The Financial Benefits of Home Ownership

The Financial Benefits of Home Ownership

Acquiring a residential property represents a substantial financial commitment for the majority of individuals, often serving as the largest investment they make in their lifetime. Nonetheless, homeownership offers numerous tax advantages and incentives as outlined in the Tax Code. These benefits encompass tax deductions for property taxes and mortgage interest during the initial purchase, tax credits for implementing energy-efficient home improvements, and even a gain exclusion when selling the property. By leveraging the financial benefits of home ownership, individuals can effectively reduce the overall cost of homeownership and strengthen the financial feasibility of real estate investments.

Strategic Planning Opportunities

Homeownership presents individuals with a range of valuable tax advantages, including:

  • Replacing nondeductible rent payments with deductible mortgage interest payments when purchasing a property.
  • The ability for homeowners to claim a deduction for property tax expenses, with certain limitations, up to a maximum of $10,000.
  • Homeowners can benefit from an exclusion of up to $250,000 of gain (or up to $500,000 for married couples filing jointly and qualifying surviving spouses) from their taxable income upon the sale of their residence.
  • No penalties for early withdrawals from an IRA used for a “first-time homebuyer” purchase.
  • The opportunity for self-employed individuals to deduct expenses for the portion of their home used for business purposes.
  • Exclusion from gross income for discharges of qualified principal residence indebtedness.
  • Residential energy tax credits available for environmentally friendly and ecologically responsible home-related expenses.
  • These tax benefits play a crucial role in enhancing the financial feasibility of real estate investments, providing individuals with increased financial flexibility and stability. With careful planning, homeowners can take advantage of these opportunities to maximize their overall financial well-being.

Home Mortgage Interest Deduction

Compliance Note:

To claim deductions for home mortgage interest and real estate taxes, taxpayers must itemize deductions and file Form 1040, Schedule A.

The Tax Cuts and Jobs Act (TCJA) has introduced limitations on the itemized deduction for home mortgage interest for tax years 2018 through 2025. The deduction now applies only to acquisition debt, with a maximum amount of $750,000 ($375,000 if married filing separately) for debt incurred after December 15, 2017. Acquisition debt refers to debt used to acquire, construct, or improve a qualified residence secured by the taxpayer’s home.

Additionally, the TCJA has suspended the deduction for interest paid on home equity loans and lines of credit from 2018 to 2026, except when used to buy, construct, or improve the taxpayer’s home that secures the loan. These limitations and suspensions have significant implications for taxpayers relying on mortgage interest deductions and should be considered in tax planning.

Key Rates and Figures:

For acquisition debt incurred before December 15, 2017, the maximum amount treated as acquisition debt remains $1 million ($500,000 if married filing separately) for debt incurred on or before that date. However, any acquisition debt incurred after December 15, 2017, will be subject to the $750,000/$375,000 limit. Taxpayers who acquired their principal residence before December 15, 2017, should be aware of this provision as it may affect their mortgage interest deduction.

Debt incurred before October 13, 1987, is treated as acquisition debt and not subject to the $1 million/$500,000 limit. Taxpayers with pre-October 13, 1987, debt are not affected by the reduced limit. However, the amount of this grandfathered debt will reduce the dollar limitation but will not go below zero.

Taxpayers with grandfathered debt still paying interest may be eligible to deduct the interest paid, subject to limitations. It is advisable to consult a tax professional to determine eligibility and ensure compliance with applicable tax rules.

Compliance Note:

For debt incurred after December 15, 2017, used to refinance existing acquisition debt on the taxpayer’s principal residence, the maximum amount treated as acquisition debt will not decrease if the refinanced debt does not exceed the amount of the original debt. This provision is outlined in Internal Revenue Code section 163(h).

However, this exception for refinancing existing acquisition debt will not apply after the term of the original debt expires or the earlier of the first refinancing of the debt or 30 years after the first refinancing date. Taxpayers considering refinancing should be aware of these provisions to ensure eligibility for the mortgage interest deduction. Consulting a tax professional is recommended to understand the impact of refinancing on their tax situation.

Points Deduction or Amortization

“Points” are fees charged by lenders to borrowers for mortgage financing. Under normal circumstances, points are amortized over the mortgage’s life. However, the IRS provides a safe harbor provision that allows cash-method taxpayers to deduct points paid in connection with the purchase of a principal residence in the year of payment, providing a more immediate tax benefit.

