How home tax deductions work
Deductions reduce how much tax you owe, but only if you itemize. However, it only pays off when your itemized deductions are higher than the standard deduction. The dollar amount of itemized deductions over the standard deduction is the only part you save money on. Multiply this excess amount by your marginal tax rate to determine how much the deduction saves you.
How much you save from home ownership tax benefits also depends on your filing status and income. If a single person, a head of household and a married couple each buy the same house for the same price, get the same mortgage, and have the same deductions (let’s say $20,000), the married couple will see significantly lower savings from their home tax deductions.
Types of tax breaks
Purchasing and owning a home can be offset by tax breaks from the IRS. Also, most states offer similar tax benefits. Here are a few of the more common federal tax breaks:
Mortgage interest. Mortgage interest paid on up to $750,000 of debt can be deducted from your income. This rule applies to mortgages over $250,000. For mortgages over $1 million, taxpayers cannot deduct mortgage interest above the $750,000 threshold.
To deduct mortgage interest, the following must be met:
- The mortgage must be secured by your home
- The proceeds must be used to build, buy, or substantially improve your primary residence or second home
- You cannot claim the deduction on an investment property
Real estate taxes. You can deduct state and local property taxes in the year you pay them, but it is limited to $10,000 per year.
Points. When you take out a mortgage, you can deduct discount points paid, usually in the year you pay them, though sometimes only over the life of the loan. Even if the home’s seller paid points for you, you can still deduct them. For your interest rate to be lowered, you must have legitimately paid points. There is a checklist to determine this.
Private mortgage insurance. The IRS counts all of these as tax-deductible when you are required to carry mortgage insurance:
- Private mortgage insurance policy
- VA loan funding fee
- USDA loan guarantee fee
- FHA loan up-front mortgage insurance premiums
Home office deduction. An employee working from home can’t claim the home office deduction, but you can if you are a small business owner or self-employed using part of your home regularly and exclusively as their main place of business.
There are two primary additions to these rules:
You can claim deductions for part of your home that you use to store inventory or samples for your business without meeting the regular and exclusive use criteria if your home is your only business location.
You can deduct expenses associated with a separate structure on your property that you use exclusively and regularly for business, such as a she-shed or other outbuilding.
Here are a few of the most common home office deductions you may be able to take a portion of, based on the percentage of your home used for business:
- Real estate taxes
- Home mortgage interest
- Mortgage insurance premiums
- Security system
This tax break has many regulations that you must follow carefully to legally claim it.
Medically necessary home improvements. As part of the medical expenses tax deduction, you can deduct medically necessary home improvements that help you, your spouse or dependents who live with you. Adding railings, installing ramps, and lowering cabinets are all options for improving accessibility.
Home sale. When you sell your home, the IRS wants its cut of the profits, but you’ll get a chunk of any profit tax free if you’ve lived in your home two of the last five years. The capital gains tax exclusion says you don’t have to pay taxes on the first $250,000 of profit from selling your home if you’re single, or $500,000 if you’re married. These amounts are exemptions, which let you keep much more of your money than a capital gains deduction would.
As a homeowner, you’ll want to save receipts for costs associated with maintaining and improving your home. You can add many of these expenses to your home’s cost basis to reduce any capital gains when you sell. Your home’s basis is the purchase price plus the costs you paid to maintain, improve and sell your home.
Tax credits. While not really home ownership related, tax credits are another thing to explore with your accountant. Tax credits reduce the amount of tax you must pay dollar for dollar. If you get a $1,000 tax credit, you owe $1,000 less on your taxes.
Mortgage credit certificate. First-time homebuyers and those with low-income levels may qualify for mortgage credit certificates offered by their state’s Housing Finance Agency (HFA). For instance, if you owe $10,000 in mortgage interest for 2021 and your state HFA issues you a 20% mortgage credit certificate. You will get a credit for 20% of $10,000, or $2,000, on your 2021 tax return. You can then include the remaining $8,000 of interest in your itemized deductions if it benefits you to itemize rather than take the standard deduction.
This is merely an overview of some of the potential tax benefits of home ownership. Check current tax rules before you count on these savings as they are subject to change. Talk with your tax preparer for more details on tax benefits when you purchase and own a home, and to determine whether it would be to your advantage to itemize deductions.