The tax deadline has come and gone and most folks are breathing a sigh of relief, at least until next year. No one likes to pay taxes. There is even an entire industry that has grown up around helping people legally avoid paying federal income taxes. Our prisons are full of people who illegally avoided paying federal income taxes.
When it comes to legally avoiding taxes and tax deductions, it is good to be rich, and the richer, the better. Like it or not, the federal tax code was written by the wealthy, and in many ways benefits the wealthy. It is widely known that billionaires like Warren Buffett and Bill Gates pay taxes at a lower rate than their secretaries.
Billionaires like Buffett and Gates pay a lower tax rate than millions of Americans because the taxes on investment income (unearned income) are paid at a lower rate than the taxes paid on salary and wages (earned income). Since a higher portion of Gates’ and Buffett’s income comes from investments, they pay a lower federal income tax rate than most ordinary Americans.
Most middle-class Americans cannot take advantage of many tax laws to the same extent as the wealthy. Most middle-class Americans get most of their income from working nine-to-five. They don’t get the same benefits from rules like the favorable capital gains rate on investment income, the stepped-up basis rule on inherited property, or the family charitable trust. Middle-class Americans can enjoy a few of the same tax breaks as the wealthy when it comes to home ownership and the mortgage interest on their home mortgage loans. For most middle-class Americans, real estate and particularly their homes is the best tax shelter available.
Real estate – owning your own home – has always been an important part of the American Dream. Real estate transactions have long been given favorable treatment by the federal tax code. The real estate industry also contributes more to the overall economy than most people realize. Whenever there’s a recession or a downturn in the American economy, the government looks for ways to stimulate the housing industry. Stimulating the housing industry also stimulates the economy in general.
HUD (Housing & Urban Development) estimates that building a new home creates the equivalent of almost three full-time jobs for a year. Looking around a house, it’s easy to see the labor of the carpenters, roofers, painters, and plumbers. But what about people who made the steel used make the appliances? Or the linesman who brought power to the home? Or the salesperson at the hardware store? It is obvious, what stimulates and is good for the housing industry is good for the economy in general.
One of the ways the Federal government can stimulate the housing industry is through the tax code and its favorable treatment of real estate ownership. Home ownership offers tax breaks that renters do not have. A home is an asset that can lower tax liability. First-time homebuyers should be aware of the housing tax deductions and credits that can save thousands of dollars and offset their cost of ownership. It might require a little more paperwork to claim these benefits, but the savings can make the effort well worth it. Whether they bought a home for the first time in 2016 or are planning to do so this year, there are lots of tax breaks can help keep more hard-earned money in a homeowner’s pocket.
The interest paid on a home mortgage is often the biggest tax benefit of home ownership. Interest paid on first and second mortgages up to $1 million is deductible against earned income. And since mortgage payments on a new mortgage have a higher ratio of interest to principal, a homeowner receives most of the mortgage tax benefit in the early years.
It is necessary for a homeowner to file an itemized tax return to claim the mortgage interest payment deduction. Most people, but especially first-time buyers, are always a little surprised at the tax benefits of owning a home in general, but particularly the tax benefits of the home mortgage deduction. The money saved more than offsets the inconvenience of filing the IRS Form 1040. Every year, the loan provider sends a statement showing the total interest paid shortly after the tax year ends.
A Tax Break on Mortgage Interest
The Mortgage Credit Certificate Program can provide another opportunity for a first-time buyers to get a tax break on mortgage interest. According to the IRS, this program “is intended to help lower-income individuals afford home ownership.”
Unlike a deduction which reduces your taxable income, a credit directly offsets the tax bill and lowers the amount owed. A buyer can get 20% to 30% of the interest they pay every year on their mortgage back as a straight tax credit, a direct offset against the amount owed, not as an just a reduction of income. This is a federal credit, but it is administered by state and local governments and can vary by state and county.
To get this credit, a homebuyer needs to qualify for and be issued a Mortgage Credit Certificate by their state or local government. This is usually done before they originate a mortgage to purchase the home. This certificate includes their mortgage and credit details, including the amount of interest they can claim as a credit. With a certificate, the homebuyer receives the credit for the life of the mortgage and can claim the credit each year using IRS Form 8396.
Mortgage points are also called prepaid interest and are fully deductible against ordinary income in the year paid. Mortgage points qualify the borrower for a lower interest rate over the life of the loan. Because they are still a payment of interest, they qualify as an interest deduction.
“This deduction is potentially worth thousands,” says Jeremy Jenks, VP of Sales at The Trembley Group Real Estate. “Although interest rates are low, buying points to lower the interest rate on your mortgage loan is one of the best tax breaks available right now. The return on investment is twofold — you get to deduct the cost of the points and you still get to deduct the interest portion of the payments paid during the year the home was purchased.”
A prospective homeowner can also qualify for a Tax-free IRA withdrawal if they’re using the funds for a down payment or other home-purchase related costs. “First-time homebuyers who tap into their IRAs for the down payment do not have to pay the 10% penalty normally applied to pre-age 59 1/2 withdrawals,” says Jeremy Jenks. “This incentive applies to current homeowners as well as first-time buyers if they have not purchased a home in two years.”
