First-time homeowners often are quickly confronted with the trials and travails of home ownership. When something goes wrong, there is no landlord to call. It's up to you to fix whatever is broken.
But there are some financial benefits to owning a home that is your principal residence, thanks to the U.S. tax code. The key, though, is living in the house full time. Most of the tax breaks for houses don't apply to investment property or second homes.
The first big tax break is the mortgage interest deduction. The tax law allows you to deduct the interest paid on a mortgage on your primary residence, and even a second home.
Must be secured by the home
Generally, the Internal Revenue Service (IRS) considers home mortgage interest to be any interest you pay on a loan secured by your home. It may be a mortgage to buy your home, a second mortgage, a line of credit, or a home equity loan.
You can deduct home mortgage interest if you file Form 1040 and itemize deductions on Schedule A and the mortgage is a debt, secured by the home.
In most cases, you can deduct all of your home mortgage interest. According to the IRS, how much you can deduct depends on the date of the mortgage, the amount of the mortgage, and how you use the mortgage proceeds. You can even deduct mortgage interest on a second home, as long as you do not rent it out during the tax year. IRS Publication 936 explains it in detail.
In addition to the mortgage interest, your tax breaks may begin when you buy the home. If you pay points on the loan at closing, the points – or prepaid interest – are deductible. Even if the seller pays your points, you still get to deduct them.
Owning a home means you will be paying property taxes. Under the tax law, taxes paid on personal property are deductible.
Since property taxes are generally rolled into your monthly payment, along with principal, interest and insurance, a significant portion of your monthly house payment is deductible. Here's an example:
Suppose your payment is $1,800 a month. After each payment the principal portion of the payment rises slightly, but in the early years you may be paying approximately $300 in principal, $1,000 in interest, $450 in taxes and $50 in insurance.
Since you can deduct the interest and taxes, $1,450 of your monthly payment is deductible, resulting in a $17,400 annual write off. If you are in the 28% tax bracket, that puts $4,872 back in your pocket. Put another way, that $1,800 house payment is actually about $1,400.
Tax-free capital gain
The biggest tax break, however, comes when you sell your home, providing you have lived in it at least two years as your primary residence. Normally, when you buy an asset and later sell it, you pay a tax on the capital gain – the difference between what you paid and what you sold it for.
Under current tax law, you are exempted from paying a capital gains tax if you have owned your primary residence two years or longer and the gain is $250,000 or less for an individual and $500,000 for a married couple.
This amounts to a sizable windfall and is a major improvement over the previous law, that allowed you to escape the capital gains tax only if you purchased another, more expensive home within two years.
Investment property can also provide some tax breaks, but not nearly as generous. If the home is treated as rental property, it can be depreciated on an annual basis. The taxes are deductible, as are the costs of any repairs.
The tax advantages of any investment are largely dependent on the overall income of the property owner. How ownership of investment property will impact your bottom line is something you should discuss – and discuss carefully – with a financial advisor or tax professional.