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The tax benefits of home ownership

In tax lingo, your principal residence is the place where you legally reside. It's typically the place where you spend most of your time, but several other factors are also relevant in determining your principal residence. Many of the tax benefits associated with home ownership apply mainly to your principal residence--different rules apply to second homes and investment properties. Here's what you need to know to make owning a home really pay off at tax time.

Deducting Mortgage Interest

One of the most important tax advantages of home ownership is the deduction of mortgage interest. If you itemize deductions on Schedule A of your federal income tax return, you can generally deduct the qualified residence interest that you pay on certain home mortgages taken on your principal residence. (This also applies to second homes.) That is, you may be able to deduct the interest you've paid on a mortgage to buy, build, or improve your home, provided that the loan is secured by your home. Such a mortgage is known as acquisition indebtedness by the IRS. Your ability to deduct interest depends on several factors.

Up to $1 million of acquisition mortgage debt ($500,000 if you're married and file separately) qualifies for interest deduction. (Different rules apply if you incurred the debt before October 14, 1987.) If your mortgage loan exceeds $1 million, some of the interest that you pay on the loan will not be deductible.

Although this deduction also applies to certain home equity loans secured by your home, the rules are different. Home equity debt involves a loan secured by your main or second home that exceeds the outstanding mortgages on the property. Home equity debt is limited to the lesser of:
  • The fair market value of the home minus the total acquisition debt on that home, or
  • $100,000 (or $50,000 if your filing status is married filing separately) for main and second homes combined The interest that you pay on a qualifying home equity loan is generally deductible regardless of how you use the loan proceeds. For more information, see IRS Publication 936.

    Tax treatment of real estate taxes

    Along with mortgage interest, you can generally deduct the real estate taxes that you've paid on your property in the year that they're paid to the taxing authority. Only the legal property owner can deduct the real estate taxes. In some cases, prepaid real estate taxes can be deducted in the year of the prepayment. Taxes placed in escrow but not yet paid to the taxing authority, however, generally aren't deductible.

    Tax treatment of home improvements and repairs

    Home improvements and repairs are generally nondeductible. Improvements, though, can increase the tax basis of your home (which in turn can lower your tax bite when you sell your home). Improvements add value to your home, prolong its life, or adapt it to a new use. For example, the installation of a deck, a built-in swimming pool, or a second bathroom would be considered an improvement. In contrast, a repair simply keeps your home in good operating condition. Regular repairs and maintenance (e.g., repainting your house and fixing your gutters) are not considered improvements and are not included in the tax basis of your home. However, if repairs are performed as part of an extensive remodeling of your home, the entire job may be considered an improvement.

    Deducting points and closing costs

    Buying a home is confusing enough without wondering how to handle the settlement charges at tax time. When you take out a loan to buy a home, or when you refinance an existing loan on your home, you'll probably be charged closing costs. These usually include points, as well as attorney's fees, recording fees, title search fees, appraisal fees, and loan or document preparation and processing fees. You'll need to know whether you can deduct these fees (in part or in full) on your federal income tax return, or whether they're simply added to the cost basis of your home.

    Before we get to that, let's define one term. Points are costs that your lender charges when you take a loan secured by your home. One point equals 1 percent of the loan amount borrowed. As a home buyer, you can deduct points in the year that you buy your home if you itemize your deductions. However, you must meet certain requirements. You can even deduct points that the seller pays for you. More information about these requirements is available in IRS Publication 936.

    Refinanced loans are treated differently. The points that you pay on a refinanced loan generally must be amortized over the life of the loan. In other words, you can deduct a certain portion of the points each year. There's one exception: If part of the loan is used to make improvements to your principal residence, you can generally deduct that portion of the points in the year that the points are paid.

    And what about other closing costs? Generally, you cannot deduct these costs on your tax return. Instead, you must adjust your tax basis (the cost, plus or minus certain factors) in your home. For example, if you're buying a home, you'd increase your basis with certain closing costs. If you're selling a home, you'd decrease your amount realized from the sale (i.e., your sale price). For more information, see IRS Publication 530.

    Exclusion of capital gain when your house is sold

    Now let's see what happens when you sell your home. If you sell your principal residence at a loss, you generally can't deduct the loss on your tax return. If you sell your principal residence at a gain, however, you may be able to exclude from taxation all or part of the capital gain.

    Generally speaking, capital gain (or loss) on the sale of your principal residence equals the sale price minus your adjusted basis in the property. Your adjusted basis is the cost of the property (i.e., what you paid for it initially), plus amounts paid for capital improvements, less any depreciation and casualty losses claimed for tax purposes.

    If you meet the requirements, you can exclude from federal income tax up to $250,000 ($500,000 if you're married and file a joint return) of any capital gain that results from the sale of your principal residence, regardless of your age. In general, an individual, or either spouse in a married couple, can use this exclusion only once every two years. To qualify for the exclusion, you must have owned and used the home as your principal residence for a total of two out of the five years before the sale.

    For example, you and your spouse bought your home in 1981 for $200,000. You've lived in it ever since and file joint federal income tax returns. You sold the house yesterday for $350,000. Your entire $150,000 gain ($350,000 - $200,000) is excludable. That means that you don't have to report your home sale on your income tax return.

    What if you fail to meet the two-out-of-five-years rule? Or what if you used the capital gain exclusion within the past two years with respect to a different principal residence? You may still be able to exclude part of your gain if your home sale was due to a change in place of employment, health reasons, or certain other unforeseen circumstances. In such a case, exclusion of the gain may be prorated.

    Additionally, special rules may apply in the following cases:

  • If your principal residence contained a home office or was otherwise used partially for business purposes
  • If you sell vacant land adjacent to your principal residence
  • If your principal residence is owned by a trust
  • If you rented part of your principal residence to tenants
  • If you owned your principal residence jointly with an unmarried taxpayer

    Note: Members of the uniformed services and foreign service personnel may elect to suspend the running of the 2-out-of-5-year requirement during any period of qualified official extended duty up to a maximum of 10 years.

    This information is intended for informational purposes only and should not be construed as tax planning advice. As always, you should consult a qualified tax professional for details and specific advice.

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