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13 Tax Breaks for Homeowners and Home Buyers

Owning a home is part of the American Dream. Whether you fancy a log
cabin in the middle of nowhere, a suburban Cape Cod with a white
picket fence, or a downtown condo in the sky, there’s just something
special about trading in a lease for a deed. But that transition can
be difficult – and expensive. It’s tough saving up enough cash for a
down payment and then keeping up with the mortgage payments — to say
nothing of the maintenance costs, which are now all on you!

Fortunately, Uncle Sam has a few tax tricks up his sleeve to help you
buy a home, save on home-related costs, and sell your home tax-free.
Some of them are complicated, limited, or come with hoops you have to
jump through, but they can be well worth the trouble if you qualify.
And if your budget is already stretched thin, you need all the help
you can get. So, without further ado, here are 13 tax breaks that can
help you buy a home and prosper as a homeowner.

Using Retirement Funds for a Down Payment

Before you can become a homeowner, you have to scrape up enough dough
for a down payment. If you have an IRA or a 401(k) account, you might
be able to tap into those funds to help you buy a home. Savers with a
traditional IRA can withdraw up to $10,000 from the account to buy,
build or rebuild a first home without paying the 10% early-withdrawal
penalty — even if you’re younger than age 59½. If you’re married, both
you and your spouse can each withdraw $10,000 from separate IRAs
without paying the penalty. (To qualify as a first home, you and your
spouse cannot have owned a home for the past two years.) However, even
though you escape the penalty, you’re still required to pay tax on the
amount you withdraw.

With a Roth IRA, you can withdraw contributions at any time and for
any reason without facing a tax or penalty. The IRS has already taken
its cut. You can also withdraw up to $10,000 in earnings before age
59½ to help buy a first home without being hit with the 10% penalty
for early withdrawals. (Your spouse can do the same.) If you’ve had
the account for five years, the earnings will be tax-free, too.

If you want to pull money out of a 401(k) account to put toward a down
payment, you’ll have to borrow from the plan. You can typically take
out a tax and penalty-free loan from your 401(k) plan for up to half
of your balance, but not more than $50,000. Money borrowed from a
401(k) usually must be paid back (with interest) within five years,
but the repayment period for loans used to purchase a main home can be
extended. Be warned, though, that you’ll have to repay the loan before
your next tax return is due if you leave or lose your job. Otherwise,
you’ll have to pay taxes on the unpaid balance and a 10%
early-withdrawal penalty if you’re not yet 55.

Mortgage Points Deduction

You usually have to pay “points” to the lender when you take out a
mortgage. In most cases, the points you pay on a loan to buy, build or
substantially improve your primary residence are fully deductible in
the year you pay them. There are some requirements that must be
satisfied — such as the loan must be secured by your main home — but
you generally don’t have to wait to deduct points paid for a standard
mortgage.

On the other hand, if you’re buying a second home, you can’t deduct
the loan points in the year you pay them. But you can still deduct
them gradually over the life of the loan. That means you can deduct
1/30th of the points each year if it’s a 30-year mortgage. That’s $33
a year for each $1,000 of points you paid — not much, maybe, but don’t
throw it away.

When you refinance, you also typically have to deduct any points you
pay ratably over the life of the new loan. However, if you use part of
the refinanced mortgage proceeds to substantially improve your primary
home, you can deduct the part of the points related to the improvement
in the year you paid them if certain requirements are met (you can
deduct the rest of the points over the life of the loan). Also, in the
year you pay off the refinance loan (e.g., because you sell the house
or refinance again), you get to deduct all as-yet-undeducted points.
There’s one exception to this sweet rule: If you refinance a second
time with the same lender, you add the points paid on the latest loan
to the leftovers from the previous refinancing, then deduct that
amount gradually over the life of the new loan. A pain? Yes, but at
least you’ll be compensated for the hassle.

There’s one last catch, and it applies whether you’re deducting points
in the year you paid them or over the life of the loan. You must
itemize to claim the deduction. (Most people take the standard
deduction instead of itemizing.) For 2021 returns, itemizers must
report deductible points on line 8a or 8c of Schedule A (Form 1040).

