Housing is a big expense, but there are a few tax advantages of home ownership that tip the scale towards owning over renting. However, home ownership often means financing in order to make that major purchase a reality. Despite the cost, as of November 2020, the nationwide average for a 30-year fixed-rate mortgage was just under 3%. In this case, the lowest rate in over 50 years! Not only are many individuals are taking advantage of the historically low rates to buy, sell, or refinance their existing mortgage, but folks who own their homes are taking out loans to lock in the low interest rates. In case this is something you’ve considered, we’ve outlined the tax benefits and drawbacks of buying, financing, and owning a home to help the decision-making process.
Tax advantages of home ownership
Purchase Costs
Purchasing a home includes costs related to escrow, attorney fees in some cases, title insurance, and other fees. Similar expenses may be incurred when refinancing an existing loan. None of these costs are deductible at the time of the purchase or refinance, but they can be added to the home’s cost (its “basis,” in tax lingo). Also these same costs are deductible when the home is sold. Likewise, purchase or refinance costs can also include loan points and property-tax adjustments (see below). However, these are not part of the home’s basis because they may be deductible at the time of the purchase or refinance.
Points
Points are essentially prepaid interest. In general, under normal circumstances, points must be amortized (ratably deducted) over the life of a loan. However, per a special tax rule, points that are paid during the purchase of a home are eligible to be deducted in the year of the home’s purchase (provided that the homebuyer uses itemized deductions). Conversely, this rule does not apply to points on VA and FHA loans. This is because those points are considered fees and are not deductible at the time of purchase. If points are paid on a loan refinance, generally, they will have to be amortized over the length of the loan.
Property Taxes
The property-tax payments for an escrow can result in either a credit or a debit. This depends on two things: whether the seller has prepaid the property taxes, and on the amount of the buyer’s prorated tax share (which is based upon the period of ownership). In some cases, the buyer must prepay the taxes for a bill that will come due shortly after the purchase.
Mortgage Payments
Mortgage (loan) payments include both principal and interest. Principal payments pay down the mortgage balance and are not deductible. However, the interest paid on a loan is deductible for taxpayers who itemize their deductions. Consequently, almost all of the loan payments for recently purchased homes consist of deductible interest. There is a limit to the amount of deductible interest, however; it is based on the amount of the loan and on when the loan took effect. If a loan is for $750,000 or less and the owner has no other home loans, then all of the interest is deductible. However, this may not be the case if a home loan exceeds $750,000 or if the owner has more than one home loan. If you have any questions regarding the limitations for acquisition loans, please contact this office for details.
When Refinancing your Home – Be Aware of the Tax Rules
If you are thinking about refinancing an existing loan, be advised that the interest on a new loan in excess of the existing balance on a loan used to acquire the property won’t be deductible for federal purposes unless the loan proceeds are used to make improvements to the home. In other words, if you take the equity out of your home and don’t use the loan funds to make substantial improvements to the home, then the interest on the equity portion of the loan will not be deductible. Prior to 2018, homeowners who itemized could deduct interest on an equity loan of up to $100,000. Federal law no longer permits equity interest as a deduction, but some states still do allow it.
Additional tax advantages of home ownership in Washington, and other states with no income tax
Property Taxes
Property taxes can represent a sizable portion of housing expenses, particularly in states with no income tax. As a result, lenders may require an escrow account. To summarize, the payments for escrow combine prorated property taxes and homeowner’s insurance costs with monthly mortgage payments. Therefore, attempting to prevent substantial lump-sum tax and insurance payments by paying the costs evenly throughout the year. For tax-deduction purposes, only the portion of the property taxes paid directly by the homeowner or transferred from escrow to the taxing agency during the owner’s calendar year is allowed. This sometimes results in confusion because the amount paid may not match the property tax bill from a real property tax agency that operates on fiscal years.
Also, keep in mind that the tax reforms effective through 2025 include a $10,000 annual limit on itemized deductions for costs related to state and local property taxes and either state and local income or sales taxes.
Inflation
The costs of both rent and homeownership rise with inflation. Purchasing a home locks in the bulk of housing costs for the foreseeable future. There will still be nondeductible expenses for repairs and maintenance, though. Under normal circumstances, a purchased home will continue to appreciate in value.
Gain Exclusion
When selling a home that has been owned and used for at least two out of the preceding five years, single taxpayers can exclude $250,000 of the resulting gain from taxation, and married couples can exclude $500,000 of that gain. Another option for those who are handy with tools is to purchase a fixer-upper property in the right neighborhood, fix it up, and sell it for a profit, which can be excluded after owning and living in the property for two years.
