By RateMarketplace.com Staff
Whether it's a million-dollar mansion or a lakeside bungalow, Uncle Sam offers many tax incentives on U.S. real estate that can sharply cut property ownership costs. This mortgage guide explains the various real estate tax deductions available to homeowners including points, mortgage expenses, property taxes, and capital gains credits associated with a home sale.
From the moment a home sale closes to the property tax bills paid for years to come, the cost of home ownership can be significantly reduced by taking advantage of tax deductions and credits that can run tens of thousands of dollars a year. U.S. home sales are driven in large part by the tax benefits of owning a house vs. renting.
Virtually all housing types qualify for tax breaks -- from single-family homes and townhouses to condos, co-ops and mobile homes. The deductions extend even to interest on loans for boats and recreational vehicles, which tax codes treat like vacation homes if they have cooking, sleeping and bathroom facilities.
To qualify for the varied tax advantages, homeowners who may have been taking the standard deduction on their returns have to itemize. Below is a look at expenses that qualify for real estate tax deductions and credits.
"Points" on a mortgage loan are an extra amount paid at closing to "buy down" the loan's interest rate. One point is equal to 1% of the total loan value and might buy a 0.5% interest-rate reduction on a 30-year-fixed mortgage. Because you're essentially pre-paying mortgage loan interest with points, you get to deduct them on a purchase or construction loan for your primary residence.
Additionally, homeowners who refinance an existing mortgage or mortgages into a lower-rate loan can deduct any points paid again -- though the deduction must be prorated annually over the life of the loan. If the homeowner takes "cash out" during refinancing for home improvements, the percentage of points attributable to that amount are fully deductible that year, with the rest amortize over the life of the mortgage. Deductions for points paid on a second home loan must always be amortized.
The most significant financial benefit of home ownership is seen on a monthly mortgage statement. The interest paid to the lender generally dwarfs the remainder of the payment, which includes a principal amount applied to pay down the loan balance and perhaps monthly set-asides for property tax and home insurance payments. The IRS allows taxpayers to deduct mortgage interest on loans up to $1 million -- which covers the vast majority of U.S. homeowners -- and limits the deduction on amounts beyond that.
Along with the tax break on a first mortgage, homeowners also can deduct interest paid on a home equity loan or a home equity line of credit -- regardless of whether the money is spent on home improvements, buying a car or paying down credit cards. The distinction: Taxpayers can deduct the interest on up to $100,000 of home-equity borrowing for general purposes and all the interest (up to the $1 million loan limit) for home additions and remodeling.
Mortgage tax breaks extend also to vacation homes, whether that's an ocean-view condo or a mountain cabin. The property need not remain vacant all year to maintain the deduction -- you can rent it out as well. You must spend at least two full weeks vacationing at the property or at least 10 percent of the time you rent it out, whichever is a longer period. In other words, if you rent the home out six months of the year (say 183 days), you must then spend at least 18 days vacationing there.
After the mortgage-interest deduction, the next biggest tax benefit is the deduction for state and local property taxes. The rationale is that federal and state governments should not impose an income tax levy on a homeowner's real estate taxes. In many states with high property taxes, this deduction can easily run $5,000 or more a year.
Real estate taxes are fully deductible regardless whether they're imposed by a state, county or municipal government. And you can deduct taxes on all your residential real estate -- rather than only on your primary and second home as it is with the mortgage tax deduction.
Along with deductions for mortgage interest and property taxes, homeowners also qualify for a huge tax break when they sell their houses. Individuals are not required to pay so-called capital-gains taxes on up to $250,000 in profit on a home sale and the waiver rises to $500,000 for married couples.
The caveat is that, to qualify, the homeowner(s) must have lived in the house at least two of the last five years prior to the sale. The tenure could be incremental -- six months at the start, a year in the middle and six months at the end -- but it must add up to a full 730 days.
Because there's no limit on the amount of times you can utilize this tax break, many second-home owners and investors in rental properties will take advantage of it when they sell their primary residence, then move into their vacation property or vacated rental home for two years to again claim that substantial tax break.
Should you have to sell your property before two full years are up, you can still qualify for the tax break on a prorated basis if the reason for the sale is due to job loss, a health problem or significant unanticipated events such as death, divorce or even the birth of twins, which might render the house too small for the family.
Be sure to hold onto all receipts for improvements you make to your property. Those expenses increase your "cost basis" for tax purposes. For example, if you bought a house for $250,000 and added a $100,000 addition, the basis would be $350,000. You could then sell the house for up to $600,000 with no capital-gains tax. In the absence of receipts for the work, $100,000 would be subject to capital gains tax.
Additionally, self-employed people who work out of their homes can take a so-called home-office deduction. This requires being able to document what percentage of the house is used for business purposes. Take note: The IRS often closely scrutinizes this frequently abused deduction.
It also bears noting several expenses that taxpayers frequently claim on their tax returns that are not deductible and will be disqualified by the IRS. They include general closing costs, homeowner's and private-mortgage insurance (generally required with less than a 20% down payment) and homeowner-association fees.
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