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Deducting Mortgage Interest
One of the most important tax advantages of home
ownership is the deduction of mortgage interest. If you
itemize deductions on Schedule A of your federal income tax
return, you can generally deduct the qualified residence
interest that you pay on certain home mortgages taken on
your principal residence. (This also applies to second
homes.) That is, you may be able to deduct the interest
you've paid on a mortgage to buy, build, or improve your
home, provided that the loan is secured by your home. Such a
mortgage is known as acquisition indebtedness by the IRS.
Your ability to deduct interest depends on several factors.
Up to $1 million of acquisition mortgage debt ($500,000 if
you're married and file separately) qualifies for interest
deduction. (Different rules apply if you incurred the debt
before October 14, 1987.) If your mortgage loan exceeds $1
million, some of the interest that you pay on the loan will
not be deductible.
Although this deduction also applies to certain home equity
loans secured by your home, the rules are different. Home
equity debt involves a loan secured by your main or second
home that exceeds the outstanding mortgages on the property.
Home equity debt is limited to the lesser of:
- The fair market value
of the home minus the total acquisition debt on that
home, or
$100,000 (or $50,000 if your filing status is married
filing separately) for main and second homes combined
- The interest that you
pay on a qualifying home equity loan is generally
deductible regardless of how you use the loan proceeds.
For more information, see IRS Publication 936.
Tax
Treatment of Real Estate Taxes
Along with mortgage interest, you can generally deduct the
real estate taxes that you've paid on your property in the
year that they're paid to the taxing authority. Only the
legal property owner can deduct the real estate taxes. In
some cases, prepaid real estate taxes can be deducted in the
year of the prepayment. Taxes placed in escrow but not yet
paid to the taxing authority, however, generally aren't
deductible.
Tax Treatment of Home Improvements
and Repairs
Home improvements and repairs are generally nondeductible.
Improvements, though, can increase the tax basis of your
home (which in turn can lower your tax bite when you sell
your home). Improvements add value to your home, prolong its
life, or adapt it to a new use. For example, the
installation of a deck, a built-in swimming pool, or a
second bathroom would be considered an improvement. In
contrast, a repair simply keeps your home in good operating
condition. Regular repairs and maintenance (e.g., repainting
your house and fixing your gutters) are not considered
improvements and are not included in the tax basis of your
home. However, if repairs are performed as part of an
extensive remodeling of your home, the entire job may be
considered an improvement.
If you make certain improvements to your home that improve
your home's energy efficiency, you may be eligible for one
or more federal income tax credits.
Deducting Points and Closing Costs
Buying a home is confusing enough without wondering how to
handle the settlement charges at tax time. When you take out
a loan to buy a home, or when you refinance an existing loan
on your home, you'll probably be charged closing costs.
These usually include points, as well as attorney's fees,
recording fees, title search fees, appraisal fees, and loan
or document preparation and processing fees. You'll need to
know whether you can deduct these fees (in part or in full)
on your federal income tax return, or whether they're simply
added to the cost basis of your home.
Before we get to that, let's define one term. Points are
costs that your lender charges when you take a loan secured
by your home. One point equals 1 percent of the loan amount
borrowed. As a home buyer, you can deduct points in the year
that you buy your home if you itemize your deductions.
However, you must meet certain requirements. You can even
deduct points that the seller pays for you. More information
about these requirements is available in IRS Publication
936.
Refinanced loans are treated differently. The points that
you pay on a refinanced loan generally must be amortized
over the life of the loan. In other words, you can deduct a
certain portion of the points each year. There's one
exception: If part of the loan is used to make improvements
to your principal residence, you can generally deduct that
portion of the points in the year that the points are paid.
And what about other closing costs? Generally, you cannot
deduct these costs on your tax return. Instead, you must
adjust your tax basis (the cost, plus or minus certain
factors) in your home. For example, if you're buying a home,
you'd increase your basis with certain closing costs. If
you're selling a home, you'd decrease your amount realized
from the sale (i.e., your sale price). For more information,
see IRS Publication 530.
Exclusion of Capital Gain When Your
House Is Sold
Now let's see what happens when you sell your home. If you
sell your principal residence at a loss, you generally can't
deduct the loss on your tax return. If you sell your
principal residence at a gain, however, you may be able to
exclude from taxation all or part of the capital gain.
Generally speaking, capital gain (or loss) on the sale of
your principal residence equals the sale price minus your
adjusted basis in the property. Your adjusted basis is the
cost of the property (i.e., what you paid for it initially),
plus amounts paid for capital improvements, less any
depreciation and casualty losses claimed for tax purposes.
If you meet the requirements, you can exclude from federal
income tax up to $250,000 ($500,000 if you're married and
file a joint return) of any capital gain that results from
the sale of your principal residence, regardless of your
age. In general, an individual, or either spouse in a
married couple, can use this exclusion only once every two
years. To qualify for the exclusion, you must have owned and
used the home as your principal residence for a total of two
out of the five years before the sale.
For example, you and your spouse bought your home in 1981
for $200,000. You've lived in it ever since and file joint
federal income tax returns. You sold the house yesterday for
$350,000. Your entire $150,000 gain ($350,000 - $200,000) is
excludable. That means that you don't have to report your
home sale on your income tax return.
What if you fail to meet the two-out-of-five-years rule? Or
what if you used the capital gain exclusion within the past
two years with respect to a different principal residence?
You may still be able to exclude part of your gain if your
home sale was due to a change in place of employment, health
reasons, or certain other unforeseen circumstances. In such
a case, exclusion of the gain may be prorated.
Additionally, special rules may apply in the following
cases:
- If your principal
residence contained a home office or was otherwise used
partially for business purposes
- If you sell vacant land
adjacent to your principal residence
- If your principal
residence is owned by a trust
- If you rented part of
your principal residence to tenants
- If you owned your
principal residence jointly with an unmarried taxpayer
Note: Members of the
uniformed services and foreign service personnel may elect
to suspend the running of the 2-out-of-5-year requirement
during any period of qualified official extended duty up to
a maximum of 10 years.
Consult a tax professional for details.
Brought to you by the North Carolina
Association of Certified Public Accountants in cooperation with the AICPA.
©2007 The American Institute of Certified Public Accountants |
