Albert Einstein reportedly 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, 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 $100,000 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 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. 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 your lender sends you.
What about points?
The IRS has a flowchart that you can use to see if points are fully 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 (this could have occurred during a loan modification) 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 and subsequent extensions changed that for loans restructured between 2007 and 2016 for primary residences. For those tax years, you don't have to consider the discharge of mortgage debt as taxable income.
However, the 2007 law doesn't cover investment properties and vacation homes, nor does it apply to forgiven home equity loans.
Lastly, some jurisdictions require filers to pay state income taxes on forgiven mortgage debt, so check with a tax professional about your personal situation.
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% 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% in federal income taxes on your home-sale profits over and above the $250,000/$500,000 exclusion rather than the 20% 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.
No. 11: How does the U.S. Supreme Court's gay-marriage ruling affect same-sex couples?
The Supreme Court's June 2015 ruling legalizing gay marriage in all 50 states doesn't affect same-sex couples' federal income taxes because the IRS has recognized legal gay marriages for tax purposes since 2013.
An earlier Supreme Court ruling that partly invalidated 1996's Defense of Marriage Act prompted the tax agency to decide that same-sex couples married in any U.S. or foreign jurisdiction that recognized gay marriage could file tax returns jointly. The rule applied even if gay couples later moved to states that didn't allow gay marriage.
However, last summer's landmark high-court decision legalizing same-sex marriage nationwide means gay couples in states that previously banned the practice should have the right to file state or local income-tax returns jointly for 2015 for the first time.
No. 12: Does my income affect my tax deductions?
The IRS has increased the maximum adjusted gross income that filers can have for 2015 and still fully itemize deductions—good news for wealthy homeowners who want to claim things like the mortgage-interest tax break.
Married joint filers can have $309,900 AGIs and still itemize all deductions, up from $305,050 in 2014. Singles can make an adjusted $258,250 versus $254,200 previously, while married couples filing separately can have $154,950 AGIs, up from $152,525 in 2014. Above those limits, IRS rules begin to phase out what percentage of expenses you can deduct.
Conversely, the IRS has also boosted standard deductions for 2015. Married joint filers who don't itemize can claim a standard $12,600 versus $12,400 in 2014, while singles and married people filing separately can claim $6,300 instead of $6,200 a year earlier. (Heads of household can receive $9,250, up from $9,100 in 2014.)
Smart homeowners will do the math to see which works out better for them—itemizing or taking the standard deduction.
Lisa Greene-Lewis, an accountant with TurboTax®, says many homeowners will do better by itemizing instead of simply claiming the standard deduction. "The mortgage-interest deduction is one of the biggest itemized deductions for many people for sure," she says. "That's usually the one that puts homeowners over the threshold to where itemizing makes sense."
Knowing what tax deductions are available to you can help minimize the tax man's bite come April 18. After all, the law says you have to pay taxes—but there's no reason to leave Uncle Sam a tip.