Homeownership provides stability and the opportunity to create a foundation for a family. However, there are also tax benefits that come with buying and owning a home. Taking advantage of these tax breaks can reduce your overall tax bill and make the home a more cost-effective investment in the long run.
There are a variety of different tax breaks which are broken up into two categories: deductions and credits.
Deductions vs. Credits
Deductions and credits both reduce your tax bill, but there are some key differences between the two:
Tax deductions are expenses that can be subtracted from a taxpayer’s gross income. Tax deductions are not a dollar for dollar deduction from the tax bill, but they do lower it. For example, if your gross income for the year was $50,000 and you had deductions of $5,000, your taxes would be based on $45,000 of income rather than $50,000. (Don’t yell at us about standard deductions, we are just trying to use a simple example here.)
Tax credits also reduce the overall tax bill but are applied slightly differently. Tax credits are a dollar for dollar deduction to a tax bill and are applied after the total taxes owed have been determined. For example, let’s say you owe $3,000 in taxes but you qualify for a $500 tax credit. Now instead of having to pay the IRS $3,000, you just have to pay $2,500.
A tax deduction will decrease the overall tax liability by reducing the taxable income, but a tax credit is more like a gift card that can be applied to the tax bill to lower the amount owed. To be able to take advantage of these tax deductions you will have to itemize your deductions and they must be more than the standard deduction.
The Seven Major Deductions:
- Mortgage Interest Deduction
This is one of the primary tax incentives of owning a home; a borrower can typically deduct all of their paid mortgage interest for the year, up to a certain amount. Talk to your tax preparer about how much mortgage interest is deductible as there are a few caveats on the limits.
- Mortgage Points Deduction
Mortgage points are paid to a lender at closing to reduce the overall interest rate. They’re expressed as a percentage of the loan, for example 1%. Think of points as a form of prepaid interest – because mortgage interest is deductible, the points paid to the lender are as well. Whether or not a homebuyer should pay points for a lower interest rate varies from person to person. Being able to write them off on taxes does not mean it is necessarily the right choice to pay points.
- Mortgage Insurance Deduction
If a down payment of less than 20% is made when the home was purchased, the owner will most likely be paying private mortgage insurance (PMI), but the good news is this is also deductible. Be sure to let your tax preparer know about any upfront mortgage premiums you paid at closing so they can include these in your deductions as well.
- Home Office or Business Use of Home Deduction
If a portion of the home is used exclusively for business, the owner can deduct a portion of those costs come tax season. As always there are caveats, talk to your tax preparer.
- Property Tax Deduction
When a homeowner pays property taxes, they can deduct the full amount paid each year. This includes state and local taxes. As with the other deductions listed here, the homeowner may be limited to what they can deduct based on their specific tax bracket.
- Necessary Home Improvements
While the definition of “necessary” can be loosely determined, it is somewhat limited for tax purposes. For example, an upgrade of a kitchen that is already fully functioning probably won’t count, but upgrades/renovations for medical purposes (medical equipment or widening doorways for ADA compatibility) will usually be deductible.
- Capital Gains
Capital gains are the profit received from selling a home. Normally, the owner will have to pay taxes on these profits, but under certain circumstances, there could be a tax break. Specifically, If the home was used as a primary residence for two of the last five years, the homeowner could keep some profits without any tax obligation. As a married couple filing jointly, they can keep up to $500,000 in capital gains. As a single filer or married couple filing separately, each party can keep up to $250,000 of capital gains without a tax obligation.
This blog is for educational purposes, so please check with your tax preparer for what deductions you qualify for. If you have any questions about getting pre-approved to purchase a home feel free to call us at (760) 930-0569 and one of our loan officers will assist you.