How does buying a house affect taxes

Published May 19, 2021
by Better

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What You’ll Learn

How to choose between standard deductions and itemized deductions

The itemized tax breaks and credits that could apply to you

What tax forms to use when you file

As a homebuyer or homeowner, you’ll be pleased to know that there is a range of tax deductions you may be able to use to lower your tax bill. But deciding whether to use them (by taking the standard deduction or itemizing) all depends on how much money you stand to save (and the advice of your tax professional). If you’ve never considered itemizing your tax deductions, you’re not alone—in recent years, only about 30% of taxpayers chose to itemize. This could be because the standard tax deductions offered in the US make paying taxes simpler. That said, if you’re not aware of the additional tax breaks for homeowners, you may be missing out.

Before we dive into the kinds of tax breaks that are available, it’s important to understand how standard deductions work. As you may expect, standard deduction amounts vary by filing status (single, married, or head of household) and the amount of tax deductions you can claim will have a big influence on which route is best for you. For example, if your tax filing status was single in 2020 and you had $10,000 in tax deductions, you were better off taking the standard deduction of $12,400. If you had over $12,400 in tax deductions, itemizing was the way to go.

Even though high-income taxpayers are much more likely to itemize their deductions, there are people in almost every taxable income bracket who choose to itemize. And as a homebuyer or homeowner, you should know that mortgage interest is one of the most common itemized tax deductions. If you don’t already know how your tax deductions are filed, speak to your tax professional. They will understand your unique financial circumstances and, as experts in the tax code, they can give tailored advice for your situation.

10 tax perks homebuyers and owners should know about

Plus one to keep in mind if you ever plan to sell

As you can see, there are a lot of ways to reduce your tax bill when you buy or own property. The first 3 perks are for homebuyers specifically, the rest are for homeowners. Read them all or skip to the ones that catch your eye. If nothing else, you’ll be able to claim mortgage interest as a tax deduction if you itemize.

1. Mortgage points
2. Moving expenses
3. Penalty-free IRA withdrawals for first-time buyers
4. Mortgage interest
5. Property tax
6. Home equity debt
7. Mortgage insurance (PMI)
8. Home office
9. Renewable energy tax credits
10. Mortgage credit certificate
11. Home improvements

Taxes and buying a house

1. Mortgage points

When you get your mortgage you have the option to pay a portion of your interest in advance to reduce your monthly mortgage payment. The amount of interest you pay upfront is called ‘points’ (aka mortgage points or discount points) because the figure is calculated as a percentage point of your loan. (Generally speaking, 1 mortgage point is worth 1% of the loan. Paying for a point upfront will lower the interest rate by .125% to .250%, depending on the lender.) Mortgage interest is tax-deductible, so provided your mortgage points fit certain criteria, this prepaid interest payment is tax-deductible, too.

Criteria include:

  • Your mortgage must be secured by your home.
  • The points didn’t cost more than what is typical in your area.
  • The points were paid as cash at closing (via your down payment) and were not in place of other closing costs, like appraisal or title fees.

Fun facts: If you convinced the seller to pay for your mortgage points at closing, you can still claim this deduction. If you pay points when you refinance your mortgage or take out a home equity line of credit (HELOC), you may be able to claim a tax deduction for these points over the life of the loan. This is possible when a small percentage of the points is built into the loan and thus, your monthly mortgage payments.

The form you need: You can find this deductible amount on the 1098 form you receive from your lender. You’ll also find this amount on the home purchase settlement sheet, but in the IRS’s eyes, the 1098 makes it official.

2. Moving expenses

Before you get your hopes up, these tax deductions are limited to moving expenses for active-duty members of the armed forces. If you meet this criteria, the move must be due to a military order resulting in a permanent change of station. You can claim all of the unreimbursed expenses for yourself, your spouse, and your dependents. And it’s not just storage and traveling expenses to your new home that you can claim. You can also claim household goods, personal effects, and lodging expenses incurred as a result of your move.

The form you need: Most military personnel should use form 3903 to report these moving expenses, but there are exceptions so speak to your tax professional to find out what you’re able to claim.

3. Penalty-free IRA withdrawals for first-time buyers

While a penalty-free IRA payout is not an actual tax deduction, it is a perk the IRS offers to first-time homebuyers. If you’re younger than 59½, a 10% penalty is typically applied to withdrawals you make from traditional IRAs. But if you plan to use up to $10,000 of that withdrawal to buy or build a first home for yourself or your family (including your spouse, kids, grandchildren, or parents) this 10% penalty doesn’t apply. The IRS definition of first-time homebuyer is broader than you might think: if you haven’t owned a home for 2 years, you may qualify. You won’t need to show the IRA administrator what you plan to use the money for when you make the withdrawal, but you will need to submit an additional form to the IRS when you file your tax return.

