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Tax benefits of owning your home.
Home Buying System™
Among the many benefits your home gives you, you’ll also find it provides major tax benefits every year. The benefits available through ownership of your home or a second residence primarily take the form of steady tax deductions year after year. All specific concerns about your tax obligations should be answered by a qualified tax consultant.
Interest deductions
Mortgage interest on your primary residence In general, the interest paid to your lender as part of your mortgage payment is tax deductible. This deduction, known as “qualified
residence interest,” is rather straightforward. Your lender will notify you of the amount of interest you paid during the tax year, and you will claim that amount as a deduction on your tax return.
To deduct the interest paid on yourmortgage, you must itemize deductions
rather than take the standard deduction. For many homeowners, the combined deductions for mortgage interest and property taxes easily exceed the standard deduction.
During the first years of your mortgage, most of your monthly payment goes toward paying the interest with very little going toward the principal.
For example, with a 30-year fixed-rate mortgage of $85,000 at 8 percent, you’ll pay $6,776.02 in interest and only $717.66 in principal the first year. Sizable interest deductions will continue throughout much of the life of the loan — in fact, only in the 22nd year of a 30- year mortgage will the principal payments be larger than the interest payments.
Potential limits to interest deductions
Under the Omnibus Budget Reconciliation Act of 1990 (OBRA), otherwise-allowable itemized deductions — including mortgage interest and real estate taxes — are
reduced by the lesser of: (1) 3 percent of the excess of adjusted gross income over $126,600 in 1999 (assuming a married couple is filing a joint federal income tax return. This amount changes annually based on inflation.) or (2) 80 percent of the amount of itemized deductions otherwise allowable for the year.
Within guidelines, you may borrow against your home and deduct the interest as qualified residence interest. Congress has set limits on two types of such home indebtedness, which are handled separately.
You may deduct all interest as qualified residence interest as long as the acquisition indebtedness (the total debt for acquiring, constructing, or making substantial home improvements on your principal residence and second home) does not exceed $1 million. An example of this indebtedness occurs in refinancing, but only if the principal balance and loan term do not exceed the terms of the original mortgage. (Interest paid on an increased mortgage amount as a result of refinancing would fall into the home equity indebtedness category.)
Home equity indebtedness refers to other debt that is secured by your principal and second home. Interest may be deducted as long as this debt does not exceed $100,000. Note: Even if your indebtedness is well below these ceilings, in order to claim all the interest you paid, the total indebtedness on your home must not be greater than your home’s fair market value.
Other mortgage-related interest The IRS treats two mortgage-related payments as “interest,” even though you might not normally consider it to be so. One is a prepayment penalty that you incur when you pay off your mortgage early. This is considered to be an interest payment and is deductible. Also, if you borrow from your mortgage lender to make a mortgage payment that’s past due, the interest on that payment isn’t deductible until the borrowed amount is repaid.
Points
The IRS divides the money you pay at closing into two categories — the amount paid for the use of money, or prepaid interest, and money paid for services performed. Prepaid interest, characterized as points, is generally deductible, and service fees are not. The money you pay at closing in loan origination fees, maximum loan charges, premium charges or discounts — points — may be considered interest and may be deductible in the year in which you pay it.
Fees paid on Veterans Administration guaranteed and FHA-guaranteed loans are not considered prepaid interest but are treated as service fees. In general, if you’re refinancing, points paid at closing of the mortgage must be spread out over the life of the loan and only a portion of them may be deducted each year. Note: Consider increasing your tax savings by paying all or almost all the points in return for some concession from the seller. Points paid by the seller aren’t deductible as interest by the seller, though they are considered a cost of the sale which, in turn, reduces the amount gained or increases a loss on the sale. Those seller-paid points can be deducted by the buyer, however.
Mortgage interest on a second or vacation home
You may deduct qualified residence interest on a second or vacation home, and how you use that home dictates how the interest deductions work. The interest paid on the second home may be considered (1) qualified residence interest, (2) interest expense on a rental property or (3) investment interest.
