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HOMEOWNERS TAX GUIDE
U.S. taxpayers have enjoyed specific tax benefits on home ownership since personal income tax was introduced by the 16th amendment in 1913.
While these benefits may not be the primary reasons motivating a person to buy a home, they are still tangible and not available to tenants.
A principal residence, according to IRS, is the place you live or expect to return. You may only have one principal residence at a time. The confusion comes because a taxpayer can deduct the interest and property taxes on two homes on the Schedule A of their tax return.
Only one of the homes is the principal residence and the other is a second home which is an investment property.
Rental property, also known as section 1231 property, is used for income purposes. It includes homes, condos, apartments, shopping centers, office buildings, warehouses and any improved property that generates rental income. It’s eligible for qualified exchanges.
Vacation property is rental property that is used for personal purposes less than 14 days or less a year or 10% of the total time it is rented.
Investment property is real estate primarily held for an increase in value. It can be improved property or vacant land. Income tax on the gain may be deferred through the use of qualified exchanges.
MORTGAGE INTEREST DEDUCTION
Acquisition Debt is the borrowed amount used to buy, build or improve a principal residence or second home. Under the Tax Cut and Jobs Act, mortgages taken after 12/14/17 are limited to a combination of $750,000 on the first and second homes. The mortgage interest on this debt is tax deductible when itemizing deductions.
It is a dynamic number that is reduced with each payment as the unpaid balance goes down. The only way to increase acquisition debt is to borrow money to make capital improvements.
Prior to the new law, homeowners could additionally borrow up to $100,000 of home equity debt for any purpose and deduct the interest when itemizing deductions. Mortgage interest on home equity debt has been repealed through 12/31/2025 unless it is for capital improvements.
Acquisition debt cannot be increased by refinancing. Some confusion occurs because mortgage lenders are concerned in making home loans that will be repaid according the terms of the note and using the home as collateral. That does not include making a tax-deductible mortgage. Another thing that adds confusion to the issue is that the lenders will annually report how much interest was paid in a year but only the amount that is attributable to acquisition debt is deductible.
It is the responsibility of the taxpayer to know what part of their mortgage debt is deductible. The challenge becomes more difficult after a cash-out refinance. Homeowners should keep records of all financing and capital improvements and consult with their tax professional.
A mortgage placed on a home within 90 days of its purchase date is considered acquisition debt. This could be an important thing to be aware of because occasionally, a buyer will pay cash for a home fully intending to put a mortgage on the home later and expect to deduct the interest. If a mortgage isn’t placed on the home within the first 90 days, the acquisition debt is considered zero.
Points are a financing term representing one percent of the mortgage. If a $100,000 mortgage had three points attached to it, it would be 3% of the $100,000 or $3,000.
Points are considered pre-paid interest and therefore deductible in some situations.
Points are deductible by the buyer when they are paid to buy, build, or improve a principal residence. The points may be paid by the buyer or the seller. Points are considered paid by the borrower, if the amount paid in earnest money, down payment, or impounds are equal to or greater than the amount of points paid.
Points are amortized over the life of the mortgage if they are used to refinance a principal residence. If $3,000 is paid in points to refinance a home for 30 years, the homeowner can deduct $100 per year in interest.
The balance of points can be deducted in the year the mortgage is paid in full.
Points paid by the seller for the benefit of the buyer may not be deducted as interest by the Seller. The Seller can treat the points as any other selling expense to arrive at the net selling price of the property.
Points are not deductible in full when a home is refinanced. Only the portion of the points that represent new borrowed funds used to buy, build or improve the home would be deductible. The balance of the points paid on a refinance would be deducted ratably over the life of the mortgage.
STANDARD OR ITEMIZED
Taxpayers can decide each year whether to take the standard deduction or their itemized deductions when filing their personal income tax returns.
Beginning in 2018, the standard deduction, available to all taxpayers, regardless of whether they own a home, is $24,000 for married filing jointly and $12,000 for single taxpayers. Let’s look at an example of a couple purchasing a $300,000 home with 3.5% down at 5% interest. The first year’s interest would be
$14,630 and property taxes are estimated at 1.5% of sales price would be $4,500.
The interest and property taxes would provide a combined total of $19,130 which is less than the $24,000 standard deduction. Unless this hypothetical couple has more itemized deductions like charitable contributions, they would benefit more from taking the standard deduction.
If the mortgage rate were at 8%, the combination of taxes and interest would be almost $28,000 which would make itemizing the deductions more beneficial.
Property taxes on a principal residence and a second home can be itemized deductions on Schedule A but have been limited under the TCJA of 2017. The limitation is referred to as “SALT” and allows an itemized deduction of up to $10,000 for the total of state and local property, income or sales taxes. This $10,000 limit applies for both single and married filers and is not indexed for inflation.
Tax professionals will compare the itemized or standard deduction alternatives to determine which one will benefit the taxpayer most.
EXCLUSION OF GAIN ON PRINCIPAL RESIDENCE
Homeowners can exclude up to $250,000 of the gain on their principal residence if single and up to $500,000 if married filing jointly. During the five-year period ending on the date of the sale, the taxpayer must have:
» Owned the home for at least two years
» Lived in the home as their main home for at least two years
» Ownership and use do not have to be continuous nor occur at the same time
During the two-year period ending on the date of sale, the taxpayer is not eligible if they excluded the gain on sale of another home.
If the gain on the sales exceeds the exclusion amount, the balance is taxed at the long-term capital gains rate. Capital assets, such as a home, that are owned for more than 12 months are subject to the favorable long-term capital gains rate which is lower than the ordinary income rate or marginal tax bracket.
HOME RECEIVED AS INHERITANCE
The basis of the home becomes the fair market value on the date of the decedent’s death as established by the executor with the aid of an appraisal or letter of value from a licensed real estate professional. The “stepped up” basis benefits the person inheriting the home by eliminating the gain because the basis would equal the fair market value.
Example of Home Received as Inheritance
Decedent’s basis in home: $100,000
Fair market value of home at time of death: $250,000
Stepped up basis in inherited home: $250,000
Potential gain avoided: $150,000
Surviving Spouse Example
Basis in jointly owned home $100,000
Fair market value of home at spouse’s death $200,000
Surviving spouse’s new adjusted basis $150,000 SALE OF HOME BY SURVIVING SPOUSE
Special consideration is made by IRS for the sale of a jointly-owned principal residence after the death of a spouse. He or she may qualify to exclude up to $500,000 of gain instead of the $250,000 exclusion for single people if certain requirements are met. The sale needs to take place no more than two years after the date of death of the spouse.
Surviving spouse must not have remarried as of the sale date.
The home must have been used as a principal residence for two of the last five years prior to the death.
The home must have been owned for two of the last five years prior to the death. Survivor can count any time when spouse owned the home as time they owned it and any time the home was the spouse’s residence as time when it was their residence. Neither spouse may have excluded gain from the sale of another principal residence during the last two years prior to the death.
If you have been widowed in the last two years and have substantial gain in your principal residence, it would be worth investigating the possibilities. Time is a critical factor in qualification. Contact your tax professional for advice about your specific situation. See IRS Publication 523 – surviving spouse.
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More Useful Guidelines and Information Including:
HOME RECEIVED AS A GIFT
THE TAX DIFFERENCE IN SECOND HOMES
HOMEOWNER'S TAX WORKSHEET
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