The Tax Benefits of Homeownership
Buying a home is a one of the largest purchases a taxpayer will make in their lifetime. Our tax code incentivizes home ownership by offering several tax deductions that are not available to renters. In addition, it may even be possible to reduce a person's tax bill by owning multiple homes depending upon their use.
Real Estate Taxes
According to the Internal Revenue Service (IRS) Publication 530, property taxes paid to the state or local government may be listed as deductions on the person's federal return. However, it is important to note that only the actual taxes paid can be deducted. If money for taxes is held in an impound account or escrow account, it cannot be listed until it is actually sent to the tax collector. In addition, the taxes levied must be assessed uniformly to all properties in a community, and the proceeds must be used for general community or governmental purposes.
Most homeowners utilize a mortgage to purchase their home. Part of every mortgage payment goes towards the interest accumulated on that home loan. Interest paid can also be deducted. The only exceptions to this are on mortgages with balances of $1 million or more and mortgages used for any purpose other than buying, building or renovating a home. In addition, the mortgage must be secured as a primary residence or a second home.
When paying interest in advance, the deduction may only be taken during the years which the interest would normally become due. If you have taken points, also referred to as discount points, loan origination fees or maximum loan charges, on your mortgage in order to obtain a lower interest rate, these payments count as prepaid interest. The deductions for points must be spread over the full term of the loan. To read more on deducting your home interest and purchase expenses see our article on Interest Expenses, here.
Other expenses related to your mortgage may also be deductible, these include:
- Late payment charges
- Prepayment penalties
- Ground rent - According to the IRS, in some states (such as Maryland), you may buy your home subject to a ground rent. Under this arrangement, you are leasing (rather than buying) the land on which your home is located.
The IRS also states that itemized deductions may be made for qualifying mortgage insurance premiums. The types of mortgage insurance that qualify for this deduction include policies issued by the Veterans Administration (VA), the Federal Housing Administration (FHA), the Rural Housing Administration (RHA) and private insurance companies. Again, if you paid this in advance, the amount must be deducted over the term of the loan or over 84 months from the date the insurance began, whichever is shorter.
Some homeowners may be eligible to receive tax credits for certain energy-efficient home improvements, including the purchase and installation of energy-efficient appliances, windows, doors and insulation. The first of these, called the Non-Business Energy, is worth up to 10 percent of the cost of item(s) with a maximum of $500 ($200 for the purchase of windows). The second is the Residential Energy Efficient, which is up to 30 percent of the total cost of alternative energy equipment (this includes solar water heaters, wind turbines and more).
Breaks for Multiple Homes
If you own a home other than your primary residence, such as a vacation home, tax breaks may still be available for it as well. If the home is not a rental but an actual second home, you can still deduct the mortgage interest. The primary rule used to determine whether this tax deduction may be taken is if you occupied it for at least 14 days or more than 10 percent of the total days it was rented in which case it can still qualify as a residence. Furthermore, if the home was rented for fewer than 15 days in a calendar year, that rental income does not need to be reported. However, If you have a second home or a vacation home that is regularly rented on short-term or long-term leases, then the Internal Revenue Service (IRS) expects you to pay secondary or vacation-home rental tax.
When this home is also used as a personal residence for the greater of 14 days or 10 percent of the total number of days it is rented, you cannot deduct expenses as a rental home. One day of personal use includes any of the following scenarios:
- The home is rented at less than a fair price.
- The home is traded for the use of another home.
- You occupy the home for the day.
- A family member occupies the home without paying a fair price.
Under section 121 of the Internal Revenue Code, up to $250,000 ($500,000 for married couples filing jointly) of the capital gain from the sale of the taxpayer's main home may be excludible. Under section 121 of the Internal Revenue Code, up to $250,000 ($500,000 for married couples filing jointly) of the capital gain from the sale of the taxpayer's main home may be excludible. For more on the home sale gain exclusion see this article.
Home Owners: Know the Difference Between Taxes and Fees
Considering the various tax deductions home owners are eligible for, it can be important to understand the difference between taxes and fees.
A tax is money that a government levies as a percentage of a larger total. There are, of course, different taxes levied by many different government agencies. Some of these include:
- Income taxes. These are imposed by the federal government as well as most state governments (and some municipal governments, such as New York City). They are based on a percentage of a person's income and often "graduated" to greater percentages for higher incomes.
- Sales taxes. These are percentages of commercial transactions collected by state and local governments.
- Property taxes. These are imposed by state, county, and local governments, including school districts. Property taxes are a percentage of a parcel's taxable value, which is usually formulated by the county assessor. A property's taxable value is not necessarily the market value. The percentage of a property's taxable value is assessed by millage rate. "Millage" is a Latin word meaning "thousandth," with 1 mill equal to $1 for $1,000 in taxable value. If the mill rate is 7 and a property's taxable value is $150,000, the property tax bill is $1,050.
One common element to taxes is they're assessed without specific earmarks. Governments levy taxes for their operational budgets.
Fees, however, are directly linked to the cost of providing a service and are generally flat assessments. For instance, the fee a homeowner pays for waste collection is usually the same regardless of home size. Fees can be a significant component within a property tax bill in areas where local governments finance road maintenance, street lighting, sewer/water upgrades and other municipal infrastructure (law enforcement, fire-fighting, and emergency services) through assessment districts rather than property taxes.
The distinction between taxes and fees is important for landowners because, while property taxes qualify for federal and state deductions, this is not available in most cases for fees.
Taxes vs Fees: Why It Matters
Keep this in mind the next time local elected officials, to avoid raising taxes, propose to finance improvements and other benefits with fees. While fees must be directly used for the purpose for which they're assessed, and certainly present a value compared to taxes in many instances, they generally don't present a deduction as with property taxes.