Before answering the question, “Are real estate taxes deductible?” and getting into the subject of homeownership, I want to state that this piece is intended as general advice. Every person’s financial situation is different, and you always should consult with a CPA, tax advisor, and/or a certified financial planner for what best suits your needs, and helps meet your financial goals.
Make no mistake, real estate ownership, in my opinion, brings about some great financial benefits. As taxpayers gear up for tax day (moved to May 17 for 2021), it’s a great time to go over some of the key benefits, financially, of owning your home. Of course, there are many other benefits: independence from a landlord, pride of ownership, and getting to implement any design you would like in your home. But ultimately, we want to show you how the numbers work to your benefit.
Mortgage Interest Deduction
The mortgage interest deduction allows you to reduce your taxable income by the amount of money you’ve paid in home mortgage interest during the year. At the end of the year, your lender will send you form 1098, which will indicate how much interest you paid during the year on your home mortgage. As you will see, when your mortgage is “young” (say, less than 5 years), the vast majority of your payment is actually mortgage interest on the principal amount financed.
If you purchased your home prior on December 15, 2017, or prior, you can deduct the mortgage interest you paid during the tax year on the first $1 million of your mortgage debt for your primary home or a second home. If you bought the house after Dec. 15, 2017, you can deduct the interest you paid during the prior year on the first $750,000 of the mortgage.
For example, if you initially took a $900,000 mortgage to buy a house in 2017, and you paid $25,000 in interest on that loan during 2020, you can likely realize the full deduction of all $25,000 of that mortgage interest on your tax return. However, if you got a $900,000 mortgage in 2020, that deduction might be a little smaller. That’s because the 2017 Tax Cuts and Jobs Act limited the deduction to the interest on the first $750,000 of a mortgage. There’s an exception to that Dec. 15, 2017, cutoff: If you entered into a written binding contract before that date to close before Jan. 1, 2018, and you closed on the house before April 1, 2018, the IRS considers your mortgage to be obtained prior to Dec. 16, 2017.
Mortgage interest is deductible on any housing type, so long as it’s a primary or second residence. Single family homes, condos, co-ops, townhomes, duplexes, and multi-unit properties all qualify, so long as they are the collateral used on the mortgage. It’s also worth noting that this deduction applies to mortgage interest, mortgage insurance, and points paid on a mortgage, although certain income limits may apply on mortgage insurance deductions. A second mortgage on the same property, or a home equity line of credit, can receive the same deduction as well.
Property Tax Deduction
As you may know, property tax, sometimes called an ad valorem tax, is a tax on real estate and some other types of property. Local governments typically assess property tax, and the property owner pays the tax. The property tax is usually based on the property location and how much it’s worth.
You are allowed to deduct your property taxes each year. The challenge now, though, is that you might not be able to deduct the total amount of property taxes you pay. That’s because of changes made by the Tax Cuts and Jobs Act, which was passed late in 2017. This tax law means you can now deduct a total of $10,000 in state and local property taxes if you are married filing jointly and $5,000 if you’re single or married filing separately.
This figure includes not only your home’s property tax bill, but also real estate taxes and other taxes assessed like personal property taxes for cars and boats. It also includes state tax and local income taxes or state taxes and local sales taxes.
If you paid $7,000 in property taxes in 2020 and $5,000 in state and local income taxes, you can only deduct $10,000 on your 2020 income taxes, not the $12,000 you actually spent.
For those of us here in Illinois, the vast majority of us will reach the $10,000 limit of this. This means you need to schedule a consultation with a tax professional to determine if you are better off taking the standard deduction, or itemized deductions. I have found that it’s still better for most people to itemize. However, for those with less expensive housing and less income, you may be better off taking the standard deduction in favor of itemizing.
Energy Improvement Tax Credits
Homeowners can claim a federal tax credit for certain home improvements that are energy efficient and sustainable. Solar, wind, geothermal, and fuel cell technology are all eligible for the Residential Renewable Energy Tax Credit. The Non-Business Energy Property Credit has been reinstated through 2020 as well. The credit applies only to home modifications made through the end of 2021, however. Adjustments apply for tax years 2019, 2020, and 2021.
You can claim three applicable percentages for the Residential Renewable Energy Tax Credit:
- 30% for property placed in service after December 31, 2016, but before January 1, 2020
- 26% for property placed in service after December 31, 2019, but before January 1, 2021
- 22% for property placed in service after December 31, 2020, but before January 1, 2022
The credit you receive is a percentage of the cost of alternative energy equipment; this also includes the installation cost. Some examples of eligible improvements would be solar panels for electricity, fuel cells, wind turbines, or solar water heaters.
It may seem basic, but building equity in your home is one of the biggest benefits, financially, of owning vs. renting. Think of this as a forced savings account, except the money you put in the savings account would be spent no matter what.
Housing is essential. Unless you’ve been given a free property or plan on living with your family rent free forever, you will be making a monthly housing payment. When you own, part of your mortgage payment is paying down the principal balance of your loan each month. Case-in-point: if you take a $400,000 mortgage to purchase a home, 5 years later, you have paid down around $44,000 in principal. All else equal, you have created savings of $44,000 just by making a housing payment! When renting, your payment is essentially doing the same thing – for the landlord.
While your monthly mortgage payment continues to eat away at the debt owed on a home, your home is also appreciating. While year-to-year, the amount a home appreciates (or depreciates) can vary. But over time, on average, housing appreciation is somewhere between 3-5% annually. From the example above, at the 5 year mark, the value of your property may also be around $65,000 more than you paid for it (assuming a 3% annual increase in value). So in this example, when we combine what has been paid down in principal and the increase in property value, you have added over $100,000 in equity! Another way to think about this: your net worth has increased over $100,000 – just by making your housing payment each month!
Tax Free Appreciation and Capitalisation
At some point, you are likely to sell and move (read some of those stats on the Census Bureau’s website). Depending on the market and how long you have lived in your home, you may be selling for much more than you paid for your house. Essentially, you might be making a profit from selling your house – which is great!
Normally, when you make a profit, you pay taxes to your taxing authority. On real estate, that’s a capital gains tax. However, when you sell your primary residence, you do not have to make tax payments on up to $250,000 of profit if you are single, or $500,000 if you’re a married couple. Even with rapid appreciation periods, it would be atypical for the value of the property to increase this much, especially after the basis (purchase price + cost of improvements made) is calculated, on which the tax is (or isn’t) paid on.
It’s important to note the following:
- You must have lived in your home for 2 of the last 5 years to be eligible for this
- During those years, the home must have been your principal residence (i.e. you cannot live in a house 1 day in 2 different years to qualify)
- Documentation is key! Keep records of what you spend on home improvements so the basis can be accurately calculated.
Home ownership rules! Not only are you free of the tethers that a landlord may impose on you, but you are building wealth while paying for an essential cost. When you’re ready to make the leap into home ownership, contact Scout Real Estate Partners to help you find the right home!