If the full amount of points cannot be deducted in the year of payment, such as in areas where paying points is uncommon, taxpayers may deduct the points evenly over the mortgage term. If the mortgage is paid off early, the remaining points can be deducted in the year of prepayment or foreclosure to receive the full tax benefit.

Taxpayers uncertain about the deductibility of points should seek guidance from a tax professional to ensure accurate reporting and maximize tax benefits.

Real Property Taxes and State/Local Tax Deductibility Limits

Real property taxes, imposed by state or local governments, are generally deductible on an individual’s federal income tax return. These taxes are payments made for the benefit of public welfare on interests in real property. However, taxes assessed for local benefits are not considered deductible as real property taxes. It is important to note that foreign real property taxes are not deductible. Real property taxes differ from special assessments, which are imposed for specific property benefits and cannot be deducted as real property taxes.

Key Rates and Figures:

For individual taxpayers who itemize deductions, there is a limit on the combined deduction for state and local property taxes, state and local income taxes, or general sales taxes. This limit is set at $10,000 ($5,000 if married filing separately) for tax years 2018 through 2025, as established by the Tax Cuts and Jobs Act.

Allocation of Real Property Taxes in Real Estate Transactions

When a home is sold, real estate taxes are often divided between the buyer and seller based on their respective ownership periods. The portion of real estate taxes paid by the buyer is generally deductible in the year they are paid or accrued. Conversely, the seller is treated as having paid the portion of real estate taxes corresponding to the period they owned the property.

Exclusion of Gain on Sale of Principal Residence

The financial benefits of home ownership extend even further. The Internal Revenue Service (IRS) provides taxpayers with the opportunity to exclude a certain amount of gain from the sale or exchange of their principal residence. This exclusion allows individuals to exclude up to $250,000 ($500,000 for qualified spouses filing jointly) of the gain from their gross income. To qualify for this exclusion, the taxpayer must have owned and used the residence as their principal home for at least two of the five previous years. Moreover, this exclusion can only be claimed once every two years.

Definition of Principal Residence

The term “residence” encompasses various property types, including houses, condominiums, houseboats, mobile homes, and cooperative housing corporation stock held by a tenant-shareholder. Determining whether a property is considered a taxpayer’s principal residence depends on the specific facts and circumstances of each case. While the regulations generally consider the residence used for the majority of the year as the principal residence, there is a nonexclusive list of factors to assist in determining the status of a property as a principal residence.

Ownership and Use Test

The ownership and use requirements for excluding gain on the sale or exchange of a principal residence do not need to be continuous. This means that a taxpayer may qualify for the exclusion if they owned and used the property as their principal residence for a total of 730 days (365 x 2) during the five-year period before the sale, even if those days were not consecutive. Additionally, a previously rented property can meet the ownership and use requirements as long as both tests are satisfied within the five-year period before the sale. Short temporary absences, such as vacations or seasonal absences, are considered periods of use, even if the property is rented out during those times.

Gain Exclusion

If certain conditions are met, the entire gain on the sale of a principal residence can be excluded, up to $500,000 for married individuals filing jointly. These conditions require that either spouse meets the ownership test, both spouses meet the use test, and neither spouse has excluded gain from a prior sale or exchange of a residence within the last two years. If the spouses do not meet all three requirements, the exclusion is determined on an individual basis, and it equals the sum of the exclusion limitations each spouse would have been entitled to if they were not married.

First-Time Homebuyer and IRA Distribution

Tax laws provide incentives for first-time homebuyers, including the option to use funds from certain retirement arrangements for purchasing a home. To be considered a first-time homebuyer, a taxpayer must not have had a present interest in a principal home during the two-year period leading up to the acquisition of the home for which the distribution is being used for purchase, construction, or rebuilding. This requirement must be met by each spouse in the case of a married couple.

IRA Withdrawals: Normally, withdrawals from an IRA before reaching age 59½ are subject to ordinary income tax and a 10% early withdrawal penalty. However, there is an exception for withdrawals from an IRA (not a 401(k) or other qualified plan) of up to $10,000 (lifetime maximum). This exception applies if the funds are used within 120 days of the withdrawal for qualified acquisition costs as a first-time homebuyer. To qualify, neither the homeowner nor their spouse should have owned a primary residence for the two years preceding the withdrawal (IRC §72(t)(2) and IRC §72(t)(8)).

