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Common Tax Misconceptions of Owning a Home

The quest for a homeownership stake in this great land of ours has long been the number one dream of most Americans. The proverbial home with a white picket fence and wraparound porch provides stability, shelter, a place to entertain friends and family, as well as a long-term investment. And, while the tax benefits of owning a home may often fuel the desire for renters to dive into purchasing a house, there are many misconceptions that need to be dispelled before taking the plunge. Here are some common tax myths of homeownership:

1. Homeownership deductions will reduce my tax bill

This may very well be the case, but it is not a given and, with regard to mortgage interest, will not last forever. In order to claim these deductions, they must exceed your standard deduction (for 2014 – $6,200 single, $9,100 head of household and $12,400 married filing jointly) when combined with your non-home write offs such as state income or sales taxes and charitable donations; and you must itemize your deductions on Schedule A.

The mortgage interest deduction may also be limited for some taxpayers. “Home acquisition indebtedness” (HAI) is any loan secured by your primary or secondary residence whose purpose is to acquire, construct, or substantially improve a primary or secondary residence (a qualified home). You may not deduct interest on more than $1,000,000 of aggregate HAI.

The timing of your home purchase may also impact whether you itemize. For instance, if you close in April, you will most likely make seven mortgage payments in that tax year, as well most of the semi-annual real estate tax payments. In that case, you will most likely itemize. However, if you close in say, October, you may make only one mortgage payment and possibly one property tax payment. As a result, the standard deduction may exceed your itemized deductions in the year of purchase, thereby causing you to have to wait for the following year to itemize and begin to realize the tax benefits of homeownership.

Purchasing your home late in the year may also affect the deductibility of points. A point is equal to 1% of the original loan amount and is often paid to lower the interest rate. You can choose to deduct the points in the year of purchase or to deduct them ratably over the life of the loan (amortize) as long as they are reasonable and consistent with those charged in the real estate market in which you bought the home. Points may also be called loan origination fees or loan discount fees on your closing statement (HUD-1) and are deductible even if the seller pays them on your behalf. If you claim the standard deduction in the year of purchase, you can still elect to amortize points paid in subsequent years as long as it makes sense to itemize. If you later refinance, any points paid must be amortized over the life of the loan.

Lastly, as a loan is repaid, the principal balance decreases. This causes less interest to accrue so that each payment consists of an increased portion applied to principal and less to interest. As a result, your mortgage interest tax break is gradually disappearing even though you are making the same mortgage payment every month. In the latter years of the loan, this may cause the standard deduction to be more advantageous. Similarly, a thirty year loan will typically accrue more interest over its life than a fifteen year loan.

You may, nevertheless, be able to do some basic tax planning in this regard. At the end of the year, you can generate an extra mortgage interest deduction by making your January mortgage payment on December 31. Similarly, you can do the same with your real estate taxes if they are not escrowed (your lender will most likely not agree to prepay them out of your escrow). This may be all you need to get you over the standard deduction threshold. You will, of course, have the option to do the same in succeeding years.

2. I emptied my checkbook at the closing, but at least it’s all deductible.

This is simply not true. Yes, you worked hard to save for that nest egg down payment and you want the most bang for your buck. But the truth is only mortgage interest, real estate taxes, private mortgage insurance (PMI) and points may be deductible.

The following items that typically appear on your HUD-1 do not provide a current tax break with regard to a personal residence:

  • Homeowners and flood insurance premiums
  • Escrows for property taxes and insurance
  • Title insurance and charges
  • Appraisal fees
  • Credit report fees
  • Tax service fees
  • Flood certification
  • State and local recording, stamp and transfer taxes
  • Home association fees (except for any portion attributable to common area property taxes)

These items cannot be written off, but instead increase the tax basis of your home, so it would be wise to retain your HUD-1 for a future sale of your residence. The higher the basis, the lower the potential gain on a sale.

