Updated: Apr 10, 2020
The tax benefits of owning a home create a strong incentive to purchase property. If the total amount you pay for property tax, mortgage interest, and even home office expenses exceed the standard deduction, you can deduct most of these expenses on your tax return to reduce your taxable income and overall tax liability.
Every home is subject to a property tax. Local governments impose taxes on properties to pay for roads, buildings, schools, and other programs. The amount of property tax paid is usually a percentage of the property’s current market value. Homeowners in Beverly Hills, for instance, pay an effective property tax rate of 1.1%. If the market value of the home is $1,000,000, then they pay property tax of approximately $11,000 (please note this calculation has been simplified for purposes of this blog - the rate and calculation varies by municipality).
Property tax is deductible on Form 1040, Schedule A. Under the 2017 Tax Cuts and Jobs Act, the maximum amount of state and local tax deductions is $10,000. So, in our Beverly Hills example, $1,000 of property tax would not be deductible.
Another property tax benefit is, if you qualify for the net investment income tax, property taxes up to $10,000 are deducted from your net investment income.
When a home is financed with a mortgage, you borrow the cost of the home from a lender. A homeowner pays a monthly fee to their mortgage lender for a period of time until the amount borrowed is fully paid off (most mortgage terms are over a 15, 30 or 40 year time period). The monthly fee paid to the lender includes a principal and interest amount.
Principal - the total amount borrowed.
Interest - the cost of borrowing the loan paid at a fixed or variable rate.
The interest portion of a mortgage will increase the long term cost of the loan. So, if a taxpayer has a $300,000 30-year mortgage at a 3% interest rate, the total loan repayment will cost $455,332 ($300,000 loan + $155,332 total interest paid). This is why many opt for a 15-year mortgage or pay more than the monthly minimum amount on a 30-year mortgage - the upfront cost will be higher with these options, but the long term expense will be much less.
Mortgage interest is tax deductible if paid towards home acquisition debt up to $750,000. Home mortgage interest is provided via Form 1098 and can be deducted on Schedule A of the personal tax return.
Note, as of 2018, mortgage interest paid on a home equity loan is no longer tax deductible unless the loan was to “substantially improve a residence.”
Home Office Deduction
If you use part of your home for business, you may be able to deduct expenses paid for the business use of your home. The home office deduction is available for homeowners and renters, and applies to all types of homes.
To qualify for the deduction, you must:
Regularly use part of your home exclusively for conducting business. For example, if you use an extra room to run your business, you can take a home office deduction for that extra room.
Show that you use your home as your principal place of business. If you conduct business at a location outside of your home, but also use your home substantially and regularly to conduct business, you may qualify for a home office deduction.
The home office deduction is calculated on Form 8829 and reported on Schedule C of your Form 1040. The IRS gives taxpayers the option to calculate the deduction via the simplified method or the standard method.
With the simplified method, taxpayers use a standard $5 per square foot (not to exceed 300 square feet) to determine the home office deduction. Under this method, taxpayers can also fully deduct home-related deductions with other itemized deductions on Schedule A.
With the standard method, actual expenses are used to determine the deduction. Since actual expenses are used, home-related deductions are apportioned between Schedule A and the appropriate business schedule. It is important to note that depreciation claimed via the home office deduction might be taxed when you sell your home under the standard method.
While I have only highlighted several benefits and limitations to each method, it is important to work with your tax adviser to evaluate which method will leave more money in your pocket before reporting the deduction.
Sale of Home
If you have a capital gain from the sale of your main home, you may qualify to exclude up to $250,000 of that gain from your income, or up to $500,000 of that gain if you file a joint return with your spouse. You are eligible for the exclusion if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its date of sale.
If you receive Form 1099-S, Proceeds From Real Estate Transactions (PDF), you must report the sale of the home even if the gain from the sale is excludable. Additionally, you must report the sale of the home if you can't exclude all of your capital gain from income.
If you cannot exclude all of your capital gain from the sale of your home, you might be be able to defer the tax on the gain through a 1031 exchange. If your primary residence was used for trade or business purposes before the time of sell, the IRS allows you to move the earnings into another like-kind business or investment property to defer the gain.
Let's say a married couple occupied their primary residence for 2 years and turned it into a rental property during years 3 through 5. After year 5, they sold their home for a gain of $550,000. They could only apply the personal residence exclusion on $5000,000 - which leaves a remaining taxable gain of $50,000. Fortunately, under IRS Code Section 1031, they are allowed to "maximize their exclusion" by rolling the $50,000 tax gain over into another investment property through a 1031 exchange to avoid being taxed on any of the $50,000.
Please keep in mind that it is best to seek a qualified tax professional before pursuing a 1031 exchange, as there are rules, time limits and restrictions within this tax benefit.
It is important to consider the tax implications of home ownership. For some, home ownership is an effective tax strategy to limit their tax liability and keep more income for themselves. For others, the repair, maintenance and other responsibilities that come with home ownership create more costs than benefit. If you have additional questions about home ownership and taxes, feel free to contact The Little CPA.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisers before engaging in any transaction.