Mortgage Insurance Premium Deduction

For 2021 tax returns, homeowners who paid private mortgage insurance
last year on loans originated after 2006 can deduct their premiums if
they itemize. (PMI is usually charged if you put down less than 20%
when you buy a home.) The deduction is phased out if your adjusted
gross income exceeds $100,000 and disappears if your AGI exceeds
$109,000 ($50,000 and $54,500, respectively, if you’re married but
file a separate return).

Look at Box 5 on the Form 1098 you receive from your lender for the
number of premiums you paid during the year. Report the deductible
amount on line 8d of your 2021 Schedule A (Form 1040).

Now here’s the bad news. This deduction expired at the end of the 2021
tax year. However, the deduction has expired and then been revived
several times in the past, so it could be extended again for 2022 and
beyond.

Mortgage Interest Deduction

For most people, the biggest tax break from owning a home comes from
deducting mortgage interest. If you itemize, you can deduct interest
on up to $750,000 of debt ($375,000 if married filing separately) used
to buy, build or substantially improve your primary home or a single
second home. (For pre-2018 mortgages, interest on up to $1 million of
debt is deductible.) Improvements are “substantial” if they add value
to the home, extend the home’s useful life or adapt the home for new
uses. Basically, additions and major renovations are “substantial,”
but basic repairs and maintenance are not.

Your lender will send you a Form 1098 in January listing the mortgage
interest you paid during the previous year. That’s the amount you
deduct on line 8a of the 2021 Schedule A (Form 1040). If you just
bought a home, make sure 1098 includes any interest you paid from the
date you closed to the end of that month. This amount is listed on
your settlement sheet for the home purchase. You can deduct it even if
the lender doesn’t include it on Form 1098. (Mortgage interest not
reported on Form 1098 is reported on line 8b of Schedule A.)

Mortgage Interest Credit

In addition to the mortgage interest deduction, there’s also a
mortgage interest tax credit available to lower-income homeowners who
were issued a qualified Mortgage Credit Certificate (MCC) from a state
or local government to subsidize the purchase of a primary home. The
credit amount ranges from 10% to 50% of mortgage interest paid during
the year. (The exact percentage is listed on the MCC issued to you.)
The credit is limited to $2,000 if the credit rate is higher than 20%.
However, if your allowable credit is reduced because of the limit, you
can carry forward the unused portion of the credit to the next three
years or until used, whichever comes first.

To claim the credit, complete Form 8396 and attach it to your 1040.
You also need to report the credit amount on line 6g of the 2021
Schedule 3 (Form 1040).

There are a number of restrictions and special rules for this credit.
For instance, no double-dipping is allowed. If you claim the mortgage
interest credit, you have to reduce your mortgage interest deduction
on Schedule A by the credit amount. If you refinance your original
loan, you’ll have to get a new MCC in order to claim the credit on the
new loan — and the credit amount on the new loan may change. Also, if
you sell the home within nine years, you may have to repay all or part
of the benefit you received from the MCC program.

Home-Office Expense Deduction

If you’re self-employed and work at home, you might be able to deduct
expenses for the business use of your home. The home-office deduction
is available for homeowners and renters, and it doesn’t matter what
type of home you have — single-family, townhouse, apartment, condo,
mobile home, or even a boat. You can also claim the deduction if you
work in an outbuilding on your property, such as an unattached garage,
studio, barn, or greenhouse.

The key to the home-office deduction is to use part of your home
regularly and exclusively for your moneymaking endeavor. Pass that
test and part of your utility bills, insurance costs, general repairs,
and other home expenses can be deducted against your business income.
You can also write off part of your rent or if you own your home,
depreciation (a non-cash expense that can save you real money on your
tax bill).

There are two ways to calculate the deduction. Under the “actual
expense” method, you essentially multiply the expenses of operating
your home by the percentage of your home devoted to business use. The
problem with this method is that it can be a nightmare pulling
together all the records you’ll need to calculate and substantiate the
deduction. If you use the “simplified” method, you deduct $5 for every
square foot of space in your home used for a qualified business
purpose. For example, if you have a 300-square-foot home office (the
maximum size allowed for this method), your deduction is $1,500.