Although real estate taxes paid are deductible, escrows taken at closing, as well as the tax escrow portion of your monthly mortgage payment are not. Your lender is simply collecting a ratable portion of your annual tax bill in order to pay them at a future date, at which time they become a write off for you.

There are also circumstances under which closings may occur between property tax bill due dates. This will require allocation between the buyer and seller of any paid and unpaid taxes. Your HUD-1 should reflect these adjustments which are needed to determine your real estate deduction in the year of purchase.

Those who purchase homes with less than 20 percent down are typically required by their lenders to obtain PMI. PMI premiums (including insurance provided by the Veterans Administration, the Federal Housing Administration and the Rural Housing Administration) are deductible subject to income limitations. The PMI deduction is phased out for taxpayers with adjusted gross incomes exceeding $100,000 and is totally eliminated once adjusted gross income reaches $110,000. Nevertheless, the PMI deduction is a temporary tax break that will be lost after 2013 unless Congress acts to extend it.

3. It may be a money pit, but it’s my money pit and besides, I can write everything off.

Again, this is another common misnomer. Your dream home may need work, but, with limited exceptions, the costs of repairs, basic maintenance and home improvements to a personal residence do not generate a tax break. You should still maintain records of these expenses in the event that you sell the property or convert it to rental property, since, like closing costs; they affect the property’s tax basis.

4. I can always take out a second mortgage if I need money and write off the interest.

Maybe. While taking on more debt is a personal decision that you must consider carefully, it should be structured to ensure that you can take advantage of the mortgage interest tax break. If your second mortgage qualifies as HAI, you would first exhaust the HAI cap. The balance would be classified as “home equity indebtedness” (HEI). HEI is any loan secured by your qualified home whose proceeds can be used for any reason such as to buy furniture for your new house, to pay for college, or to purchase a car; or any loan whose purpose was to substantially improve your home, but that exceeds the HAI limit. You may not deduct interest on more than $100,000 of HEI. It should be noted, however, that interest paid on HEI is not deductible for purposes of the alternative minimum tax (AMT), regardless of the HEI amount.

5. There must be some other tax breaks I can take related to my home.

  • Did you buy the house after relocating to accept a new job? If so, you may be able to write off some moving expenses if the move was either to start a new job or your current employer relocated you more than 50 miles from your old job.
  • If you are self-employed and work out of your house, you might be able to claim a home office deduction.
  • Before you moved, you may have had a garage sale, threw out some unwanted items and donated the rest. Did you obtain receipts for the latter? In the year of a move, it is quite common to have a significant amount of charitable donations for clothing and household items as you transition to your new home. In addition, for first time homeowners who may not have itemized previously, property donations may be a new annual deduction along with their charitable cash giving.
  • Any improvements you make to your home that are medically necessary, such as the addition of a wheelchair access ramp and handrails, the widening of doors, or the installation of central air conditioning to alleviate allergies or asthma, might be deductible as a medical expense as long as they do not increase the value of your home.
  • If itemizing, you may be able to claim some miscellaneous deductions such as unreimbursed employee expenses and tax preparation and investment fees.
  • Prior to 2014, there were tax credits available up to $500 for the installation of residential energy efficiency products such as insulation, energy efficient windows and doors, high efficiency air conditioners and heaters. Like the PMI tax break, the future of this credit is contingent upon Congress acting to extend it.
  • A separate and more substantial one-time federal tax credit of 30% is available for solar energy installations. Qualifying equipment includes geothermal heat pumps, solar water heaters, solar panels, small wind turbines, or fuel cells placed in service for an existing or new construction home through December 31, 2016. Except for fuel cells (which must be installed in your primary residence to qualify), the credit can be used for items installed in vacation or second homes as well.

Whether you are a first time buyer or are trading up to that palatial estate, the tax breaks are the same, so plan for the possible effects of the income, HAI, HEI and AMT limitations on your itemized deductions. It would be wise to consult your tax advisor.

For more information on this topic or another area of accounting, please contact Victor C. Belgiorno at 516-861-3704 or  or Bob Jahelka at 516-861-3707 or .

 
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