Requirements for claiming interest deductions include:
No rental income: If you don’t rent your second home for more than 15 days, try to sell it during the year or even use it personally, the interest, subject to limitations, can be deductible.
Renting less than 15 days: Your income from the rental is tax-free. You may deduct mortgage interest and property taxes, but no other rental expenses. Mortgage interest would be deducted as qualified residence interest.
Renting (and trying to sell) while personally using home: To deduct the interest, your personal use of the home must exceed a certain number of days during the year — the greater of either 14 days or 10 percent of the total number of days the home was rented. Your rental income minus the allocable portion of property taxes and mortgage interest will give you the amount you may deduct for expenses and depreciation. Note: The deductions you may claim for the time you rented the home are
determined by a formula that can vary. Discuss this formula for your specific situation with a tax advisor.
Renting and using your home personally without meeting the personal use requirements: You may not consider this property your second residence if you didn’t use it for the required amount of time. Technically, the home would be considered a rental
property and governed by rental property laws.
In general, you may claim rental expense deductions only up to the amount of your income from the rental property. There is an exception to this rule, and your tax advisor should be consulted in this situation. Note: Some rental activities are defined as passive activities and others imply active participation — and the deductions for each situation vary. Discuss the use of this type of property with a tax advisor to determine what deductions apply.
Real estate tax deductions
As long as you itemize deductions, your property tax payments can also provide a tax benefit.
Property taxes
Typically, a portion of your monthly payment goes into an escrow fund to pay your property taxes. At year’s end, the lender sends a statement showing how much property tax was actually paid. That number is the amount you may deduct — not the amount you paid into the escrow fund. A deduction for property taxes is taken from your adjusted gross income, and you must itemize deductions in order to claim it. Property taxes in the year of sale
The law assumes that you, the buyer, paid the property taxes from the date of sale until the end of the “real property tax year” (the period of time in which the tax is accrued — which may or may not follow the calendar year). Regardless of the agreement you make
with the seller about paying all or a portion of the tax bill, the law assumes the property taxes were imposed on you from the date of sale. You cannot deduct the real estate taxes that the seller has not yet paid.
Special assessment taxes, local benefit taxes
If a special assessment would increase the value of your property (such as paving a street or adding a sidewalk), you can’t claim a deduction. However, if part of the tax is for maintenance or for interest related to the project, you can claim a deduction as long as you can prove for what the municipality used the money.
Transfer or stamp taxes, mortgage recording taxes
In some areas, transfer or stamp taxes are levied when certain types of property are transferred through a sale or gift. These taxes or a mortgage recording tax are not deductible.
Deductions for Casualty Losses
A deduction for a casualty loss can be taken for many types of personal property, including the home. To qualify, you must have experienced a casualty recognized by the IRS such as fire, tornado, storm or some other event of sudden, unusual and unexpected causes. You can’t claim a deduction for something that has occurred over a long period of time, such as damage from termites or rust. To determine whether you have a casualty loss claim, you must first determine the amount of the loss. The IRS considers this to be the lower of two different measurements — the decrease in fair market value of
your home or the adjusted basis in your home at the time of the damage.
For the amount of loss, you must subtract the money you received from your insurance company and $100. At the end of the year, you can add up all casualty and theft losses, claiming as an itemized deduction whatever portion of that total amount exceeds 10 percent of your adjusted gross income. Note: If you’re insured for the loss, you must file a claim with your insurance company before you can take a deduction or a casualty loss on your tax return.
Deductions for special uses of your home
As long as you meet certain requirements, you can take additional deductions when you use part of your home for business or rental.
Business use
The IRS is very specific about requirements for deductions for business uses of your home (or separate buildings such as a garage or detached guest house). Key requirements include:
You must use that portion of your home exclusively for business.
You must use it on a regular basis.