2 The Financial Benefits of home ownership

Business Use of the Home and Exclusion of Discharged Debt

More individuals are operating businesses from their homes, and if certain requirements are met, they may be eligible to deduct expenses associated with maintaining a home office. The deduction for home-related business expenses generally applies to a part of the home that is exclusively and regularly used as (1) the principal place of business for the taxpayer’s trade or business, (2) a place to meet or deal with clients, customers, or patients in the normal course of business, or (3) a separate structure that is not attached to the dwelling unit, in connection with the taxpayer’s trade or business.

Expense Types and Allocation

Home office expenses are categorized as direct or indirect expenses. Alternatively, the IRS provides a simplified optional method for claiming a home office deduction. Under this method, taxpayers can deduct $5 per square foot of the home used for business, up to a maximum of 300 square feet. The simplified method eliminates the need to allocate and substantiate actual expenses, and taxpayers can still claim allowable mortgage interest, real estate taxes, and casualty losses on the home as itemized deductions on Schedule A (Form 1040).

Compliance Note:

Business use of the home expenses are reported on Form 8829, Expenses for Business Use of Your Home. However, for sole proprietors, the home office deduction using the simplified method is calculated directly on Schedule C, Profit or Loss From Business.

Exclusion of Discharged Debt: An individual may be able to exclude a limited amount of discharged qualified principal residence debt from gross income before January 1, 2026. To qualify as qualified principal residence debt, the debt must have been incurred to acquire, construct, or substantially improve the individual’s principal residence and be secured by that residence. This exclusion was extended by the Taxpayer Certainty and Disaster Tax Relief Act of 2020.

The exclusion for discharged qualified principal residence debt expired at the end of 2017 but has been retroactively extended to cover 2018. Furthermore, the exclusion has been extended through December 31, 2026. Qualified principal residence indebtedness refers to debt incurred to acquire, construct, or improve the taxpayer’s principal residence and secured by that residence. The exclusion for discharged qualified principal residence indebtedness is limited to $2 million ($1 million for married taxpayers filing separately).

Residential Clean Energy Credit (formerly the residential energy efficient property credit)

Individuals who install eligible clean energy property on or in connection with their dwelling unit in the United States, used as a residence, can claim a tax credit known as the Residential Clean Energy Credit. This credit, extended by the 2022 Inflation Act, applies to eligible property placed in service on or before December 31, 2034. To qualify, the property must be installed on the taxpayer’s principal residence in the United States that they own and use. Additionally, the property must be placed in service by the taxpayer and remain in use for a minimum of 5 years.

Qualified residential energy-efficient property includes:

  • Solar electric property
  • Solar water heating property
  • Fuel cell property
  • Small wind energy property
  • Geothermal heat pump property
  • Biomass stoves and water heaters (expenditures incurred after 2020)
  • Qualified battery storage technology (for expenditures incurred after December 31, 2022)

The Residential Clean Energy Credit is calculated using Form 5695, Residential Energy Credits. The maximum credit for fuel cell property is limited to $500 for each one-half kilowatt of capacity. The credit amount varies as follows:

  • 30% of the cost of eligible property placed in service between 2022 and 2032
  • 26% of the cost of eligible property placed in service in 2033
  • 22% of the cost of eligible property placed in service in 2034

Energy Efficient Home Improvement Credit (formerly, the nonbusiness energy property credit)

Individuals who make eligible energy-efficient home improvements to their dwelling unit in the United States, used as a residence, can claim a tax credit known as the Energy Efficient Home Improvement Credit. This credit, formerly known as the Nonbusiness Energy Property Credit, has been extended by the 2022 Inflation Act and applies to eligible property placed in service on or before December 31, 2032.

Annual Credit Limits. The credit is calculated using Form 5695, Residential Energy Credits. The 2022 Inflation Act introduces new annual credit limits as follows:

  • $1,200 for the maximum credit for all property types per year
  • $600 for any item of qualified energy property
  • $600 for exterior windows and skylights
  • $250 for any exterior door, with an annual aggregate limit of $500 for all exterior doors

Certain annual limitations apply specifically to the Energy Efficient Home Improvement Credit.

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2023-10-30T16:56:15+00:00May 17th, 2023|Individual, Tax|

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