Employees who work remotely can’t deduct the costs of maintaining a
home office (that includes employees working from home during the
pandemic). Before 2018, employees could claim home-office expenses as
a miscellaneous itemized deduction if the costs exceeded 2% of their
adjusted gross income. However, this deduction was eliminated by the
2017 tax reform act.

Credits for Energy-Saving Improvements

To encourage the use of renewable energy sources, Uncle Sam will
reward you with a tax credit if you install certain energy-efficient
equipment in your home. You’ll save 26% on qualifying new systems that
use solar, wind, geothermal, biomass, or fuel cell power to produce
electricity, heat water, or regulate the temperature in your home. The
credit for fuel cell equipment is limited to $500 for each one-half
kilowatt of capacity. (Note that this credit drops to 23% in 2023 and
is currently scheduled to expire in 2024.)

For the 2021 tax year, homeowners going green can also shave up to
$500 off their tax bill with another credit by installing
energy-efficient insulation, doors, roofing, heating, and
air-conditioning systems, wood stoves, water heaters, or the like. The
credit is worth up to $200 for new energy-efficient windows. The $500
general cap and the $200 maximum for windows are lifetime credit
limits (e.g., credits taken in previous years count towards the
limit). There are also other individual credit limits for advanced
main air circulating fans ($50), certain furnaces and boilers ($150),
and energy-efficient building property ($300). Unfortunately, this
credit expired at the end of 2021, so it isn’t available for the 2022
tax year or beyond.

If you qualify for either of these tax credits for the 2021 tax year,
use Form 5695 to calculate the amount and then claim the credit(s) on
line 5 of the 2021 Schedule 3 (Form 1040).

Deduction of Medically Necessary Home Improvements

You may qualify for a medical expense deduction if you install special
equipment in or make modifications to your home for medical reasons.
Common examples of medically necessary upgrades to the home include
adding ramps, widening doorways, installing handrails, lowering
cabinets, moving electrical outlets, installing lifts or elevators,
changing doorknobs, and grading the ground to provide access to the
home. Costs for the operation and upkeep of these upgrades are also
deductible as medical expenses if the upgrade itself is medically
necessary. However, improvements that simply make your home more
elderly-friendly (such as “aging-in-place” upgrades) aren’t deductible
if they’re not medically necessary.

There are some limitations, though. You have to itemize on Schedule A
(Form 1040) to claim the deduction, and you can only deduct medical
expenses that exceed 7.5% of your adjusted gross income. The deduction
is also reduced by an increase in the value of your property. So, for
example, if you spend $50,000 to install an elevator, and that
increases your home’s value by $40,000, you can only deduct $10,000
($50,000 – $40,000). And, again, the upgrade must be for a medical
reason.

Deduction of Rental Expenses

What if you rent out a part of your homes, such as a room or the
basement? You’ll owe tax on your rental income, but you can deduct
expenses for the rental space. Potentially deductible expenses include
insurance, repair and general maintenance costs, real estate taxes,
utilities, supplies, and more. You can also deduct depreciation on the
part of your house used for rental purposes, and on any furniture or
equipment in the rented space. You don’t have to itemize to deduct the
rental-space expenses on Schedule A, either. Instead, you claim them
on Schedule E (Form 1040) and subtract them from your rental income.

The tricky part is figuring out how much you can deduct if an expense
covers the whole house, such as an electric bill or property taxes. In
this case, you have to divide the expense and allocate a portion of it
to the rental space. You can use any reasonable method for dividing
the expense. For example, if you rent a 200-square-foot room in a
2,000-square-foot house, you can simply allocate (and deduct) 10% of
any whole-house cost as a rental expense. You don’t have to divide
expenses that are only connected to the rented area. For instance, if
you paint a room that you rent, your entire cost is a deductible
rental expense.

The rules are a bit different if you’re renting out a vacation home or
investment property. You’ll still owe tax on the rental income, and
you’ll still be able to deduct rental expenses, but there are other
methods for calculating those two amounts.

