Tax Benefits of Real Estate Ownership
Prior to the tax reform act of 1986, all interest payments were tax deductible including credit cards, car loans, personal loans as well as mortgage loans. The tax reform act eliminated all the other consumer loan interest deductions but kept the mortgage interest deduction intact. The idea was to give Americans an incentive for homeownership.
IN THIS ARTICLE:
- Mortgage Interest Deduction: Primary Home/Second Home
- Interest Deduction: Rental Property
- Closing Costs/Points Deduction
- Property Taxes, Hazard Insurance and Mortgage Insurance Deductions
- Mortgage Insurance: Primary Property
- Federal Income Tax Credits for Energy Home Improvements
- Capital Gain Exclusion
- Partial Exclusion
Mortgage Interest Deduction: Primary Home/Second Home
According to the IRS, the mortgage interest paid on a “qualified home” is tax deductible under most circumstances. A “qualified home,” as defined by the IRS, is a main or second home that is a house, condominium, cooperative, mobile home, house trailer, boat or similar property that has sleeping, cooking and toilet facilities. A main home is the place where you ordinarily live most of the time. The IRS has defined two definitions for second homes:
- Second home that is not rented out: If the home is not up for sale or rent to others at anytime during the year, you can treat it as a qualified home and do not necessarily have to use it during the year.
- Second home that is rented out: If the home is rented out for part of the year, it must also be used as a home for a portion of that year. The home must be used for a minimum of 14 days or 10 percent of the number of days that the property is rented out, whichever is longer. If the property is not used long enough the IRS classifies it as rental property.
Mortgage interest must be due to a secured property loan, which is a loan that uses a financial instrument to secure the property by placing a lien on it such as a mortgage, deed of trust or land contract. This can be any loan used to purchase a home, a second mortgage, a line of credit or a home equity loan, unless the loan meets one of the following exceptions:
- You must file IRS form 1040 with a Schedule A, to itemize deductions: If you are not able to do so or it’s not advantageous to do so, mortgage interest deduction does not help you.
- The mortgage you took out was on or before Oct.3 13, 1987: This debt is “grandfathered debt” and is totally deductible.
- Mortgage loans dated after Oct.13, 1987: Mortgage loan amounts are limited to a maximum of $1 million total ($500,000 or less if married filing separately) for “acquisition debt,” which is used to buy, build or improve your home.
- Mortgage loans dated after Oct. 13, 1987: Mortgage loan amounts are limited to $100,000 ($50,000 if married filing separately) for “home equity debt,” which is used for anything other than to buy, build or to improve the property, and the total liens on the property do not exceed the fair market value of the property.
Mortgage Interest Deduction: Rental Property
Unlike the mortgage interest deduction for a “qualified home,”which is handled as an itemized deduction, rental property interest deductions are used to offset any rental income claimed for the subject property. The IRS has defined two categories of investors who may affect the rental property interest deduction:
- Real estate professionals: Those who meet the IRS’ definition of a real estate professional have their real estate investments treated as active income. To meet this definition, you must spend at least 750 hours per year working in the real estate industry. Paid employees who own at least 5 percent of a real estate business are also considered a professional. If you are a full-time developer for your own account or a full-time real estate agent paid only on commission, you are a real estate professional. In these two instances, you can use losses from your investments to offset income you make in other real estate business activities.
- Non-real estate professionals: If you are not a real estate professional but oversee your rental real estate, your revenue qualifies as a different type of passive income, and you might be able to claim a portion of any losses against active income. As of the 2014 tax season, you can write off up to $25,000 a year in losses as a married couple filing jointly — $12,500 if you file separately or are single — if your adjusted gross income as a married couple is $100,000 or $50,000 if single. If your AGI is over the threshold, the size of the loss you can claim goes down by 50 cents for every dollar of income. At an AGI of $150,000, or $75,000 if single, you no longer can take the passive loss against other income.
The advantages of the rental property deduction are that you don’t have to be eligible to itemize your deductions to take advantage of this tax benefit, and it is not subject to the maximum loan amounts that are placed on “qualified” homes.
Closing Costs/Points Deduction
Primary home/second home: Typically third-party closing costs such as title insurance, appraisal fees, recording fees, etc., are not tax deductible. Origination fees and/or discount points are considered prepaid interest and may be deducted. If the following are met, the deduction may be taken in the year that they occurred:
- Paying points is an established business practice in the area where the loan was made.
- The points paid were not more than the points generally charged in that area.
- You use the cash method of accounting. This means you report income in the year you receive it and deduct expenses in the year you pay them. Most individuals use this method.
- The points were not paid in place of amounts that ordinarily are stated separately on the settlement statement, such as appraisal fees, inspection fees, title fees, attorney fees and property taxes.
- The funds you provided at or before closing, plus any points the seller paid, were at least as much as the points charged. The funds you provided are not required to have been applied to the points. They can include a down payment, an escrow deposit, earnest money and other funds you paid at or before closing for any purpose. You cannot have borrowed these funds from your lender or mortgage broker.
- The funds you provided at or before closing, plus any points the seller paid, were at least as much as the points charged. The funds you provided are not required to have been applied to the points. They can include a down payment, an escrow deposit, earnest money, and other funds you paid at or before closing for any purpose. You cannot have borrowed these funds from your lender or mortgage broker.
- You use your loan to buy or build your main home.
