Tax Breaks for Buying a Home

Jessica Anderson
Kiplinger.com
Sunday, February 17, 2008; 12:00 AM

Buying your first home is a huge step. When you leave the world of renting behind, you begin building equity in an investment. And Uncle Sam is there to help ease the pain of high mortgage payments. The deductions now available to you as a homeowner will reduce your tax bill substantially. And, if you have been claiming the standard deduction up until now, the extra write-offs from owning a home almost certainly will make you an itemizer. Suddenly, the state taxes you pay and your charitable gifts will earn you tax-saving deductions, too.

Mortgage interest. For most people, the biggest tax break from owning a home comes from deducting mortgage interest. You can deduct interest on up to $1 million of debt used to acquire your home. Your lender will send you Form 1098 in January listing the mortgage interest you paid during the previous year. That is the amount you deduct on Schedule A. Be sure the 1098 includes any interest you paid from the date you closed on the home 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 does not include it on the Form 1098. If you are in the 25% tax bracket, deducting the interest basically means Uncle Sam is paying 25% of it for you. A $1,000 deduction will reduce your tax bill by $250.

Points. When you buy a house, you usually have to pay "points" to the lender to get your mortgage. This charge is usually expressed as a percentage of the loan amount. If the loan is secured by your home and the number of points you pay is typical for your area, the points are deductible as interest if you paid enough cash at closing -- via your down payment, for example -- to cover the points. For example, if you paid two points on a $300,000 mortgage -- $6,000 -- you can deduct the points as long as you put at least $6,000 into the deal. And, believe it or not, you get to deduct the points even if you persuaded the seller to pay them for you as part of the deal. The deductible amount should be shown on your 1098 form.

Real-estate taxes. You can deduct the local property taxes you pay each year, too. The amount may be shown on a form you receive from your lender, if you pay your taxes through an escrow account. If you pay them directly to the municipality, though, check your records or your checkbook registry. In the year you purchase your residence, you probably reimbursed the seller for real estate taxes he or she had prepaid for time you actually owned the home. If so, that amount will be shown on your settlement sheet. Include this amount in your real-estate tax deduction. Note that you can't deduct payments into your escrow account as real-estate taxes. Your deposits are simply money put aside to cover future tax payments. You can deduct only the actual real-estate tax payments made from the account by your lender.

PMI premiums. Buyers who make a down payment of less than 20% of a home's cost usually get stuck paying premiums for private mortgage insurance (PMI), an extra fee that protects the lender if the borrower fails to repay the loan. For mortgages issued in 2007, PMI premiums can be deducted by homebuyers. This new write-off phases out as income increases above $50,000 on single returns and above $100,000 on joint returns. (If you're paying PMI on a mortgage issued before 2007, you're out of luck on this one.)

Penalty-free IRA payouts for first-time buyers. As a further incentive to homebuyers, Congress offers to waive the normal 10% penalty for or first-time homebuyers who withdraw from traditional IRAs before age 59�. At any age you can withdraw up to $10,000 penalty free help pay to buy or build a first home for yourself, your spouse, your kids, your grandchildren or even your parents. That $10,000 is a lifetime limit, not an annual one.

To qualify, the money must be used to buy or build a first home within 120 days of the time it's withdrawn. And, get this, you don't really have to be a first-time homebuyer to qualify. You're considered a first timer as long as you haven't owned a home for two years. Sounds great, but there's a serious downside. Although the 10% penalty is waived, the money would still be taxed in your top bracket (except to the extent it was attributable to nondeductible contributions). That means as much as 40% or more of the $10,000 would go to federal and state tax collectors rather than toward a down payment.

There's a Roth IRA corollary to this rule, too. The way the rules work make the Roth IRA a great way to save for a first home. First, you can always withdraw your contributions to a Roth IRA tax and penalty free at any time for any purpose. And, once the account has been opened for at least five years, you can also withdraw up to $10,000 of earnings tax and penalty free to buy a first home.

D.C. homebuyer's credit. Buyers in the nation's capital get extra frosting on the homebuyer's incentive cake. First-time buyers (liberally defined) get a federal tax credit of up to $5,000. That's the same as having Uncle Sam kick $5,000 into your down payment. Even if you own a home somewhere else (including the D.C. suburbs), you can qualify for this sweet tax break if the house you buy is the first one you own in D.C. In fact, you can qualify even if you have owned a home in D.C. before ... as long as you have not been an owner for at least one year. This tax break phases out as income rises between $70,000 and $90,000 on single returns and between $110,000 and $130,000 on joint returns.

Home improvements. Save receipts and records for all improvements you make to your home, such as landscaping, storm windows, fences, a new energy-efficient furnace and any additions. You can't deduct these expenses now, but, when you sell your home, the cost of the improvements is added to the purchase price of your home to determine the cost basis in your home for tax purposes. Although most home-sale profit is now tax free, it's possible for the IRS to demand part of your profit when you sell. Keeping track of your basis will help limit the potential tax bill.

Tax-free profit on sale. Another major benefit of owning a home is that the tax law allows you to shelter a large amount of profit from tax if certain conditions are met. If you are single and owned and lived in the house for at least two of the five years before the sale, then up to $250,000 of profit is tax free. If you're married and file a joint return, up to $500,000 of the profit is tax free if one spouse owned the house as a primary home for two of the five years before the sale and both husband and wife lived there for two of the five years before the sale. Thus, in many cases, you won't owe any tax on the home-sale profit. (If you sell for a loss, you cannot take a deduction for the loss.)

You can use this exclusion every time you sell a primary home, as long as you owned and lived in it for two of the five years leading up to the sale and have not used the exclusion for another home in the last two years. If your profit exceeds the $250,000/$500,000 limit, the excess is reported as a capital gain on Schedule D.

In certain cases, you can treat part of your profit as tax free even if you don't pass the two-out-of-five-year tests. A partial exclusion is available if you sell your house before passing those tests because of a change of employment or a change of health or because of other unforeseen circumstances such as a divorce or multiple births from a single pregnancy. A partial exclusion does not mean you can exclude part of your profit; it means you get a part of the $250,000/$500,000 exclusion. If you qualify and have lived in the house for one of the five years before the sale, for example, you can exclude up to $125,000 of profit if you're single or $250,000 if you're married-50% of the exclusion of those who meet the two-out-of-five-year test.

Return to: Tax Planning for All Life's Events


© 2008 The Kiplinger Washington Editors