are reflected on Form 1098 if you recently purchased a house. The settlement form for your house purchase should include this figure. You can still claim the deduction even if the lender doesn’t report it on Form 1098. Schedule A also has mortgage interest that was not included on Form 1098.
Tip 4: Mortgage Interest Credit
Suppose you are a low-income homeowner and were given a Mortgage Credit Certificate (MCC) by your state or local government to help you buy a property. In that case, you may be eligible for a mortgage interest tax credit in addition to the deduction. The credit can be as much as half of your annual mortgage interest payments. Your MCC will specify the exact percentage. If the credit rate is above 20%, the maximum amount of the credit is $2,000. But if your credit is capped, you can roll over any unused portion into the following three years or keep it until it expires.
Make sure to complete Form 8396 and include it with your 1040 to receive the credit. Schedule 3 is where you’ll want to detail the amount of your credit (Form 1040).
This credit is subject to a slew of exceptions and limitations. There is a strict prohibition against, for instance, doubling up on benefits. If you qualify for the mortgage interest tax credit, you must subtract that amount from the mortgage interest deduction you itemize on Form 1040, Page 2. If you refinance your existing loan, you will need a new MCC to receive the credit on the refinanced loan, and the amount of the credit may also vary. Moreover, if you obtain an MCC program benefit and sell the house before the nine years, you may be required to refund all or a portion of that benefit.
Tip 5: Home-Office Expense Deduction
You may be eligible to deduct some of the costs associated with using your home for business if you are self-employed and conduct at least some of your work there. The home-office deduction is available to both homeowners and renters, regardless of whether they own or are living in a single-family residence, a two-family, a three-family, a four-family, a mobile home, a boat, or any other form of dwelling. Similarly, if you labor in a detached garage, studio, barn, or greenhouse on your property, you can take advantage of this deduction.
To qualify for the home-office deduction, you must devote regular and exclusive use of a specific room in your house to your business. If you pass, you’ll be able to deduct a portion of your power bills, insurance premiums, general repairs, and other home-related business expenses. Non-cash expenses, such as rent or depreciation, if you own your house, can help reduce your taxable income and, in turn, your tax liability.
The deduction can be determined in two ways. By dividing the overall cost of running your home by the proportion of your home you use for business, you may calculate your business’s “real expenses” using the “actual expense” technique. The difficulty in calculating the deduction and providing supporting documentation is a significant drawback to this approach. Using the “simplified” technique, you can deduct $5 for every square foot of your house that you utilize for legitimate business purposes. So, if you had a home office that is the maximum size allowed under this method—say, 300 square feet—you can deduct $1,500.
Costs associated with a home office, including those incurred by telecommuting workers, are not deductible during the pandemic. In years before 2018, workers could deduct home-office costs as an itemized deduction if they amounted to more than two percent of their AGI. However, the Tax Cuts and Jobs Act of 2017 did away with this deduction.
Tip 6: Credits for Energy-Saving Improvements
When you install certain energy-efficient appliances in your house, the federal government will give you a tax credit to encourage you to adopt renewable energy sources. If your new energy system generates electricity, heats water, or controls the temperature with solar, wind, geothermal, biomass, or fuel cell power, you are eligible for a 30% discount. Equipment used to produce electricity from fuel cells is suitable for a $500 credit for every 500 milliwatts of output. It is important to note that the credit will no longer apply to biomass systems after 2023 but will apply to battery storage technologies.
Homeowners that go green in 2022 will save up to $500 on their tax bill with another credit if they install energy-efficient insulation, doors, roofs, heating, air conditioning systems, wood stoves, water heaters, or similar appliances. If you install new, energy-efficient windows, you can get a credit of up to $200. The $500 general limit and the $200 window limit are cumulative, meaning that credits earned in one year will contribute toward the total in subsequent years. Additional individual credit thresholds are set at $50 for high-efficiency central air circulating fans, $150 for select heating and cooling systems, and $300 for energy-saving building assets.
Tip 7: Credit for Electric Vehicle Charging Equipment
Everyone knows you can get a tax break if you buy an electric car, but did you know you can also get one if you put in the infrastructure to charge your EV at home? Up to $1,000 can be credited against the purchase of qualified machinery.
Bidirectional charging technology, which can either charge an EV battery or transmit power back to the grid, will also be eligible for the credit beginning in 2023.
You can claim the credit on Schedule 3 after completing Form 8911. (Form 1040).
Tip 8: Deduction of Medically Necessary Home Improvements
If you have to put in medical equipment or make significant alterations to your home because of a medical condition, you may be able to deduct those costs. The addition of ramps, widening of entrances, installation of handrails, lowering of cabinets, relocation of electrical outlets, installation of lifts or elevators, replacement of doorknobs, and grading of the ground are standard medically necessary changes to a property. If an upgrade is medically required, the costs associated with running and maintaining it might be written off as medical expenditures. However, home renovations made only to accommodate an elderly person (known as “aging-in-place” changes) are not tax deductible unless a doctor requires them.
But there are restrictions to be aware of. Deductible medical costs are limited to the amount that is more than 7.5% of your adjusted gross income and can only be claimed if you itemize on Schedule A (Form 1040). Any appreciation in the value of your home also lowers the amount you can deduct. In this case, if the elevator costs $50,000 to install and adds $40,000 to the value of your home, you can only deduct $10,000 ($50,000 minus $40,000). The upgrading also has to be necessary for medical reasons.
