The process of buying and selling a house has evolved over the years but one thing has remained the same, taxes. When buying, selling, or even renovating a home, there are tax benefits and penalties that all homeowners must be aware of. The last thing a homeowner needs is to receive a penalty letter for not paying taxes on something they should have. Worse than that, you could end up paying too much in taxes by failing to take advantage of the exclusions and deductions made available by the IRS.
When purchasing a home there are three important deductions to be aware of: points, mortgage interest, and property tax deductions. There are other tax benefits for homeowners, but they vary based on the state in which you own your home.
Mortgage points are a fee charged by the lender that is usually 1-2 percent of the total loan amount. Most buyers are not aware that these “points” can be used as deductions on your tax return. The handling of the mortgage points depends on who pays the fee and if it meets certain criteria set forth by the IRS. The criteria that the IRS specifies are this: It must stay within regional averages and not exceed certain yearly set limits. If the mortgage points meet these requirements and are paid by the buyer, they can use this payment as a deduction similar to paying interest on your mortgage. If the seller pays the fee, they can use the points to increase their basis in the home. An owner’s basis in a home is the amount they originally paid for the home plus any additional renovations and fees (ex. Points). There are some instances where the basis can be decreased as well. Once the basis in the home is determined, that is the number that the IRS will use to determine the gain/loss the owner receives from selling their home. If the points paid do not meet the criteria set forth by the IRS, they are not eligible to be deducted the year they are paid. They can, however, be deducted in even amounts over the life of the loan. So if you have a 30-year mortgage, you can take the points paid and divide it out over the 30 years.
Interest expense is any amount of interest you are charged on your mortgage during the year. Your primary home interest expense can be used as a deduction on your yearly taxes. For secondary homes, you can deduct your interest expense only if you live in the home for 14 days, or at least long enough to equal 10% of the time it is rented during the year. This allows you to deduct the interest from both your primary residence and your secondary home. As a homeowner, you will receive a Form 1098 from your mortgage company that will breakdown the amount of mortgage interest you paid during the year.
Property taxes paid to your local township are also deductible on your federal tax return. As a homeowner, if your property taxes are paid through your mortgage, you will receive a statement with the breakdown of property taxes paid during the year. If you do not have a mortgage, or property taxes are not included in your mortgage, then you can simply keep track of your payments and include what you paid during that calendar year. (Topic 504-505, IRS)
Renovations on a Home
Typically, home renovations are not eligible for tax deduction but there are a few exceptions. Improvements that fall under the energy efficiency guidelines set forth by the IRS like energy efficient air conditioners and hot water heaters are eligible for tax deduction. If you replace your air conditioner or hot water heater and it is energy efficient, then you can receive a deduction either in the year of purchase/installation or over the expected life of the unit.
If you make improvements to your home like a kitchen or bathroom remodeling, then this is not deductible on your taxes. However, there are benefits to keeping track of the cost of these renovations. The amount you spend on the remodeling of a room or adding a deck/patio to your home can be added to your basis in the home. This means that when you sell the home your realized gain will actually be lower, making it more likely to fall under the exclusion amount. A realized gain is the amount that the IRS qualifies as your gain on the sale of your home. This is calculated using the owner’s basis in the home as mentioned above. The realized gain is what the government uses to determine if you qualify for the Capital Gain Exclusion that will be explained more in the next section. Even if you are over the exclusion amount, your taxable gain (the amount of gain from your sale that the IRS can tax) will be lower due to the renovations or improvements you made being added to the cost you paid for the home.
Selling a Home
Though very exciting, selling a home can be stressful, as the transaction will certainly affect your tax position for the year. When selling a home, we are always focused on making as much on the house as possible but remember if you’re making money, Uncle Sam wants his share.
There are two things that all sellers must remember for tax purposes. 1.) Sellers should maintain records to establish their basis in the home (as explained in the home Renovations Section) and 2.) The realized gain as a result of the sale. For someone selling their primary residence (resided in the home two of the previous five years) you are allowed to use the Capital Gain Exclusion, as long as your gain does not exceed $250,000 if you are single, or $500,000 if you are married filing jointly. Capital Gain Exclusion allows you to exclude the gain up to those limits from your income on your federal tax return. Maintaining proper documentation for home improvements is important because it could result in you keeping your realized gain below the threshold and, therefore, not having to report any income from the sale in your total income for the year.
There are a couple of reasons that the IRS would allow you to take advantage of this exclusion if you haven’t lived in the house two of the previous five years. Those reasons include the following: death, divorce, job loss, employment changes that force the owner to move, multiple births from the same pregnancy, and partial exclusion if the sale is caused by damage done by a major storm. This exclusion can also be used for second homes. You will not be allowed to use the full amount, but if you can prove that you’ve lived in the home for a certain period of time, you will be allowed to take a partial exclusion based on the time lived in the home. (Topic 701 Selling your Home, IRS)
So whenever it comes to buying, selling, or renovating a home, you must be aware of the tax opportunities available through the IRS. Maintaining proper documentation allows you or your tax preparer to make the most of the available deductions. Just like no one wants to over pay for their home, no one wants to give more to the government than legally required. Best of luck!