The $10,000 limit is a lifetime cap and it’s something both you and your spouse can access if you’re buying a home together. So if you both have IRA accounts with money to spare, the two of you could take out $20,000 in total to put toward your new home—so long as you use the money within 120 days of the date you withdraw it. Keep in mind, however, that the money may still be taxed in your top tax bracket meaning you may end up with less cash than you think. So speak to your tax advisor to see if taking advantage of this perk is a smart move for you.

If you have a Roth IRA you can withdraw money from it at any time, tax-free (and usually penalty-free) for any purpose at any time. If your account has been open for at least 5 years, you can take out $10,000 of your investment earnings without any tax or penalty for a qualifying first home purchase.

The form you need: If you withdraw money from a traditional IRA account you need to file form 5329.
If you withdraw after-tax money from a Roth IRA or a traditional IRA you’ll need to file form 8606.

Tax benefits of home ownership

4. Mortgage interest

For most people itemizing their tax deductions, this is where you’ll find the biggest tax break for owning a home. In 2021, if you’re an individual taxpayer or a married couple filing jointly you can deduct the interest paid on up to $750,000 of mortgage debt. If you’re a married couple filing separately, the limit is $350,000. In the first few years of your mortgage you’re charged more for interest payments in the first few than you are for your last. This is because of amortization, the process lenders use to ensure the full loan balance (and all the interest owing) is paid off by the end of the loan. So, if you have a 30-year mortgage, you’ll be paying a lot less in interest at year 25 than at year 5. This is good to know because if you’re going to claim the mortgage interest tax deduction, you’ll save more if you start claiming it in the beginning of your mortgage.

The form you need: To claim this deduction you’ll need the 1098 form you receive from your lender. It’s the same form you’d use to claim mortgage points as a tax deduction.

5. Property tax

Of all the property-related tax deductions, this is the most straightforward. You pay property tax each year, either through a mortgage escrow account or directly to your city, municipality, or county. You can deduct up to $10,000 for the property taxes you paid during a taxation year. If your lender is collecting funds earmarked for property taxes in an escrow account, you can’t claim these funds as a tax deduction until the property tax bill has actually been paid.

The form you need: Again, you’ll need the 1098 form from your lender to claim this deduction as it will also detail your property tax total.

If you pay property taxes directly to your city, municipality, or county, providing a record of the payments you’ve made will suffice (they’re probably on your bank statements). Some local governments will include the previous year’s taxes on the property tax bill they send to each homeowner. If you’re still having trouble locating a record of the property taxes you paid, call or visit your county assessor’s office.

6. Home equity debt

Home equity is the portion of the home you fully own as opposed to the portion of the home you’re paying off with a mortgage. Your home equity has value so you can take out a loan on this equity through either a home equity loan (aka a second mortgage) or a home equity line of credit (HELOC). Because these loans are secured by your home equity, they typically offer lower interest rates than unsecured loans such as credit cards. Provided you spend the proceeds from home equity debt on your home—the home that secures the loan—the interest you’re charged is tax-deductible. That means if you want to renovate or substantially improve your property, using home equity debt to pay for it gets you access to this tax deduction. On the flip side, if you spend the proceeds from home equity debt on anything else, such as credit card payments or college fees, the interest charged won’t be tax-deductible.

The form you need: If you’re hoping to deduct interest from your home equity debt you’ll need the 1098 form that’s issued by your lender.

7. Mortgage insurance (PMI)

If your down payment is less than 20% of the purchase price of the home you buy, you’ll likely need to pay for private mortgage insurance (PMI) in addition to your regular monthly mortgage payments. If you’re paying for PMI there’s a chance you’ll be able to claim this as a tax deduction, but this is one break that has been changing a lot in recent years. It was set to expire in 2020 but was extended for the 2021 tax period. The eligibility requirements are still in flux and there’s a strong possibility there’ll be more changes to the mortgage insurance tax deduction in the future.

For 2021 at least, if you’re a homeowner who earns an adjusted gross income (AGI) up to $100,000 (or up to $50,000 if you’re married filing separately) you can claim your entire PMI payments as a tax deduction. If your AGI is between $100,000 and $109,000 (or up to $54,500 if you’re married filing separately) you can still claim the deduction, but at a reduced amount. Your AGI is always less than your actual gross income, so if your gross income is in the low 6 figures, your tax advisor will let you know if you’re eligible to claim the deduction.

The form you need: This is another deduction that you’ll need the 1098 form from your lender to claim.