Renting versus Owning
Comparisons of the day-to-day costs of renting versus owning can be complicated. Although home-mortgage interest and property taxes are deductible, only the amount that exceeds the standard deduction will provide any tax benefit. Taxpayers in higher tax brackets experience greater benefits from such deductions, of course.
The following worksheet can be used to estimate monthly after-tax housing expenses; prospective homeowners can then compare this value to their current rent payments.
Worksheet to compare Tax Advantages of Home Ownership versus Renting
This worksheet does not consider maintenance expenses, utility costs (which are usually higher for homeowners than for renters), and certain other costs of homeownership.
How to Use the Worksheet
After finding a prospective home, here’s where to start. First, determine the annual mortgage interest, the estimated annual property tax (which is based on the sale price) and the estimated cost of home insurance. In addition – especially if the property is governed by a homeowners’ association – determine the annual amount of that association’s dues. Then use these amounts in the worksheet to determine the monthly after-tax housing expenses, which are comparable to a rent payment.
The worksheet can also be used to determine the tax savings if a loan is being refinanced. Complete the worksheet once with the data for the current loan and a second time with the refinancing information, and then compare the results to see what the tax savings will be. Keep in mind that if the current balance of a home loan is refinanced at a lower interest rate, the amount of interest that will be paid and the deductible will also go down.
Monthly After-tax Housing Expenses Worksheet
| 1 | Total Itemized Deductions (including home interest and taxes) |
| 2 | Annual Home Loan Interest |
| 3 | Annual Home Loan Principal Payments |
| 4 | Annual Home Property Taxes (after accounting for the $10K tax-deduction limit discussed earlier) |
| 5 | Annual Home Insurance Premiums |
| 6 | Annual Homeowners’ Association Dues (if any) |
| 7 | Tax-Deductible Amounts (total of lines 2 and 4) |
| 8 | Annual House Expenses (total of lines 2, 3, 4, 5, and 6) |
| 9 | Standard Deduction (from the table below) |
| 10 | Line 1 Minus Line 9 (but not less than zero) |
| 11 | Tax Benefit (the lesser of line 7 or line 10) |
| 12 | Tax Bracket (from the table below, in decimal form, so 22% = .22) |
| 13 | Annual Tax Savings (line 11 times line 12) |
| 14 | Annual House Expenses, Net of Tax Savings (line 8 minus line 13) |
| 15 | Monthly After-Tax House Expenses (line 14 divided by line 12) |
2021 FEDERAL TAX BRACKETS
Taxable Income (Line 15 on Form 1040), in Dollars
| Tax Bracket | Single | Head of Household | Married Filing Jointly | Married Filing Separately |
| 10% | 0 – 9,950 | 0 – 14,200 | 0 – 19,900 | 0 – 9,950 |
| 12% | 9,951 – 40,525 | 14,201 – 54,200 | 19,901 – 81,050 | 9,951 – 40,525 |
| 22% | 40,526 – 86,375 | 54,201 – 86,350 | 81,051 – 172,750 | 40,526 – 86,375 |
| 24% | 86,376 – 164,925 | 86,351 – 164,900 | 172,751 – 329,850 | 86,376 – 164,925 |
| 32% | 164,926 – 209,425 | 164,901 – 209,400 | 329,851 – 418,850 | 164,926 – 209,425 |
| 35% | 209,426 – 523,600 | 209,401 – 523,600 | 418,851 – 628,300 | 209,426 – 314,150 |
| 37% | Above 523,600 | Above 523,600 | Above 628,300 | Above 314,150 |
2021 STANDARD DEDUCTIONS
| Filing Status | Standard Deduction |
| Single | $12,550 |
| Head of Household | $18,800 |
| Married Filing Jointly | $25,100 |
| Married Filing Separately | $12,550 |
Conclusion? Tax advantages of home ownership comes down to individual circumstances
Purchasing a first home is a big step, and there are lots of unknowns. For this reason, it’s important to consider the after-tax costs of home ownership, as this helps to as determine how much one can afford. Similarly, those who already own a home may want to determine how refinancing a current loan will affect their income taxes in addition to overall housing expenses – before refinancing.
If you have questions related to how buying or refinancing your home will impact your taxes, please give this office a call at 360-778-2901.
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