Your home office must be your “principal place of business” or the place of business used by your clients, customers or patients during the normal course of business. Your home office can also qualify as your principal place of business if you use it exclusively and regularly to conduct administrative or management activities of a business and if there is no other fixed location of the business where you conduct substantial administrative or management activities or management activities of the business.
If you’re employed, the business use of your home must be for the convenience of the employer. In most cases, no portion of the house used for business can be used for
personal use. Some exceptions include care of children, the elderly, persons with disabilities and other services for which you meet specific licensing requirements. If you meet the IRS requirements, the deductions you can claim include the business area’s proportionate share of mortgage interest, property taxes, casualty losses and operating and maintenance expenses such as utilities, hazard insurance, mortgage insurance and depreciation.
Several other items within the requirements are worth noting.
Depreciation: A home office that was placed in service after 1993 is depreciated using a straight-line method — depreciated in equal amounts each period over a total period
of 39 years.
Limits: The total amount of deductions that you may claim cannot exceed your net income.
Carry over: Deductions that exceed your net income aren’t lost forever. The excess deductions may be carried forward into the next year’s tax return — a process that can go on indefinitely until all deductions have been used.
Renting part of your home: If you live in part of your home and rent out another part of it such as an attic bedroom, you may be able to deduct the proportionate share of home expenses (such as mortgage interest, property taxes, utilities if paid by you and hazard insurance) as rental expense. In addition, you may deduct expenses directly related to the rental, such as painting. You may deduct only the amount of depreciation up to your rental income minus the allocable part of property taxes and mortgage interest payments, other business expenses and homerelated expenses.
Residential rental property placed in service after December 31, 1986, follows a straight-line depreciation method over a 27.5-year life.
Note: Tax laws governing rental and business use of your home contain many requirements and restrictions. Seek advice from a qualified tax professional to make sure you meet the requirements.
Tax provisions that help the seller
Selling your home at a profit doesn’t have to mean giving up your tax benefits.
When you have a gain on the sale of your home, you may not have to pay taxes. Instead, you may be able to exclude part or all of the gain on the sale of your principal residence.
Qualifying for tax benefits
Though the place you choose to move to after you sell your home will be based on considerations other than taxes, you should be aware of the tax implications of your move.
When you sell your home, you may be able to change the way you receive payment. Trade concessions on your contract for sale that may help minimize the tax, or simply plan better if taxes are due.
Exclusion of gain on sale of your personal residence
New Tax Law
New tax laws have replaced the old “rollover” rules that have allowed taxpayers to defer the gain on the sale or exchange of a principal residence to the extent that the proceeds of the sale are applied to a replacement residence within two years. The new tax laws have also replaced the once-in-alifetime $125,000 exclusion on the sale of a principal residence for taxpayers age 55 and over.
Effective date: The new exclusion provisions apply to sales and exchanges of a personal residence after May 7, 1997.
Exclusion of income: Under the new tax law, you are permitted in certain cases to exclude from taxable income up to $250,000 of gain realized ($500,000, in general, for married couples filing a joint return) on the sale or exchange of property that has been used as your principal residence.
Ownership and Use Requirement
This exclusion is allowed each time an individual who sells or exchanges their principal residence meets the defined eligibility requirements, but generally no more than once every two years.
To qualify for the exclusion, you must have:
owned the property for at least two years, and
used the property as your principal residence for two years during the last five year period.
Partial Exclusion
You are entitled to a “pro rata” amount of the exclusion if you fail to meet either of the two-year requirements by reason of a change in employment, health, or unforeseen circumstance. In such cases, the amount of the exclusion you are entitled to is a ratio of the amount that would have been allowed if the twoyear requirements had been met. The ratio is the aggregate amount of time you have owned and used the property
as your principal residence during the five-year period, or, if shorter, the amount of time since the most recent sale or exchange to which the exclusion applies bears to two years.
Amount of Exclusion
$500,000 Exclusion: Married couples filing joint tax returns can exclude $500,000 on the sale of a principal residence where:
either spouse meets the ownership requirement;
both spouses meet the use requirement; and
neither spouse has sold a principle residence in the last two years subject to this exclusion.