8. Home office

Are you a self employed business owner who has a room at home that you use exclusively for business? If so, you’ve just found yourself another tax deduction. To be eligible for this deduction, you must show that your home office is the main location used to conduct your business, and that the space is used exclusively and regularly for business purposes. This tax deduction is based on the square footage of your home office. The regular method to calculate this deduction involves determining the percentage of your home that’s used for business activities. The simplified method allows you to deduct $5 per square foot, for up to 300 square foot of office space. If you work from home, but your “office” also doubles as your bedroom, you won’t be eligible for this tax break.

The form you need: To claim expenses for business use of your home, you’ll need to complete form 8829.

9. Renewable energy tax credits

Unlike tax deductions, tax credits reduce your tax bill dollar-for-dollar which means more tax savings for you. If you’ve recently made energy improvements to your home—installing solar panels, wind turbines, even insulation systems, or a new roof, for example—you may be able to claim this tax credit. Some energy-saving home improvements are eligible for a fixed credit amount up to $500. Others will earn you a credit between 10% to 30% of the improvement cost, depending on the improvement. Some of the qualifying energy-efficient upgrades (such as water heaters, water boilers, and outside doors) are relatively commonplace so have a word with your tax professional to see if any of the recent work you’ve done on your home qualifies.

The form you need: Form 5696 is what you’ll need to claim these credits.

10. Mortgage credit certificate

Many, but not all, states and local housing finance agencies offer a mortgage credit certificate (MCC) program to help lower-income families afford homeownership. First-time homebuyers who receive a mortgage credit certificate can claim a dollar-for-dollar tax credit for a portion of the mortgage interest they pay each year, up to $2,000. You may also be able to itemize any remaining mortgage interest you paid. To qualify for an MCC, you must meet the MCC program’s income and purchase limits, and in this case to be considered a first-time homebuyer you must not have owned a home in the last 3 years. If you buy a home in a ‘targeted area’ you may also be eligible for an MCC even if you earn above the income threshold and are not a first-time buyer.

If you’re eligible for the program and if your state offers it, you can apply for an MCC when you get a mortgage through a participating lender that’s been approved by the state Housing Finance Authority (HFA). Once you get the MCC you’ll still need to claim the credit on your tax return to get any benefits or potential savings.

The form you need: You’ll need form 8396 to claim this mortgage credit.

11. Home improvements

This tax perk won’t save you money immediately, but when you’re looking to sell you’ll be glad you started thinking about it early. (Early as in right now.) You see, from 2014 to 2018, the average homeowner spent $7,560 on home improvements each year. Multiply this by the number of years you’re likely to own your home, and the cost of home improvements can add up. The value of homes also went up in 2020, and many agree that we're likely to see more growth in much of the US. Selling your home for more than you paid to buy it is a great way to make a profit, but when you sell, you may be required to pay taxes on the profit—aka capital gains tax.

When you sell, tax rules let you add the cost of home improvements to the home’s purchase price (the IRS calls this the ‘basis of your property’). Doing so reduces your profit, which in turn, can reduce your capital gains tax. You may be exempt from paying this capital gains tax if the sale of your home makes less than $250,000 profit and you're a single tax filer (or less than $500,000 profit if you file jointly). Since 2000, the average US home has more than doubled in value, so even if profits like these seem far-fetched to you now, you should still keep track of those home improvement receipts—especially if you plan to stay in your home for a while.

As with all things tax-related, your definition of a home improvement may be different from the IRS’s. Examples of eligible home improvements include a new bathroom, a new addition, a main suite addition, or a finished basement. In other words, if the improvement adds value to the home, prolongs its life, or adapts it to new uses, you can add the expense to the basis of your property. If you’ve made home improvements, or are thinking about doing some in the future, a tax consultant can give you personalized guidance for your situation.

Forms you need: The most important thing to do in this case is to store your receipts in a safe place and keep a record of any home improvements you’ve made. Tax laws change over time, so knowing you have this information on hand will give you peace of mind.

See your potential mortgage interest tax deduction

Armed with the knowledge of the kinds of property-related tax breaks and credits that could be available to you, your next step is to take stock of your complete financial picture and the range of other tax deductions and credits you’re eligible for. This will help you see whether standard deductions or itemized deductions will save you the most money.

If you’re thinking of buying, there are more pros to buying a home than just the tax benefits. Before taking the plunge, get an accurate estimate of your homebuying potential. In as little as 3 minutes, you can get pre-approved with Better Mortgage and receive your free, no-commitment pre-approval letter. We’ll offer you a range of interest rates to choose from, you can set your house-hunting budget, and you’ll get a loan estimate so you’ll know what mortgage interest you’ll be likely to pay, and what mortgage interest deduction you could claim on your taxes.

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