Owning a home is part of the American Dream. Whether you fancy a log cabin in the middle of nowhere, a suburban Cape Cod with a white picket fence, or a downtown condo in the sky, there's just something special about trading in a lease for a deed. But that transition can be difficult - and expensive. It's tough saving up enough money for a down payment and then keeping up with the mortgage payments -- to say nothing of the maintenance costs, which are now all on you!
Fortunately, Uncle Sam has a few tax tricks up his sleeve to help you buy a home, save on home-related costs and sell your home tax-free. Some of them are complicated, limited or come with hoops you have to jump through, but they can be well worth the trouble if you qualify. And during difficult economic times like these, you need all the help you can get. So, without further ado, here are 13 tax breaks that can help you buy a home and prosper as a homeowner.
Using Retirement Funds for a Down Payment
Before you can become a homeowner, you have to scrape up enough dough for a down payment. If you have an IRA or a 401(k) account, you might be able to tap into those funds to help you buy a home. Savers with a traditional IRA can withdraw up to $10,000 from the account to buy, build or rebuild a first home without paying the 10% early-withdrawal penalty -- even if you're younger than age 59½. If you're married, both you and your spouse can each withdraw $10,000 from separate IRAs without paying the penalty. (To qualify as a first home, you and your spouse cannot have owned a home for the past two years.) However, even though you escape the penalty, you're still required to pay tax on the amount you withdraw.
With a Roth IRA, you can withdraw contributions at any time and for any reason without facing a tax or penalty. The IRS has already taken its cut. You can also withdraw up to $10,000 in earnings before age 59½ to help buy a first home without being hit with the 10% penalty for early withdrawals. (Your spouse can do the same.) If you've had the account for five years, the earnings will be tax-free, too.
If you want to pull money out of a 401(k) account to put toward a down payment, you'll have to borrow from the plan. You can typically take out a tax- and penalty-free loan from your 401(k) plan for up to half of your balance, but not more than $50,000. Money borrowed from a 401(k) usually must be paid back (with interest) within five years, but the repayment period for loans used to purchase a main home can be extended. Be warned, though, that you'll have to repay the loan before your next tax return is due if you leave or lose your job. Otherwise, you'll have to pay taxes on the unpaid balance and a 10% early-withdrawal penalty if you're not yet 55.
(Note that, under the CARES Act, people impacted by the coronavirus can borrow more from their 401(k) plan -- up to the lesser of $100,000 or 100% of the account balance -- until September 23, 2020. They are also given an additional year to repay existing 401(k) loans due between March 27 and December 31, 2020.)
Mortgage Points Deduction
You usually have to pay "points" to the lender when you take out a mortgage. In most cases, the points you pay on a loan to buy, build or substantially improve your primary residence are fully deductible in the year you pay them. There are some requirements that must be satisfied -- such as the loan must be secured by your main home -- but you generally don't have to wait to deduct points paid for a standard mortgage.
On the other hand, if you're buying a second home, you can't deduct the loan points in the year you pay them. But you can still deduct them gradually over the life of the loan. That means you can deduct 1/30th of the points each year if it's a 30-year mortgage. That's $33 a year for each $1,000 of points you paid -- not much, maybe, but don't throw it away.
When you refinance, you also typically have to deduct any points you pay ratably over the life of the new loan. However, in the year you pay off the loan -- because you sell the house or refinance again -- you get to deduct all as-yet-undeducted points. There's one exception to this sweet rule: If you refinance a second time with the same lender, you add the points paid on the latest loan to the leftovers from the previous refinancing, then deduct that amount gradually over the life of the new loan. A pain? Yes, but at least you'll be compensated for the hassle.
There's one last catch, and it applies whether you're deducting points in the year you paid them or over the life of the loan. You must itemize to claim the deduction. (Because the standard deduction was nearly doubled by the 2017 tax reform law, most people don't itemize.) Itemizers must report deductible points on line 8a or 8c of Schedule A (Form 1040).