“Taxpayers who itemize their deductions on Schedule A are also eligible for a Real estate tax deduction for real estate taxes paid on their primary and secondary residences,” adds Jenks. The closing attorney will prorate the taxes due between the seller and buyer based on the length of time each will own the home. The buyer’s portion will be fully deductible in the year paid. “Some vacation home buyers forget that the federal tax deductions available for home ownership are also available for second homes.”
Home Improvements Can Help
Home improvements can qualify for deductions in two ways. If any loan secured by a home, including a home equity loan, is used to finance home improvements, the interest will qualify as a deduction just like the mortgage interest deductions on the first or second mortgage. Paying cash might be a better idea but this deduction makes paying for improvements a little easier.
Second, when it comes time to sell a home, the cost of improvements made to the property can be included in the cost basis when determining your capital gains or losses on the sale. If a home sells for more than the purchase price, that increase in value is considered profit and is taxable income. The tax liability on this profit can be reduced by writing off home improvement costs. “That can save thousands in taxes at the time of sale,” says Jenks. “It’s really important that you keep your receipts for major improvements so you can prove the costs that you claim,” he adds.
A couple of Trembley Group Real Estate blog posts published earlier dealt with energy efficiency home improvements and mentioned the home energy tax credits available for homebuyers or homeowners wanting to make their home a little greener. The Residential Energy Efficiency Property Credit can help offset the cost of energy efficiency improvements. “You could save up to 30% of the total cost of installing certain renewable energy sources in your home,” said Brad Emond, a Trembley Group Sales Executive and former owner of an energy performance contracting company. “Since this is a credit, it directly lowers your tax bill.”
The Residential Energy Efficiency Property Credit applies to technology that harnesses off-the-grid energy, like wind turbines, solar panels, geothermal heat pumps and fuel cells. “The 30% credit applies to the cost, including labor and installation, and must be taken in the year the item was placed in service,” Emond said. Keep all receipts and contracts from the installation, and file for this credit using Form 5695.
Private mortgage insurance (PMI) premiums are added to mortgage payments when the loan’s value exceeds 80% of the home’s value. While PMI payments have been tax deductible in recent years, this tax break isn’t part of the tax code, and Congress has to renew it each year.
Congress voted to extend the PMI deduction through the tax year of 2016. Chances appear that lawmakers will opt to extend this benefit for the 2017 tax year as well. This is a significant deduction and Homeowners should watch for new developments each year at tax time.
When it comes time to sell, the IRS grants some tax deductions for home sellers. To take advantage of the deductions, it is necessary to itemize the taxes returns which can be a bit tedious but is a job that is most definitely worthwhile. Home sellers shouldn’t miss these deductions.
What Parts of the Purchasing Process Can I Deduct?
If a seller didn’t qualify for a 121 exclusion, they will owe taxes on any profit. A seller needs to be sure to deduct all selling costs associated with the sale. A seller can deduct:
- A real estate agent’s commission
- Legal fees
- Title insurance
- Inspection fees
- Advertising costs
- Escrow fees
- Legal fees
- Any fee paid on behalf of the purchaser
The partial exclusion for selling a home due to unforeseen circumstances like divorce, a change in employment, or a change in health should not be overlooked.
If a real estate sale occurred as a result of a change of jobs, it may be possible to deduct moving expenses. Deductions could include transportation costs, travel to the new place, storage costs, and lodging costs while looking for a new home.
The real estate taxes owed for the portion of the year the seller lived in the house can be deducted. The closing attorney will prorate the property taxes paid by the buyer and the seller and will include the figures on the closing statement.
Unfortunately, sometimes it is necessary for a seller to make home improvements for the benefit and enjoyment of the purchaser. If a seller makes home improvements that help sell a home like repairing leaky plumbing or a leaky roof or replacing a defective HVAC system, and if the improvements are made within 90 days of the closing, the repairs are considered a deductible selling costs.
And speaking of home improvements, any permanent improvements like additions and major renovations add value to your house and increase its cost basis for income tax purposes. Replacement of items that have worn out, such as carpeting of a leaky roof cost money, are considered maintenance and do not increase a home’s cost basis.
Caution: Keep Receipts!
As with all things tax, these general guidelines may or may not apply to your situation. In every case, tax season is a good reminder to label and keep all receipts related to owning, buying, and selling a house. The paper you save now could save you money down the road.
How Can I Receive More Information
When it comes to state and local income taxes, the one thing that can be said with absolute certainty is tax deductions are fickle. They vary from state to state and from year to year. The Trembley Group Real Estate Sales Executives are Myrtle Beach and Grand Strand real estate experts, not tax experts. When it comes to the tax treatment of buying or selling a home, it is prudent to consult a tax expert to confirm the deductions are still available at the time of the sale.
Need help? Call The Trembley Group at 843.945.1880 ext. 100 and we’ll help you look for the perfect listing or buyers agent!
At The Trembley Group, we pride ourselves on being the experts at more than just selling real estate. We are local residents, some of us have been here for a lifetime. The rest of us will be here until the end of time. We love living, working, and playing in the diverse backyard of Coastal Carolina, and look forward to helping you live and love your dreams soon too. Please reach out to us by phone or email for personalized service and one-on-one advice.