Property Tax Deduction

You get hit with all kinds of taxes — not just income taxes. As a
homeowner, one of the additional taxes you’re going to have to get
used to paying is your local real property tax. The good news is that
you might be able to deduct the state and local property taxes you pay
on your federal income tax return.

There are, however, a few wrinkles that can spoil this deduction.
First, you have to itemize in order to deduct real property taxes. If
you do itemize for the 2021 tax year, you can deduct them on line 5b
of Schedule A (Form 1040).

There’s also a $10,000 limit ($5,000 if you’re married but filing a
separate return) on the combined amount of state and local income,
sales and property taxes you can deduct. Anything over $10,000 is not
deductible. That hits homeowners particularly hard in states where
income, sales, and/or property taxes are on the high end.

Forgiveness of Debt on a Foreclosure or Short Sale

In tough economic times, more homeowners fall behind on their mortgage
payments. In some cases, the lender may eventually reduce or eliminate
your mortgage debt through a “short sale” or foreclosure. Normally,
when a debt is wiped clean, the amount forgiven is treated as income
to the debtor. But, when it comes to mortgage debt forgiven as part of
a foreclosure or short sale, up to $750,000 of discharged debt on a
principal residence is tax-free ($375,000 if married filing
separately).

The exclusion only applies to a mortgage you took out to buy, build,
or substantially improve your main home. It also must be secured by
your main home. The debt secured by the main home that you used to
refinance a mortgage you took out to buy, build, or substantially
improve your main home also counts, but only up to the amount of the
old mortgage principal just before the refinancing.

No tax break is available in the discharge of debt is because of
services you performed for the lender, or for any other reason not
directly related to a decline in your home’s value or your financial
condition. In addition, the amount excluded reduces your cost basis in
the home.

Capital Gain Exclusion When Selling Your Home

The IRS has a special gift for you when you sell your home: You
probably won’t have to pay taxes on all or part of the gain from the
sale. Your home is considered a capital asset. Normally, you have to
pay capital gains tax when you sell a capital asset for a profit.
However, if you’re married and file a joint return, you don’t have to
pay tax on up to $500,000 ($250,000 for single filers) of the gain
from the sale of your home if you (1) owned the home for at least two
of the past five years, (2) lived in the home for at least two of the
past five years, and (3) haven’t used this exclusion to shelter gain
from a home sale in the last two years. So, for example, if you bought
your home five years ago for $600,000 and sold it for $700,000, you
won’t pay any tax on the $100,000 gain if all the exclusion
requirements are satisfied. (Unfortunately, if you sold your home for
a loss, you can’t deduct the loss.) Any profit over the $500,000 or
$250,000 exclusion amount is reported as capital gains on Schedule D.

If you don’t meet all the requirements, you still might be able to
exclude a portion of your home-sale profits if you had to sell your
home because of a change in your workplace location, a health issue, a
divorce, or some other unforeseen situation. The amount of your
exclusion depends on how close you come to satisfying the ownership,
live-in, and previous-use-of-exclusion requirements. For instance, if
you’re single, you owned your home for two out of the past five years,
you did not use the exclusion for another home sale in the past two
years, but you lived in your home for only one of the past five years
because your employer transferred you to another city, you can exclude
$125,000 of profit — half the normal exclusion because you satisfied
only half of the live-in requirement.

Caution: When you sell your home, you might have to pay back any
depreciation you claimed for business use of your home, first-time
homebuyer credits if you purchased your home in 2008, or any federal
mortgage subsidies you received.

Increased Basis When Selling Your Home

If the capital gain exclusion doesn’t completely wipe out your tax
bill when you sell your home, you can still reduce the tax you owe by
adjusting the basis of your home. Your taxable gain is equal to the
sales price of your home, minus the home’s basis. So, the higher the
basis, the lower the tax.

What you originally paid for the home is included in the basis —
that’s good! But you can also tack on various costs associated with
the purchase and improvement of your home. For example, you can
include certain settlement fees and closing costs you paid when you
bought the home. If you had the house built on land you owned, the
basis includes the cost of the land, architect and contractor fees,
building permit costs, utility connection charges, and related legal
fees. The cost of additions and major home improvements can be added
to the basis, too (but not basic repair and maintenance costs).

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