The tax advantages of buying a home

When buying a home, Uncle Sam plays a big role, offering a variety of tax breaks for homeowners. But taxes are messy and they can be complicated and arcane. So learn all about the benefits, the pitfalls and how to file the paperwork properly.

More than 75 years ago, the U.S. government decided to award homeowners with a lucrative tax break, permitting home loan interest to be deductible from personal taxable income. Most states that have income taxes permit the same deduction.

This benefit is particularly useful to first-time home buyers because during the early years of the loan most of each monthly payment going to pay interest, which is deductible. Very little principal is paid back. For example, at the end of the first year of a 30-year fixed mortgage at 8 percent, less than 1 percent of the principal is repaid. The longer you pay on an amortized loan, the more of each monthly payment goes to pay the principal. Less of each monthly payment goes toward interest. You lose some of your interest write-off as you build equity in the property.

Remember you can only take these tax deductions if you switch from the standard deduction, which all taxpayers are entitled to, to itemized deductions. If your itemized deductions, including mortgage interest and property taxes, do not exceed the standard deduction amount, you are better off taking the standard deduction.

TIP: The longer the term of the mortgage the higher the tax savings, because there is more interest on a 30- or 40-year loan than there is on a 15-year mortgage. The higher the amount of interest paid, the larger the tax deduction. However, even when you take the tax savings into account, a 15-year loan will probably cost you less in the long run.

What is deductible?

Interest on your mortgage, whether paid to a lender or to a home seller or another party, as long as it is for debt secured by real property.
Property taxes are completely deductible, but special government fees such as water or sewer assessment may not be.
For a purchase mortgage, loan points are fully deductible in the year that they are paid. In a refinance, the points are written off in increments over the term of the loan.

What is not deductible?

Home improvement expenses
Closing costs other than prorated property taxes and points on the home loan
Real estate commissions paid to real estate or loan brokers
Home inspections, appraisals or loan application fees
Homeowner and co-op dues
Insurance expenses

IRAs and Real Estate

You can not use a conventional IRA account or 401-K plan for a downpayment without paying steep penalties and taxes on the gains that were made while the money sat in the savings plan.

But if you are saving to become a first-time home buyer, check out a Roth IRA. The Taxpayer Relief Act of 1997 created a new type of individual retirement account called a Roth IRA, which allows penalty-free withdrawals for first-time homebuyers.

But read the fine print carefully.

Deduct income not contributions: Contributions to a Roth IRA are not deductible, but no taxes are paid on qualified distributions.
Must wait five years: To be qualified for a Roth IRA, a distribution must be made five taxable years after the first contribution to the account was made. In addition, the distribution must meet at least one of the following conditions:
Limits on the contribution: Up to $2,000 a year can be contributed to an account, but only by single tax-filers with adjusted gross income of less than $95,000 and joint-filers with combined income below $150,000.
Convert your existing IRA carefully: The new tax law permits you to convert your existing individual retirement account into a Roth IRA if your adjusted gross income is less than $100,000 and the conversion is made before Jan. 1, 1999. But any amount that would have been taxable as income when withdrawn from the existing account will be taxed, but the tax liability can be spread out over four years. Importantly, the traditional 10 percent penalty on early withdrawals will not be levied on taxpayers who convert their current IRA into a Roth IRA.

The three deductibles at closing

Three closing costs are tax-deductible in the year of the sale: points, prorated mortgage interest and prorated property taxes. Lenders collect enough money at closing to cover the interest owed and property taxes from the closing date until the next payment period. This is called proration. Make sure that you keep a record of this figure. At the end of the year, the lender will send you a 1099 form (for your income tax filing) which indicates the amount of interest you paid for the year. This 1099 form might not include the pro-ration of interest you paid at closing.

Capping capital gains

The Taxpayer Relief Act of 1997 allows married couples who sell their primary home to keep up to $500,000 in profits tax-free and lets single-filers keep up to $250,000. If the sale exceeds that amount, capital gains taxes of 20 percent must be paid. When a rental property is sold, the seller is obligated to pay capital gains tax. The IRS also allows property owners to defer capital gains liability if they buy another rental property and meet the requirements for a 1031 exchange. The IRS does not allow property owners to defer their capital gains tax from the sale of a rental property if they use the proceeds to buy a personal residence. The proceeds must go into another rental property.