When you consider buying a home, you may be overwhelmed by the costs involved. In addition to the purchase price, you are responsible for mortgage interest, real estate taxes, closing costs and any necessary home improvements. While buying a home is a big decision and one of the most significant investments decisions you will make, there are many tax benefits you could take advantage of. Below you will find a detailed explanation of the tax benefits you should look out for as a homeowner.
There is a notable distinction between a tax deduction and a tax credit, as these are often confused. A tax deduction lowers your taxable income, whereas a tax credit reduces your tax liability (the amount of tax you owe). The tax deductions listed are only available if you itemize deductions on your Schedule A (Form 1040). You cannot apply these deductions if you opt to take the standard deduction. Read more on the distinction between the standard and itemized deductions here. When assessing these tax benefits, consider which items are deductions and credits.
There are many different tax deductions that individuals can claim to reduce their tax liability. Some of the most common deductions include charitable donations, medical expenses and home office expenses. Additionally, there are several itemized deductions available for homeowners.
Real estate taxes
State and local real estate taxes are deductible on your federal income tax return on Schedule A. However, only some people can deduct the total amount of real estate taxes paid during the year. The Tax Cuts and Jobs Act of 2017 limited the State and Local Tax (SALT) deduction to $10,000 for single taxpayers and married couples filing jointly ($5,000 for married taxpayers filing separately). Therefore, you can only deduct $10,000 of state and local taxes paid, including income, sales and property tax.
For example, if you paid $6,000 in state income taxes and $8,000 in real estate taxes, you can only deduct $10,000 on your tax return even though you paid $14,000 in state and local taxes.
The mortgage interest deduction is one of the most popular tax deductions and allows homeowners to deduct the interest they pay on their mortgage from their taxable income. However, it's important to note that you can only deduct the interest expense, not the mortgage principal payment. To take advantage of this deduction, you will need to review box 1 of Form 1098, which you should receive from your mortgage lender if you paid more than $600 in mortgage interest during the year. If you paid less than $600 in mortgage interest, you wouldn't receive a Form 1098, but you can still deduct your mortgage interest by attaching a statement to your tax return.
It's important to note that you can only deduct mortgage interest on the first $750,000 ($375,000 if married filing separately) of indebtedness.
Mortgage points, also known as loan origination fees or loan discounts, are fees paid to the lender at closing to lower the interest rate on the loan. One point equals one percent of the loan amount. If you itemize your deductions on Schedule A, you may be able to deduct the mortgage points paid on your home mortgage. To deduct mortgage points, you must pay the points in cash when you get the loan and use the loan to buy or build your main home. The number of points reported on Form 1098 should be included on line 8a of Schedule A. You can deduct the total amount of points paid in the year of purchase if you meet all three of the following requirements:
You pay cash when you get the loan.
You use the loan to buy or build your main home.
The settlement statement correctly reports how many points were paid.
If you do not meet these requirements, you may have to spread the deduction for mortgage points over the life of the loan. For more information, see IRS Publication 936, Home Mortgage Interest Deduction.
Medical Home Improvements
If you've made any improvements to your home and their primary purpose is medical care for you, your spouse, or your dependents, you may be able to deduct those expenses come tax time. Improvements can include widening doorways or adding railings and ramps. Not only can these updates help make day-to-day life easier, but they can also increase the tax basis of your home. However, there are limitations on how much you can deduct. According to Schedule A lines 1-4, you can only deduct the amount that the medical home improvement expenses exceed 7.5% of your AGI (adjusted gross income). Keep track of all improvement costs and paperwork to deduct all possible expenses.
Selling a Home
When it comes time to sell a home, you may think you’ll have to pay tax on a large gain if you are able to sell it for a higher price than you paid for it. Usually, that isn’t the case. If you owned and lived in the home for a total of two of the five years before the sale, then $500,000 of the gain is tax-free ($250,000 if filing single). If your profit exceeds the $500,000 limit (or $250,000), then the excess needs to be reported as a capital gain on Schedule D of your Form 1040.
A tax credit is a dollar-for-dollar reduction in the taxes you owe and can be claimed regardless of whether you itemize your deductions or take the standard deduction. There are two types of tax credits: refundable and nonrefundable. A refundable tax credit can be refunded even if you don't owe any taxes. A nonrefundable tax credit can only reduce your tax liability to zero. There are many different tax credits available that can save you significant money on your taxes. Be sure to research the various available tax credits to see if any apply to you.
Residential Energy Efficient Property Credit
The Residential Energy Efficient Property Credit is a popular incentive for homeowners to install certain energy-efficient insulation, windows, doors, roofing, and similar energy-saving improvements. For the tax year 2022, the credit is worth 10% of the costs of installing these upgrades with a lifetime limit of $500. However, starting in 2023, due to the Inflation Reduction Act, the credit will equal 30% of the costs for all eligible home improvements made during the year, and the lifetime limit will be replaced by a $1,200 annual limit. If you spread out your qualifying home projects, you can claim the maximum credit each year. You'll need to file Form 5695 with your tax return to claim the credit.
Mortgage Interest Credit
A mortgage interest credit allows you to claim a federal tax credit for a portion of the interest you pay on your mortgage. To be eligible, you must have a qualified mortgage credit certificate issued by a state or local government agency under a qualified mortgage credit certificate program. You must also file Form 8396 with your tax return to claim it. The amount of the credit is typically based on the interest you paid during the year, and it can help to offset some of the costs of owning a home. If you think you may be eligible, consult your tax advisor to see if you meet the requirements.
There are several deductions and credits available to homeowners, but certain limitations may prevent you from taking advantage of each. Calculating these tax benefits can significantly impact the actual annual cost of owning a home, so take note before you sign on the dotted line and get the keys to your new place. Our tax team is here to help. Contact us with any questions.
Contributor: Claire Donahoe, Accounting Intern
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