Housing is a big expense for everyone. The choice generally involves either renting or purchasing – and financing that purchase with a home loan. This article explores the tax benefits and drawbacks that individuals should consider when deciding whether to buy a home.
Purchase Costs – Purchasing a home includes costs related to escrow, title insurance, and other fees. None of these costs are deductible at the time of the purchase, but all of them add to the home’s cost (its “basis” in tax lingo) and are deductible when the home is sold. Purchase costs can also include loan points and property-tax adjustments, but these are not part of the home’s basis because they may be deductible at the time of the purchase.
Points – Points are essentially prepaid interest. 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 in the purchase of a home to be deducted in the year of the home’s purchase (provided that the homebuyer uses itemized deductions). However, this rules does not apply to points on VA and FHA loans, as those points are considered fees and are not deductible at the time of purchase.
Property Taxes – The property-tax payments for an escrow can result in either a credit or a debit, depending upon 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 is required to prepay the taxes for a bill that comes due shortly after the purchase.
Mortgage Payments – Mortgage payments include both principal and interest. The principal payments pay down the mortgage balance and are not deductible. However, the interest paid on the loan is deductible for taxpayers who itemize their deductions. 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. This may not be the case if a home loan exceeds $750,000 or if the owner has more than one home loan, however. If you have any questions, please contact this office for details.
Property Taxes – Property taxes can represent a sizable portion of housing expenses, particularly in states with no income tax. Lenders may require an impound or escrow account; the payments for such an account combine prorated property taxes and homeowner’s insurance costs with monthly mortgage payments. The goal is to prevent substantial lump-sum tax and insurance payments by defraying the costs throughout the year.
However, keep in mind that recent tax reforms include a $10,000 annual limit on itemized deductions for costs related to local property taxes and state property, income, and 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. An 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 that 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 and owning can be complicated. Although home-mortgage interest and property taxes are deductible, only the amount that exceeds the standard deduction provides 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.
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, determine the annual mortgage interest, the estimated annual property tax (which is based on the sale price), the estimated cost of home insurance, and – if the property is governed by a homeowners’ association – the annual amount of that association’s dues. Use these amounts in the worksheet to determine the monthly after-tax housing expenses, which is comparable to a rent payment.
|WORKSHEET – MONTHLY AFTER-TAX HOUSING EXPENSES|
|1||Total Itemized Deductions (including home interest and taxes)|
|2||Annual Home Interest|
|3||Annual Home-Principal Payments|
|4||Annual Home Property Taxes (after compensating 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)|
|2019 FEDERAL TAX BRACKETS|
|Federal Taxable Income (Line 10 on Form 1040), in Dollars|
|Single||Head of Household||Married Filing Jointly||Married Filing Separately|
|10%||0 – 9,700||0 – 13,850||0 – 19,400||0 – 9,700|
|12%||9,701 – 39,475||13,851 – 52,850||19,401 – 78,950||9,701 – 39,475|
|22%||39,476 – 84,200||52,851 – 84,200||78,951 – 168,400||39,476 – 84,200|
|24%||84,201 – 160,725||84,201 – 160,700||168,401 – 321,450||84,201 – 160,725|
|32%||160,726 – 204,100||160,701 – 204,100||321,451 – 408,200||160,726 – 204,100|
|35%||204,101 – 510,300||204,101 – 510,300||408,201 – 612,350||204,101 – 306,175|
|37%||Above $510,300||Above 510,300||Above 612,350||Above 306,175|
|2019 STANDARD DEDUCTIONS|
|Filing Status||Standard Deduction|
|Head of Household||$18,350|
|Married Filing Jointly||$24,400|
|Married Filing Separately||$12,200|
Purchasing a first home is a big step, and first-time homebuyers may not be familiar with all the aspects of the process. It is important for these individuals to avoid surprises and to consider the after-tax cost of homeownership when determining how much they can afford.
Isler Northwest LLC is a firm of certified public accountants and business advisors based in Portland, Oregon. Our local, regional, and global resources, our expertise, and our emphasis on innovative solutions and continuity create value for our clients. Our service goals at Isler Northwest is to earn our clients trust as their primary business and financial advisors.
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