SEE ALSO: 10 Tax Breaks for the Middle Class
Mortgage Insurance Premium Deduction
Homeowners who pay private mortgage insurance on loans originated after 2006 can deduct their premiums if they itemize. (PMI is usually charged if you put down less than 20% when you buy a home.) The deduction is phased out if your adjusted gross income exceeds $100,000 and disappears if your AGI exceeds $109,000 ($50,000 and $54,500, respectively, if you're married but file a separate return).
Look at Box 5 on the Form 1098 you receive from your lender for the amount of premiums you paid during the year. Report the deductible amount on line 8d of Schedule A (Form 1040).
This deduction is set to expire after the 2020 tax year. (However, the deduction has expired and then been extended several times in the past.)
Mortgage Interest Deduction
For most people, the biggest tax break from owning a home comes from deducting mortgage interest. If you itemize, you can deduct interest on up to $750,000 of debt ($375,000 if married filing separately) used to buy, build or substantially improve your primary home or a single second home. (For pre-2018 mortgages, interest on up to $1 million of debt is deductible.) Improvements are "substantial" if they add value to the home, extend the home's useful life or adapt the home for new uses. Basically, additions and major renovations are "substantial," but basic repairs and maintenance are not.
Your lender will send you a Form 1098 in January listing the mortgage interest you paid during the previous year. That's the amount you deduct on line 8a or 8b of Schedule A (Form 1040). If you just bought a home, make sure the 1098 includes any interest you paid from the date you closed to the end of that month. This amount is listed on your settlement sheet for the home purchase. You can deduct it even if the lender doesn't include it on the Form 1098.
(Note that, before 2018, you could deduct interest on up to $100,000 of home-equity loans or lines of credit even if you used the cash to pay for personal expenses, such as paying off credit card debt or buying a car. After the 2017 tax reform law, that interest is no longer deductible. The interest is only deductible now if the loan proceeds are used to purchase, construct or improve your home.)
SEE ALSO: 2020 Election: Joe Biden's Tax Plans
Mortgage Interest Credit
In addition to the mortgage interest deduction, there's also a mortgage interest tax credit available to lower-income homeowners who were issued a qualified Mortgage Credit Certificate (MCC) from a state or local government to subsidize the purchase of a primary home. The credit amount ranges from 10% to 50% of mortgage interest paid during the year. (The exact percentage is listed on the MCC issued to you.) The credit is limited to $2,000 if the credit rate is higher than 20%. However, if your allowable credit is reduced because of the limit, you can carry forward the unused portion of the credit to the next three years or until used, whichever comes first.
To claim the credit, complete Form 8396 and attach it to your 1040. You also need to report the credit amount on line 6 of Schedule 3 (Form 1040). Don't forget to check box c and write "8396" on line 6, too.
There are a number of restrictions and special rules for this credit. For instance, no double dipping is allowed. If you claim the mortgage interest credit, you have to reduce your mortgage interest deduction on Schedule A by the credit amount. If you refinance your original loan, you'll have to get a new MCC in order to claim the credit on the new loan--and the credit amount on the new loan may change. Also, if you sell the home within nine years, you may have to repay all or part of the benefit you received from the MCC program.
Property Tax Deduction
You get hit with all kinds of taxes -- not just income taxes. As a homeowner, one of the additional taxes you're going to have to get used to paying is your local real property tax. The good news is that you might be able to deduct the state and local property taxes you pay on your federal income tax return.
There are, however, a few wrinkles that can spoil this deduction. First, you have to itemize in order to deduct real property taxes. If you do itemize, you can deduct them on line 5b of Schedule A (Form 1040).
There's also a $10,000 limit ($5,000 if you're married but filing a separate return) on the combined amount of state and local income, sales and property taxes you can deduct. Anything over $10,000 is not deductible. That hits homeowners particularly hard in states where income, sales and/or property taxes are on the high end.