$250,000 Exclusion: In the following situations you can exclude $250,000 on the sale of a principal residence:
Married couples who do not share a principal residence are each entitled to an exclusion of $250,000.
A single individual who marries someone who has used the exclusion within two years prior to the marriage.
Single individuals.
Note: Once both spouses satisfy the eligibility requirements and two years have passed since the last exclusion was allowed to either spouse, a full $500,000 would be available for the next sale of their principal residence, if they are filing joint tax returns.
Who Benefits
Most homeowners will benefit from the new tax rules, such as: older sellers who have more than $125,000 of appreciatio on their homes and sellers who want to move to a less expensive home. But not everyone will benefit from the new rules that apply to the sale of a principal residence. Sellers of any age having more than $250,000 or $500,000 of home profit will have to pay tax on the excess gain (at applicable capital gains tax rates). The old tax law’s rollover rules might have deferred the immediate tax under these circumstances.
Did you have a gain?
Figure your tax situation on the sale of one home and the purchase of another by working your way through three important questions.
To determine whether you realized a gain, you must first figure out what you actually made on the sale of your home. Subtract selling expenses such as commissions, points, transfer or mortgage recording fees, legal fees and advertising from the sales price.
Next, look at what your home cost you — the adjusted basis. Beginning with the price you paid for the house, add any money you spent on major capital improvements such as replacing a roof, landscaping, etc. Also add any special assessments you paid such as you share of the cost of paving a street. Then subtract any gain postponed from any previous residences, any deductible portion of casualty losses, or energy credits.
Determine the bottom line by subtracting your adjusted basis from the amount you reaized on the sale. If the number is positive, you realized a gain; if it’s negative, you sustained a loss. If you came up with zero or a loss, you have no tax consequences in the year of the sale.
More home sale situations
Other special rules apply:
You can elect not to have the exclusion apply to any sale or exchange.
Certain periods an individual resides in a nursing home on account of physical or mental incapacity are included as part of the two-year use requirement if certain other rules are met.
An individual whose spouse is deceased on the date of the sale of the property can include the period the deceased spouse owned and used the property before death.
An individual is treated as using property as his or her principal residence during any period of ownership while the individual’s spouse or former spouse is granted use of the property under a divorce or separation instrument.
In the case of stock held as a tenantstockholder in a cooperative housing corporation, the ownership requirement applies to the holding of such stock and the use requirement is applied to the house or apartment the individual is entitled to occupy as a stockholder.
Where a taxpayer acquires his or her residence in a transaction covered by the prior rollover rules, the periods of ownership and use of the prior residence are taken into account in determining ownership and use of the current residence.
Installment Financing: If the buyer of your home pays over a number of years, the gain that is not excluded under the new tax laws will be reported under the installment method. The gain in excess of the $250,000 or $500,000 exclusion will be taxable as payments are received over the term of the note.
Lump sum: If you receive a lump sum payment for your home and can’t exclude it under the tax limitations, you must pay taxes on the excess gain in the year you receive the payment.
You experience a loss on the sale: If you don’t realize a gain in the sale of your home, you won’t be able to take a deduction for the loss. However, you can claim a deduction for part of the loss if you used part of your home for business at the time of the sale. You may also claim loss by converting your home to other uses, prior to the sale, if you expect a loss. Consult a tax advisor for advice in this situation.
Special tax provisions that may affect you
If one of these situations affects you, consult a tax expert for further advice.
Taxes and condominiums
Below-market interest rate loans, loans with no interest.
Transfer of property in divorce settlements
Sale-leaseback arrangements
Our special thanks to KPMG LLP for giving considerable time and energy to ensure the accuracy of the tax information presented. The tax information contained herein is general in nature and based on authorities that are subject to change, both retroactively and/or prospectively. Applicability to specific situations is to be determined through consultation with your tax advisor.
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