Purchasing a home is a major life decision, but it’s one made easier by the many tax advantages available to homeowners. Items that can affect your taxes include:
- Mortgage interest
- Lender points
- Property taxes
- IRA withdrawals for first-home purchases
- Qualified home improvements
- Improvements that make a home energy-efficient
In addition to these, you can also benefit from a tax shelter on profits from the sale of your home. You also may be able to reduce their federal tax withholding in anticipation of lower tax bills related to future mortgage interest and property tax deductions. This can increase your take-home pay and make it easier to make your monthly payments.
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The mortgage interest deduction
Often, the largest tax deduction for most homeowners is for mortgage interest paid throughout the year. Because this deduction can only be claimed for interest payments made during the tax year, first-time home buyers usually gain a larger mortgage interest deduction from purchases made early in the year than they do from purchases made later in the year.
- For mortgages originated after December 14, 2017, homeowners can deduct interest paid on home loans up to $750,000. Interest on debt above that amount is not tax-deductible.
- For mortgages originated prior to this date the limit is $1,000,000.
The amount of mortgage interest you paid throughout the year will usually be provided to you by your lender in January on Form 1098. Because of this large deduction, most new homeowners who claimed the standard deduction in the past find it beneficial to begin itemizing their deductions. Combining deductible mortgage interest and property taxes with other deductible items such as charitable giving often totals up to more than the standard deduction. This can result in a larger deduction that can lower your taxes.
Many lenders require home buyers to pay a percentage of the loan amount up front in what is known as percentage points or simply “points.” Like monthly mortgage interest payments, these up-front interest payments are tax-deductible, as long as they are secured by the home and are paid at the closing. Important: you can deduct the points whether you paid them or the seller did as part of the closing agreement.
- Example: You pay two points (2%) on a $400,000 mortgage. You can deduct $8,000 on your taxes ($400,000 x .02 = $8,000).
Form 1098 that you receive from your lender should show the deductible amount for points.
In some states, one of the largest itemized deductions homeowners can take is for the property taxes they pay. Up to $10,000 of state and local taxes, including property taxes, are tax-deductible. If you pay property taxes through an escrow account, this amount is often included on a form provided by your lender. If you pay your property taxes directly, rather than through an escrow account, you need to track these payments so you can deduct them on your tax return.
- Note: You can only deduct property taxes that you paid because you were assessed, i.e. for which you have received a property tax bill. If you want to prepay property taxes to take the deduction this year, you can only do so if you have already received the tax bill.
In the year you purchase a home, you may be required to reimburse the seller for prepaid property taxes that covered some of the time you owned the home. These payments are usually tax-deductible.
Using IRA and 401(K) savings for first-home purchases
Coming up with the money for a down payment on a first home can be difficult. To make it easier, the tax code allows first-time home purchasers to withdraw up to $10,000 from a traditional individual retirement account (IRA) or a Roth IRA without the normal penalties that usually apply to withdrawals made before age 59½. The usual penalty for early withdrawal is 10% of the withdrawn amount. As a result of this tax break, first-time homeowners can save up to $1,000 in penalties for early withdrawal ($10,000 x .10 = $1,000).
In some cases, you can borrow money from your 401(K) plan to use as a down payment on a home. There are several advantages to this move. For one, it is not a taxable event. You do not incur the 10% early withdrawal penalty, because it is a loan that must be repaid, rather than a withdrawal. For the same reason, you do not have to pay income tax on the loan amount. On the downside, you may lose out on some of the growth from your 401(K) that would have come from the borrowed funds. However, since you have to begin repaying your 401(K) plan immediately, with interest, those losses are likely to be negligible over the long term.
Qualified home improvements
Purchasing a home often kicks off a new round of homeowner spending to make the house more comfortable, efficient, and attractive. These home improvements may save you on your taxes when you sell your home. The cost of home improvements can be used to reduce the profit you may make on the sale of your home, which may be subject to taxation if it exceeds certain amounts. As a result, it is important to save the receipts for the home improvements you make.
Improvements to make a home energy-efficient
Up to 30% of qualifying expenses that make a home more energy-efficient may be tax-deductible. Equipment that may qualify for this deduction includes electricity-generating solar panels and solar water heaters. There is no limit to the dollar amount of these tax-deductible expenses. However, the percentage of the expense will begin to step down from 30% after 2019.
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Shelters for profits on the sale of a home
Homes don’t always increase in value, but when they do, the profit can be considerable. Normally, profits from the sale of personal property, such as stocks and bonds, are taxable. But the profits from the sale of a home are tax-free up to certain amounts and under certain conditions. For example:
- If you have used the home as a primary residence for two of the five years preceding the sale, then up to $250,000 of the profits from the home sale is exempt from taxation.
- The tax-free amount increases to $500,000 for married couples filing a joint return when one or both spouses owned the house as a primary residence for two of the five years preceding the sale and both spouses occupied the residence for two of the five years prior to the sale.
This tax shelter is available for every home you sell, provided you owned and occupied it for at least two of the five years preceding its sale and that you did not use the tax-free exclusion for another home in the prior two years.
You might be able to shelter some of the profits from the sale of your home if you qualify under certain exceptions, even if you lived in it less than two years. These exceptions involve unforeseen circumstances that required you to sell the home. Qualifying exceptions can include:
- A change in employment
- A change in health
- A divorce
- Multiple births from a single pregnancy
Under these exceptions, you can usually shelter a portion of the exclusion amount based on the portion of the 2-year requirement that you meet. For example, if you lived in the home for one year, you might qualify to take 50% of the usual deduction, since one year is 50% of the 2-year requirement.
Reducing your federal tax withholding
There is no reason to wait until you file taxes to start benefiting from homeownership. Based on your anticipated tax savings, you can reduce your federal income tax withholding, increasing your take-home pay. To do so, obtain a W-4 form and its instructions at work (or visit www.irs.gov to download one), complete it, and turn it into your employer.
To learn other tax advantages when buying your first home, visit TurboTax.com.