SEE ALSO: 8 Steps to Appeal Your Property Tax Bill
Home-Office Expense Deduction
If you're self-employed and work at home, you might be able to deduct expenses for the business use of your home. The home-office deduction is available for homeowners and renters, and it doesn't matter what type of home you have -- single family, townhouse, apartment, condo, mobile home or even a boat. You can also claim the deduction if you work in an outbuilding on your property, such as an unattached garage, studio, barn or greenhouse.
The key to the home-office deduction is to use part of your home regularly and exclusively for your moneymaking endeavor. Pass that test and part of your utility bills, insurance costs, general repairs and other home expenses can be deducted against your business income. You can also write off part of your rent or, if you own your home, depreciation (a noncash expense that can save you real money on your tax bill).
There are two ways to calculate the deduction. Under the "actual expense" method, you essentially multiply the expenses of operating your home by the percentage of your home devoted to business use. The problem with this method is that it can be a nightmare pulling together all the records you'll need to calculate and substantiate the deduction. If you use the "simplified" method, you deduct $5 for every square foot of space in your home used for a qualified business purpose. For example, if you have a 300-square-foot home office (the maximum size allowed for this method), your deduction is $1,500.
Employees who work remotely can't deduct the costs of maintaining a home office anymore (that includes employees working from home during the coronavirus pandemic). Before 2018, employees could claim home-office expenses as a miscellaneous itemized deduction if the costs exceeded 2% of their adjusted gross income. However, this deduction was eliminated by the 2017 tax reform act.
Credits for Energy-Saving Improvements
To encourage the use of renewable energy sources, Uncle Sam will reward you with a tax credit if you install certain energy-efficient equipment in your home. You'll save 30% on new systems that use solar, wind, geothermal or fuel cell power to produce electricity, heat water or regulate the temperature in your home. The credit for fuel cell equipment is limited to $500 for each one-half kilowatt of capacity.
Homeowners going green can also shave up to $500 off their tax bill with another credit by installing energy-efficient insulation, doors, roofing, heating and air-conditioning systems, wood stoves, water heaters, or the like. The credit isworth up to $200 for new energy-efficient windows.
SEE ALSO: 11 Surprising Things That Are Taxable
Deduction of Medically Necessary Home Improvements
You may qualify for a medical expense deduction if you install special equipment in or make modifications to your home for medical reasons. Common examples of medically necessary upgrades to a home include adding ramps, widening doorways, installing handrails, lowering cabinets, moving electrical outlets, installing lifts or elevators, changing door knobs, and grading the ground to provide access to the home. Costs for the operation and upkeep of these upgrades are also deductible as medical expenses if the upgrade itself is medically necessary. However, improvements that simply make your home more elderly-friendly (such as "aging-in-place" upgrades) aren't deductible if they're not medically necessary.
There are some limitations, though. You have to itemize on Schedule A (Form 1040) to claim the deduction, and you can only deduct medical expenses that exceed 7.5% of your adjusted gross income (10% after 2020). The deduction is also reduced by any increase in the value of your property. So, for example, if you spend $50,000 to install an elevator, and that increases your home's value by $40,000, you can only deduct $10,000 ($50,000 - $40,000). And, again, the upgrade must be for a medical reason.
SEE ALSO: 15 Tax Breaks You Won't Believe Are Real
Deduction of Rental Expenses
What if you rent out a part of your home, such as a room or the basement? You'll owe tax on your rental income, but you can deduct expenses for the rental space. Potentially deductible expenses include insurance, repair and general maintenance costs, real estate taxes, utilities, supplies, and more. You can also deduct depreciation on the part of your house used for rental purposes, and on any furniture or equipment in the rented space. You don't have to itemize to deduct the rental-space expenses on Schedule A, either. Instead, you claim them on Schedule E (Form 1040) and subtract them from your rental income.