Tip 9: Deduction of Rental Expenses
Consider renting out a basement apartment or spare bedroom. Your rental revenue is taxable, but any related expenses are deductible. Insurance premiums, general repair and maintenance fees, property taxes, utility bills, and supplies may all be tax deductible. The portion of your home you rent out, and any furnishings and appliances therein are eligible for depreciation. Rental space costs can be deducted from Schedule A without having to itemize. They are instead deducted from rental income and claimed on Schedule E (1040).
Problems arise when deducting costs that apply to the entire home, such as the energy bill or the property tax. The price must be broken out with a percentage for the rental unit. Any suitable technique for distributing the cost can be used. For instance, if you rent a 200-square-foot room in a 2,000-square-foot residence, you need to assign (and subtract from) 10% of the total cost of the property as rent. Expenses that are specific to the rented space need not be shared. For instance, if you rent a room and decide to paint it, the entire cost is considered a legitimate rental fee.
If you’re looking to rent a second home or investment property, you’ll want to keep specific subtle differences in the regulations. There are different ways to determine whether you owe tax on rental income and whether or not you can deduct rental expenses.
Tip 10: Property Tax Deduction
Other than income taxes, you’ll be slammed with many others. Real property taxes are an additional expense that homeowners must learn to budget for. In a positive turn of events, state and local property taxes may be deductible on your federal income tax return.
However, there are a few snags that could invalidate this deduction. Real estate tax deductions are only available to those who first itemize their tax returns. Deduct them on Schedule A if you use that tax filing method (Form 1040).
The sum of your state and local income, sales, and property taxes that you can deduct from your federal taxes cannot exceed $10,000 (or $5,000 if you are married and filing separately). Spending exceeding the $10,000 cap is not tax deductible. This is a significant burden for homeowners in states with high income, sales, and property taxes.
Tip 11: Forgiveness of Debt on a Foreclosure or Short Sale
More people default on their mortgages during recessions. Your mortgage obligation may be reduced or even canceled by the lender after a “short sale” or foreclosure. A debt discharged in full is considered revenue to the debtor in most cases. However, debt discharged on a primary house in a foreclosure or short sale is exempt from taxation up to $750,000 ($375,000 if filing separately).
To be clear, this exemption does not apply to any other type of mortgage save the one you used to acquire, construct, or materially enhance your primary residence. Additionally, it should share the same level of safety as your primary residence. The debt secured by your primary home obtained through the refinancing of a mortgage obtained for purchasing, constructing, or significantly improving said primary residence is also considered to be qualifying debt, but only up to the amount of the principal of the mortgage held before the refinancing.
Discharge of debt due to services rendered to the lender or for any other reason unrelated to a drop in the home’s value or the debtor’s financial situation does not qualify for the mortgage debt forgiveness tax credit. Your home’s cost base will also be lowered by the amount you remove.
Tip 12: Capital Gain Exclusion When Selling Your Home
When you sell your property, the Internal Revenue Service gives you a present: you may not be required to pay taxes on all or any of the profit. In the eyes of the law, your home qualifies as an investment. You must often pay capital gains tax when selling an investment asset for a profit. However, suppose you’re married and file a joint return. In that case, you can avoid paying tax on up to $500,000 ($250,000 for single filers) of the gain from the sale of your home if you meet all three of the following conditions: (1) you owned the home for at least two of the past five years, (2) you lived in the home for at least two of those years, and (3) you haven’t used this exclusion to shelter gain from a home sale in the last two years. In this case, if all the exclusion criteria are met, the seller of a home purchased five years ago for $600,000 and sold for $700,000 will not have to pay tax on the $100,000 gain. Unfortunately, you cannot deduct the loss you incurred on selling your house. Any earnings beyond the exclusion level (currently $500,000 or $250,000) must be reported as capital gains on Form 1040, Schedule D.
Even if you don’t fulfill all of the criteria, you may still be able to exclude any of your home-sale earnings if you were forced to sell because of a move for your job, a health problem, a divorce, or some other unforeseen situation. How closely you meet the ownership, live-in, and prior use standards will determine the size of your exclusion. If you are a single person and you have owned your home for two of the last five years, but you have only lived in it for one of those years due to an employer transfer, you can exclude $125,000 of profit, or half the regular exclusion, because you only satisfied half the live-in requirement.
Attention: If you bought your house in 2008 and claimed first-time homebuyer credits or federal mortgage subsidies, you may have to pay them back when you sell your property if you later decide to use the proceeds for business purposes.
Tip 13: Increased Basis When Selling Your Home
You can lower the tax you owe when you sell your house by modifying the basis if the capital gain exclusion doesn’t cover the entire profit you make. Gain for tax purposes is the difference between the sales price and your cost basis for the property. Therefore, the tax is reduced in proportion to the basis.
The original purchase price of the property is factored into the basis, which is positive. However, there are other expenses when buying a home or renovating it. Closing costs and settlement charges incurred during the purchase of a home are one such example. For a house constructed on privately held land, the basis would consist of the purchase price of the land plus the costs of design and construction as well as any applicable permits, fees, and legal expenses. The price of significant renovations and extensions can be factored into the basis, but routine upkeep is excluded.
Even if you are in the 24% tax bracket, you are still responsible for 75% of your mortgage interest payment. Please do not believe paying interest is advantageous since it reduces your tax liability. The most prudent financial decision is to pay your mortgage as quickly as possible. If you want to maintain the home for an extended period, you can avoid a prepayment penalty by spending as much of the mortgage as you can afford each month. Discuss with your financial planner the optimal way to pay down your debt.
- Tobacco Tax: Another Important Tax You Should Not Ignore
- The Essential Tax Tips For New College Graduates
- What Are Real Estate Taxes And Personal Property Taxes?
- What Is Tax Liability?
Read more: Taxes