Real estate has an enviable record of being second only to stocks as a broad asset class across the last 100 years. There is a lot of potential in home ownership, and taxes are but a part of a complex situation.
Geography may be a home’s biggest asset or detriment. Homes in some areas appreciate seemingly without end; other areas are lucky if they remain flat.
There are many factors that go into evaluating a purchase decision. As with most financial decisions, taxes alone shouldn’t be the overriding factor, but may help sway a potential investment from mediocre to good — or the other way around. In many cases, taxes make home ownership more affordable. How and why they do that is often not well understood.
Some of the confusion surrounding taxation of a home you own is due to different rules for different times. You have tax rules related to the purchase, tax rules during the period you own the home, and tax rules related to the sale of your home.
Understanding what tax benefits are available with each phase of ownership can assist potential homeowners in evaluating whether or not it is financially advantageous to become a homeowner.
Here we will cover the tax benefits that may be available for the purchase and ongoing ownership of a home you live in.
Tax Benefits at the Time of Purchase
It is rare that the purchase of an asset provides tax benefits simply for making the purchase and real estate doesn’t buck that trend. There is little tax benefit associated with the purchase transaction itself. Little, however, doesn’t mean there’s always none.
If you pay points on your mortgage, they may be deductible. For points to be deductible, they need to be bona fide prepaid interest.
That’s what points are supposed to be: You pay the lender some additional interest up front; they provide you with a lower ongoing rate than they would have given you otherwise.
You can’t deduct points that are paid in lieu of paying other costs you should be paying; they need to be prepaid interest, and it needs to be normal and customary.
You often pay some real estate taxes at closing. Real estate taxes are typically paid in advance; you pay the seller back a pro rata share of the taxes for the period the home will be yours.
Real estate taxes paid at closing for a period where the home will be yours are deductible. If you had to pay the prior owner’s unpaid back taxes, that wouldn’t be deductible. It doesn’t apply to the period in which you own the home.
You may have costs that are not deductible but add to your cost basis in the home.
This is important as you recognize gain on a future sale only to the extent it exceeds the basis; raising the basis may lower your future taxes on a sale.
Purchase costs that add to your basis include abstract fees, appraisals, recording fees, surveys, and title insurance. Other costs are neither deductible nor includable in basis, including property insurance, utilities, or utility deposits.
Tax Benefits of Owning a Home
There are ongoing tax benefits to home ownership. These may help you or not help you financially, depending on your income and tax situation. We’ll first go over how they work, then look at how to determine if they will help you in your situation, and if so, to what extent.
The big two for deductibility are mortgage interest and property taxes. Both are deductible only for taxpayers who itemize. Both also have limitations.
Mortgage interest is deductible on only the first $750,000 of mortgage for mortgages taken out after December 14, 2017, for the purpose of buying or improving a first or second residence.
Property taxes paid to state and local governments are deductible for federal tax purposes, but this deduction is limited to $10,000 per year. State and local taxes over this amount are not deductible on your federal return.
One big tax benefit of owning a home is that appreciation is not taxed while you own the home.
Any taxes associated with appreciation are deferred until the time of sale. To determine the extent to which these deductions may help on your taxes, you must compare your tax situation with the deductions to your tax situation without them.
Itemizing Your Deductions
You need to be able to itemize to claim these deductions. When you itemize, you do so instead of claiming the standard deduction.
You will reduce your taxable income only to the extent that your itemized deductions exceed your standard deduction.
Let’s look at two examples. For our first example, let’s say we have a couple with a combined income of $100,000 and a combined state income tax liability of $4,000. They have no other itemized deductions, so it makes sense for them to take the standard deduction of $24,800.
They are considering purchasing a home for $250,000. They would put 20 percent down, financing the balance at 4 percent. The real estate taxes on the property are $7,000 per year.
Their itemized deductions for a full year of owning a home would be their state tax liability of $4,000, their mortgage interest of $8,000, and their real estate taxes of $7,000, for a total of $19,000.
This is less than their standard deduction of $24,800, so they would not benefit from ongoing tax deductions for home ownership unless their situation changes dramatically.
For our second example, let’s look at a young suburban professional couple. They have a combined income of $160,000 per year and a state income tax liability of $8,000.
They are considering purchasing a $600,000 starter home, putting $120,000 down and financing the balance at 4 percent. Real estate taxes on the property run $19,000 per year. They have no other itemized deductions.
This couple’s itemized deductions for a full year of home ownership would be their state tax liability of $8,000, their mortgage interest of $19,200, and the first $10,000 of their annual property taxes, for a total of $37,200. This is greater than their standard deduction of $24,800, so they would garner tax benefits due to home ownership.
They don’t benefit by the entire amount of their new itemized deductions; they benefit to the extent those new deductions exceed the standard deduction they took before. They have an additional $12,400 of deduction, saving them approximately $2,728 in federal taxes at their likely 22 percent marginal tax rate.
Many homeowners who purchase properties for $100,000 or $200,000 will find that the deductibility of interest and property taxes makes little difference on their taxes. Those who are purchasing properties with higher values will likely see a greater impact.
It is possible that other factors can affect the extent to which you benefit or don’t benefit from the deductibility of mortgage interest and property taxes.
If you have significant other itemized deductions, you will receive greater benefit than if you don’t.
You might, for example, have enough state income taxes and charitable deductions to push you up close to the amount of the standard deduction and nearly all of your mortgage interest and property taxes would reduce taxable income.
Private mortgage insurance (PMI) also bears mention. PMI is required by lenders of some borrowers, generally those making lower down payments. PMI protects lenders in case of borrower default. The deductibility of PMI has swayed with Congress.
The last action Congress took restored deductibility, but only through the 2020 tax year. Barring any changes, deductibility of PMI will be gone again for 2021.
The Bottom Line
The decision to purchase a home is a complex one. Home ownership has historically been the biggest wealth driver for the average American, followed by investment in qualified plans. Taxes enable benefits that make owning a home more affordable for some people, but won’t help everyone.
The bigger issues are lifestyle and long-term control of costs. Some people want to own an home and all that it entails; others would prefer to not have to deal.
If you are in an appreciating market, someone will get the benefit of that appreciation. It could be you, or it could be a landlord.
And if it’s a landlord, they will most likely charge you increasing rents as their property increases in value. By choosing to not own you not only miss out on appreciation, you also stand a good chance of paying more in the long run as rents increase.
As with other equity investments, it is risky to try to make money on home ownership in the short term. Purchasing a home to live on if you’re going to be moving in a year or two will rarely make financial sense.
There is significant exemption from taxes for the gain on the sale of your primary residence: Generally individuals can exclude $250,000 of gain from taxes, and couples can exclude $500,000. Rules apply, but that’s a subject for another column. But you may not have to pay gains tax on much of your gain — making what is generally a very good investment even better.