- The points were computed as a percentage of the principal amount of the mortgage.
- The amount is clearly shown on the settlement statement (such as the Settlement Statement, Form HUD-1) as points charged for the mortgage. The points may be shown as paid from either your funds or the seller’s.
If you meet all of these tests, you can choose to either fully deduct the points in the year paid, or deduct them over the life of the loan.
Home improvement loan: You can also fully deduct in the year points were paid on a loan to improve your main home, if tests 1 through 6 are met.
Refinancing: Generally, points you pay to refinance a mortgage are not deductible in full in the year you pay them. This is true even if the new mortgage is secured by your main home.
Second home: You cannot fully deduct in the year paid points on loans secured by your second home. You can deduct these points only over the life of the loan.
Rental property: Third-party closing costs are not tax deductible just like primary and second homes scenarios. Origination fees/discount points are deductible spread over the life of the loan (same as second homes).
Property Taxes, Hazard Insurance and Mortgage Insurance Deductions
The real estate property taxes for “qualified homes” are tax deductible in the year that they are paid as itemized deductions (just like mortgage interest). For rental properties they are an expense that may be deducted from the rental income (just like mortgage interest) to reduce the amount of the passive gain.
Hazard insurance (homeowners insurance) is not a deductible expense for a “qualified home” but is considered an expense and is totally deductible for rental properties.
Mortgage Insurance: Primary Property
Borrower-paid mortgage insurance premiums are tax-deductible (as an itemized deduction).
Households with adjusted gross incomes of $100,000 or less will be able to deduct 100 percent of their mortgage insurance premiums. The deduction is reduced by 10 percent for each additional $1,000 of adjusted gross household income, phasing out after $109,000.
Married individuals filing separate returns who have adjusted gross incomes of $50,000 or less will be able to deduct 50 percent of their mortgage insurance premiums. The deduction is reduced by 5 percent for each additional $500 of adjusted gross income, phasing out after $54,500.
Federal Income Tax Credits for Energy Home Improvements
One of the best ways to lower your taxes is to take advantage of energy tax credits by installing qualified energy generating systems.
You can get a one-time federal tax credit of 30 percent of the cost of qualifying geothermal heat pumps, solar water heaters, solar panels, small wind turbines or fuel cells placed in service for an existing or new construction home through Dec. 31, 2016. Except for fuel cells (which must be installed in your primary residence to qualify), the credit can be used for items installed in vacation or second homes as well. Rental properties are not eligible.
The 30 percent credit applies to the cost, including labor and installation, and there is no maximum limit (except for fuel cells). For example, if you purchase and install a small wind turbine for $10,000, you get a $3,000 tax credit right off the bat – not counting the future savings on your electric bill.
Capital Gain Exclusion
If you sold your main home and made a profit, you may be able to exclude that profit from your taxable income. Here’s how it works.
$250,000 Exclusion on the Sale of a Main Home
Individuals can exclude up to $250,000 in profit from the sale of a main home (or $500,000 for a married couple) as long as you have owned the home and lived in the home for a minimum of two years. Those two years do not need to be consecutive. In the 5 years prior to the sale of the house, you need to have lived in the house for at least 24 months in that 5-year period. In other words, the home must have been your principal residence. You can use this rule to exclude your profits each time you sell or exchange your main home. Generally, you can claim the exclusion only once every two years. Some exceptions do apply.
Exceptions to the 2 out of 5 Year Rule
If you lived in your home less than 24 months, you may be able to exclude a portion of the gain. Exceptions are allowed if you sold your house because the location of your job changed, because of health concerns, or for some other unforeseen circumstance.
1) Change in the Location of Your Job
If you lived in your house for less than two years, you can exclude a part of your gain on the sale of your house if your work location has changed. This exception would apply if you started a new job, or if you are moved to a new location with your employer.
2) Health Concerns
If you are selling your house for medical or health reasons, be ready to document those reasons with a letter from your physician. Such a letter does not need to be filed with your tax return. Instead, keep the documentation in your personal records just in case the IRS wants further information.
3) Unforeseen Circumstances
If you are selling your house because of unforeseen circumstances, be ready to document what those reasons are. IRS defines an unforeseen circumstance as “the occurrence of an event that you could not reasonably have anticipated before buying and occupying your main home.” The IRS has given specific examples of unforeseen circumstances:
- Natural disasters
- Acts of war
- Acts of terrorism
- Change in employment or unemployment that left you unable to meet basic living expenses
- Multiple births from the same pregnancy
You can exclude a portion of your gain if you are selling your home and lived there less than two years and you meet one of the three exceptions shown above. You calculate your partial exclusion based on the amount of time you actually lived in your home.
Count the number of months you actually lived in your home. Then divide that number by 24. Then multiply this ratio by $250,000 (if unmarried) or by $500,000 (if married). The result is the amount of gain you can exclude from your taxable income.
For example: You are an unmarried person, lived in your home for 12 months, and then sold the home because your employer asked you to relocate to a different office. You calculate your partial exclusion: 12 months divided by 24 month (for a ratio of .50) times your maximum exclusion of $250,000. The result: you can exclude up to $125,000 in gain. If your gain is more than $125,000, you include only the amount over $125,000 as taxable income. If your gain is less than $125,000, then your gain can be excluded from your taxable income.
Second homes and rental properties are eligible for this capital gain tax exclusion.