by Nancy Osborne, COO of ERATE®
One of the most profitable tax benefits of home ownership actually relates to the tax saving received when you sell or unload the property. The capital gains exclusion for both single and married individuals amounts to a significant chunk of change. The exclusion can be taken advantage of if you have owned and lived in the home for 2 years during a 5 year period. The 2 year residency requirement need not be consecutive, it must only have been any 2 of the prior 5 years and the exclusion can only be used one time within a 2 year period. The maximum amount of the exclusion is $250,000 for singles and $500,000 for married couples. To calculate your potential gain or loss upon sale you simply subtract the cost basis of your home from the sales price. The cost basis is calculated by adding together both your purchase plus selling expenses along with the costs of any improvements you have made to the property, then subtracting any allowable depreciation expense that may have been taken related to the home (i.e. a home office deduction). That sum is then subtracted from your sales price to arrive at the cost basis from which you would then subtract your qualified capital gains exclusion to determine if you have a net capital gain or loss.
This is an area of home ownership where there are many misconceptions. Mortgage interest is a possible deduction on your tax return but many homeowners overemphasize the impact of this tax break and misconstrue how it really works. The tax break received on mortgage interest is limited by one's federal tax bracket. Suppose you are tax payer in the 25% middle income bracket, that means that for every dollar you pay in mortgage interest, you would save you 25 cents on your federal income taxes. If you are in a higher or lower tax bracket, that would mean saving 35 or 15 cents per mortgage interest dollar spent.
Many new homeowners will use the argument that they needed to purchase a home because they need a tax break. However this argument is not a logical because in reality you are paying out a dollar to receive 25, 35 or 15 cents in exchange. Also many new homeowners' interested in the currently popular “interest only” mortgages employ the same logic to make a case for obtaining this type of loan. They are mistakenly under the impression that if they pay only interest on their mortgage, without paying any principal, they will achieve a mortgage that is completely tax deductible on their federal return. This thinking is simply not accurate.
To utilize the tax breaks of home ownership, you must have enough deductions to justify itemizing them. Yet almost 70% of all taxpayers take the standard deduction and do not itemize. Many homeowners simply don't pay enough in the way of mortgage interest and property taxes to warrant itemizing. But even if you do itemize, note that the tax relief you would achieve through home ownership will only equal the amount by which your write-offs exceed the standard deduction*. The fact that you receive in essence a freebie standard deduction whether or not you fork out a penny in mortgage interest, significantly reduces the net tax benefit of paying mortgage interest for most homeowners. Also note that the declining amount of interest paid on a mortgage loan runs counter to the ever increasing amount of the standard deduction. Because the amount of interest paid on a typical mortgage is highest in the beginning when you are paying the highest ratio of interest to principal on the loan, yet the standard deduction will continue to rise (presumably keeping pace with the rate of inflation) so they are moving inversely, making the standard deduction more valuable to the taxpayer who itemizes at some point.
*Note the standard deduction for 2006 is $6,400 for single taxpayers and $11,300 for married taxpayers filing jointly.
You can completely deduct the points paid (note points are essentially pre-paid interest) on your mortgage loan in the year they are paid or incurred as long as the points were not in excess of points generally paid on a loan in your area. The points must have been paid on a mortgage loan that is used to purchase or construct your primary residence. You can even deduct the points on your loan if they were paid on your behalf by the seller.
Points paid in the course of refinancing a mortgage tied to your primary residence are not fully deductible in the year they are paid or incurred. The deduction of points in this case must be applied evenly over the life of the loan (i.e. on a 30 year loan, 3.33% per year and on a 15 year loan, 6.66%). However there is an exception to this general rule (see Home Improvement Loans below). Also note that when a refinance loan is paid off in full before the deduction is fully realized over the 30 or 15 year period, you can then accelerate the deduction and deduct in full any un-deducted portion of the points yet to be taken on the loan. The exception to this accelerated mortgage points deduction rule applies if you were to refinance the loan again with the same lender. In that case you would simply extend the deduction of the points on the previous loan over the term of the new loan.
Various Fees Associated With a Loan
Fees charged for services connected to the mortgage loan, other than points, such as appraisal, notary, document preparation fees, mortgage insurance premiums and the like are not deductible in either the year they are paid or over the life of the loan.
Home Improvement Loans
You can fully deduct the points paid on a loan used solely to improve your primary residence in the year in which they are paid or incurred. Suppose that you refinance the mortgage on your home and only a portion of the loan is to be used for the purpose of home improvement. In this case you are permitted to deduct the percentage of the points paid from your own funds that correlate directly to the portion used for the improvements.
Second Home Loans
For homes that are purchased or refinanced as second residences, the deduction of points can only occur over the life of the loan. Note if you own more than one second home, only one of the homes would qualify for consideration as a valid second home under IRS guidelines.
IRS Publication 936 covers the topic of The Home Mortgage Deductions: http://www.irs.gov/publications/p936/index.html Consult with your tax advisor to discuss your individual tax situation.
Income or Rental Property
For income or rental property owners, please consult your tax advisor and refer to the IRS Publication below for more information.
IRS Publication 527 covers the topic of Residential Rental Property http://www.irs.gov/publications/p527/index.html Consult with your tax advisor to discuss your individual tax situation.
Nancy Osborne has had experience in the mortgage business for over 20 years and is a founder of both ERATE, where she is currently the COO and Progressive Capital Funding, where she served as President. She has held real estate licenses in several states and has received both the national Certified Mortgage Consultant and Certified Residential Mortgage Specialist designations. Ms. Osborne is also a primary contributing writer and content developer for ERATE.
"I am addicted to Bloomberg TV" says Nancy.