If you missed Part One in the home ownership mini-series, stop. Go back. Read it. If you have completed the required reading, then we are going to soldier on to tax benefits of owning a home.
#3 Tax Benefits
Homeowners enjoy a number of tax benefits, including the mortgage interest deduction, the real property tax deduction, and the exemption from tax for capital gains realized on the sale of a qualified principal residence. There are a couple others I won’t discuss: mortgage insurance premiums can be deductible, as well as points purchased in connection with your home loan.
The mortgage interest deduction applies to interest you pay on a loan secured by your home (main home or a second home). The loan may be a mortgage to buy your home, a second mortgage, a line of credit, or a home equity loan. You can deduct home mortgage interest if: (1) you itemize deductions; and the mortgage is a secured debt on a qualified home in which you have an ownership interest. Secured debt means if you don’t pay you lose your house. Thus, a mortgage is almost invariably secured debt because if you don’t make your payment the lender can take back possession of your home.
The real property tax deduction is exactly what it sounds like. You can deduct real property taxes you paid during the year to state and local governments. Real property tax is usually between 1% and 1.5% of the assessed value of your home. For reference, my property tax rate is 1.36%. You can check yours by simply dividing the real property tax paid during the year by the assessed value of your home for the same year, then multiply by 100 for the percentage.
Last, when you sell a capital asset, typically, you pay capital gains tax of between 0% and 20%. Not so fast Batman! A house is treated differently. When you sell a qualified principal residence, $250,000 of capital gains is exempt from capital gains tax. If you are married, double that to $500,000. This is huge because stock or other assets you are almost invariably going to pay capital gains tax upon realizing a capital gain.
At any time there are a number of tax breaks for homeowners. Talk with your real estate professional or lawyer if you have specific questions concerning your home or your taxes.
Quick Aside: Calculating Capital Gains
Capital gain is calculated by taking the amount you realized on the sale of your home (i.e. sale price) and subtracting your basis (i.e. the amount of money you paid for the home plus amounts paid for improvements). For example, if you buy your home for $250,000, do $50,000 of remodeling, and then sell it for $600,000, you would have a capital gain of $300,000. If you lived in the home for two out of the last five years, then the residence is considered your “principal” residence. If you are married, you owe no tax because you have a $500,000 exemption available. If you are single, then you would pay capital gains tax on $50,000 (i.e. the amount in excess of your exemption) resulting in actual tax owed of $10,000 (20% capital gains rate * $50,000 capital gain).
I Have a Few Deductions from Owning a Home, So What?
Let’s translate your deductions into real dollars saved. A key to this discussion is determining whether you itemize your deductions or take the standard deduction. The standard deduction is free to any taxpayer. You don’t even have to prove it. The IRS just gives it to you. In 2016, the standard deduction for single persons was $6,300. What about for married couples filing jointly? Daily double it for $12,600. So if you don’t have deductions that exceed $12,600, then the mortgage interest deduction is useless to you. So question #1, did you itemize your deductions last year?
Here is a list of deductions that I have each year (numbers are falsified go make you think I’m more charitable than I really am):
- Charitable gifts – $500
- Health Savings Account Contribution – $600
- Contribution to Traditional IRA – $1000
- Medical/Dental Expenses – $1000
- Real Property Taxes – $700
- State and Local Income/Sales Tax – $500
- Unreimbursed Job Expenses – $0
If these amounts total more than your standard deduction, then you should itemize your deductions. If they don’t, then the all of the individual deductions are not actually reducing your tax or increasing your refund.
If you itemize your deductions, beautiful! So what does a deduction translate into for you as far as tax savings? Easy – take the amount of the deduction and multiply by your highest tax rate. If you are in the 15% tax bracket, then a $5,000 deduction will result in you saving $750 of income tax. The formula is easy: Amount of Deduction * Your Highest Tax Rate = Cash Back in Your Vacation Fund.
Key takeaway on the deduction front: if you don’t itemize, then the deductions are not helping you one penny (doesn’t mean you shouldn’t pay, just keep in mind that the deduction isn’t why you are paying mortgage interest, saving in an HSA, paying dental bills, or paying your real estate taxes).
Nice work! You are 2/3rds of the way through the home ownership mini-series. Come back tomorrow for another filling of financial freedom from the fountain of finance!