Albert Einstein once said, "The hardest thing in the world to understand is the income tax.” If you buy, sell, finance or own real estate, it gets even worse. Property and taxes go together like blood and leeches.
Yet there's no reason to pay more than the minimum, and the Internal Revenue Code actually gives property owners lots of tax breaks.
"For many homeowners, real estate taxes and mortgage interest are by far some of their biggest tax deductions," says Art Ford, a certified public accountant in Boston. "If I pay $1,500 a month in mortgage interest, that's an $18,000-a-year deduction."
So before you belly up to the nearest bar or start pulling your hair out, here are some commonly asked questions about taxes and homeownership. Knowing these answers will help keep your tax bill as low as possible.
No. 1: How much of my mortgage payment is tax deductible?
On a Schedule A (see pdf form at end of article), you can generally deduct the following:
- Interest on debt used to buy, build or improve your primary or second home (called acquisition debt), as long as mortgages totaled $1 million or less ($500,000 if single or married filing separately)
- Mortgage insurance (or funding fees for government loans) for loans taken after 2006 as long as your adjusted gross income does not exceed $109,000 for a married couple (half that for singles and those married filing separately)
- Property taxes on first and second homes (if you itemize your deductions)
No. 2: I sold my home this year. Will I owe capital gains tax?
As long as the property was your principal residence for at least two of the last five years, you can exclude $250,000 of your profit ($500,000 for married couples) from your federal taxable income. If you profited less than the $250,000/$500,000 threshold, no extra form is required. You can do this as often as every two years.
If you made a higher profit or otherwise don't qualify for the exclusion (say, you sold after just one year), Ford says you'll generally owe up to 23.8% in federal taxes on your gains over and above the "excluded" amount. (Your actual rate will vary depending on your income.)
But when calculating your taxable gains, Ford suggests looking beyond what you originally paid for your home. You should also factor in anything that you spent on home improvements while you owned the property.
Say you and your spouse bought a place for $100,000 two decades ago, lived there as your primary residence and sold the home for $800,000. You'd ordinarily have to pay capital-gains taxes on $200,000 -- your $800,000 sale price minus your $100,000 purchase price minus the $500,000 exclusion for married couples.
However, if you spent $150,000 on upgrades, you can deduct that from your capital gain. In the example above, that would reduce your taxable profit from $200,000 to just $50,000.
That said, IRS Publication 523 (see pdf form at end of article) notes that you generally can't deduct repairs or maintenance, only "improvements" that are designed to increase your home's value. Unfortunately, the rules for what's a "repair" versus an "improvement" are pretty vague.
For instance, the IRS says fixing a broken windowpane is a repair, but replacing it as part of a project to swap out all of your home's windows is an improvement. So, consult with a tax professional or read IRS Publication 523 for further guidance.
If you still have taxable profits on your home after factoring in all of the above, you'll report your gains on a Schedule D, Capital Gains and Losses (see pdf form at end of article). There are special rules for vacation homes. You may be able to exclude some or all of your gain.
Remember different states have different rules. Always consult with a tax professional if you need personal advice.
No. 3: I lost money on the sale of my home. Do I get to deduct the loss?
Loss on the sale of a personal residence is treated like a loss on the sale of any personal property. It is not deductible. Losses on investment properties are deductible.
No. 4: Are my closing costs tax deductible?
You can claim a deduction for real estate taxes you paid as part of your mortgage closing costs. The same goes for prepaid interest. It will be included on the 1098 form (see pdf form at end of article) your lender sends you.
What about points?
The IRS has a flowchart that you can use to see when points are and are not deductible. In general, you must have paid points to build, buy or improve your primary residence in order to deduct the entire amount in the year they were paid. Otherwise, they may still be deducted but on a prorated basis.
No. 5: What happens with points on a refinance?
This deduction is often overlooked, and it could be worth a lot. When you pay points on a refinance, they have to be prorated.
For example, if you paid $3,000 in points on a 30-year mortgage, you can deduct $100 a year for 30 years. But if you refinanced again this year and have prorated points that have not yet been deducted -- for example, you are 10 years into a 30-year loan and have only deducted $1,000 of $3,000 in points paid -- you can deduct the remaining $2,000 in the year you refinance.
No. 6: Does a mortgage modification affect my taxes?
If you modify your mortgage, one consequence might be that you pay so much less interest that you will save more by choosing the standard deduction rather than itemizing. Don't just assume that itemizing is always best because you did it in the past.
No. 7: Does a foreclosure, short sale or principal reduction affect my taxes?
Homeowners who lost their homes to either a foreclosure, short sale or had a bank "forgive" part of their mortgage principal used to have to pay income taxes on any money that their lender agreed to write off.
But the Mortgage Forgiveness Debt Relief Act of 2007 changed that for loans restructured between 2007 and 2014 for primary residences. For those tax years, you don't have to consider the discharge of mortgage debt as taxable income.
However, Congress has yet to extend this relief to loans restructured after Dec. 31, 2014. Additionally, the 2007 law doesn't cover investment properties and vacation homes, nor does it apply to forgiven home-equity loans.
Lastly, states have their own rules about taxes on forgiven mortgage debt, so check with a tax professional.
No. 8: Can I deduct prepayment penalties?
Prepayment penalties paid on a mortgage are tax deductible in the year that they are paid.
No. 9: What expenses am I NOT allowed to deduct from my income?
Unless your property is a rental or investment, you don't get tax breaks for the following:
- Hazard insurance
- Homeowners association dues
- Principal payments
- General closing costs like appraisal fees or title insurance
- Local assessments to improve your neighborhood
No. 10: Does the so-called "Obamacare" tax affect gains from property sales?
The 2010 "Obamacare" Affordable Care Act added an extra 3.8 percent tax on capital gains incurred by certain high-income taxpayers.
If you fall under the law's requirements, you'll have to pay 23.8 percent in federal income taxes on your home-sale profits over and above the $250,000/$500,000 exclusion rather than the 20 percent rate that you'd otherwise face.
However, this extra tax only applies to single or head-of-household filers who have a $200,000 adjusted gross income or married joint filers with a $250,000 adjusted gross income. And remember, the first $250,000 of a single taxpayer's profits ($500,000 for joint filers) is federally tax free.
Knowing what tax deductions are available to you can help minimize the tax man's bite come April 15. After all, the law says you have to pay taxes -- but there's no reason to leave Uncle Sam a tip.
IRS Publication 523
Schedule D Capital Gains and Losses
Gina Pogol was the original author of this article. (Image: ljdema/iStock)
Jerry Kronenberg writes about investing and personal finance for HSH.com and other media, with a special emphasis on real estate, autos and other pocketbook topics. A veteran business journalist, Kronenberg has held senior editorships at CNN Financial News, United Press International and the Boston Herald. He is also a former vice president of Fidelity Investments.