The tricky part is figuring out how much you can deduct if an expense covers the whole house, such as an electric bill or property taxes. In this case, you have to divide the expense and allocate a portion of it to the rental space. You can use any reasonable method for dividing the expense. For example, if you rent a 200-square-foot room in a 2,000-square-foot house, you can simply allocate (and deduct) 10% of any whole-house cost as a rental expense. You don't have to divide expenses that are only connected to the rented area. For instance, if you paint a room that you rent, your entire cost is a deductible rental expense.
The rules are a bit different if you're renting out a vacation home or investment property. You'll still owe tax on the rental income, and you'll still be able to deduct rental expenses, but there are other methods for calculating those two amounts.
Forgiveness of Debt on a Foreclosure or Short Sale
In tough economic times, more homeowners fall behind on their mortgage payments. In some case, the lender may eventually reduce or eliminate your mortgage debt through a "short sale" or foreclosure. Normally, when a debt is wiped clean, the amount forgiven is treated as income to the debtor. But, when it comes to mortgage debt forgiven as part of a foreclosure or short sale, up to $2 million of discharged debt on a principal residence is tax free ($1 million if married filing separately).
The exclusion only applies to a mortgage you took out to buy, build, or substantially improve your main home. It also must be secured by your main home. Debt secured by your main home that you used to refinance a mortgage you took out to buy, build, or substantially improve your main home also counts, but only up to the amount of the old mortgage principal just before the refinancing.
No tax break is available if the discharge of debt is because of services you performed for the lender, or for any other reason not directly related to a decline in your home's value or your financial condition. In addition, the amount excluded reduces your cost basis in the home.
The exclusion is only available for mortgage debt discharged before 2021.
Capital Gain Exclusion When Selling Your Home
The IRS has a special gift for you when you sell your home: You probably won't have to pay taxes on all or part of the gain from the sale. Your home is considered a capital asset. Normally, you have to pay capital gains tax when you sell a capital asset for a profit. However, if you're married and file a joint return, you don't have to pay tax on up to $500,000 ($250,000 for single filers) of the gain from the sale of your home if you (1) owned the home for at least two of the past five years, (2) lived in the home for at least two of the past five years, and (3) haven't used this exclusion to shelter gain from a home sale in the last two years. So, for example, if you bought your home five years ago for $600,000 and sold it for $700,000, you won't pay any tax on the $100,000 gain if all the exclusion requirements are satisfied. (Unfortunately, if you sold your home for a loss, you can't deduct the loss.) Any profit over the $500,000 or $250,000 exclusion amount is reported as capital gains on Schedule D.
If you don't meet all the requirements, you still might be able to exclude a portion of your home-sale profits if you had to sell your home because of a change in your workplace location, a health issue, a divorce or some other unforeseen situation. The amount of your exclusion depends on how close you come to satisfying the ownership, live-in and previous-use-of-exclusion requirements. For instance, if you're single, you owned your home for two out of the past five years, you did not use the exclusion for another home sale in the past two years, but you lived in your home for only one of the past five years because your employer transferred you to another city, you can exclude $125,000 of profit--half the normal exclusion, because you satisfied only half of the live-in requirement.
Caution: When you sell your home, you might have to pay back any depreciation you claimed for a business use of your home, first-time homebuyer credits if you purchased your home in 2008, or any federal mortgage subsidies you received.
Increased Basis When Selling Your Home
If the capital gain exclusion doesn't completely wipe out your tax bill when you sell your home, you can still reduce the tax you owe by adjusting the basis of your home. Your taxable gain is equal to the sales price of your home, minus the home's basis. So, the higher the basis, the lower the tax.
What you originally paid for the home is included in the basis -- that's good! But you can also tack on various costs associated with the purchase and improvement of your home. For example, you can include certain settlement fees and closing costs you paid when you bought the home. If you had the house built on land you owned, the basis includes the cost of the land, architect and contractor fees, building permit costs, utility connection charges, and related legal fees. The cost of additions and major home improvements can be added to the basis, too (but not basic repair and maintenance costs).
Copyright 2019-2020 The Kiplinger Washington Editors