Unlock the potential for plenty of tax deductions by purchasing a home
Jun 19 '09
The Bottom Line Mortgage interest is usually the final touch to get you in a position to itemize deductions and save thousands of tax dollars in the process.
Especially in today's economy, people are always looking for ways to save money. Since lots of people like to complain about the government, saving money on taxes, specifically, tends to get people excited. One of the best ways to save on taxes, especially in 2009, is to own the home you live in.
A Brief Look at the 1040--that form you send to the IRS every year
Every year, prior to April 15th, people send their personal financial report to the government on the form 1040. Back in the day, people who took the Standard Deduction from their income (which the IRS allows everyone to do) called their tax returns the "short form." Those who itemized their deductions instead (using actual amounts spent on various things) called their returns the "long form." The majority of people who use the "long form" can do so because they pay mortgage interest on their home.
What you can take on the "long form"
Going from top to bottom of the Schedule A (the form you put the items on when you itemize), the first thing you can deduct is out-of-pocket Medical and Dental Expenses. Before you get too excited about this, there are a couple of caveats to this that preempt most taxpayers from being able to take this deduction.
The first obstacle is that the expenses have to be after-tax money. I know that many people are confused in determining what "after-tax" means. Basically, it means that if the expense was not included in your income to begin with, you can't use it to reduce your taxable income. Most employers who handle health insurance payments take the money out before taxes. The best way to find out if this is the case for you is to look at one of your pay stubs. Many employers show on their pay stubs a year to date (YTD) amount for total wages earned, taxable income, and every little deduction you have from your paychecks. If the difference between your total wages earned and taxable income YTD is equal to the YTD amount of medical insurance premiums, those premiums were paid for before taxes and are not deductible on your tax return.
The other big obstacle with Medical and Dental Expenses is that you can only deduct the amount you paid in excess of 7.5% of your Adjusted Gross Income. To simplify things, let's say that you earned $100,000 in wages last year, with no deductions for student loan interest, moving expenses, or IRA contributions. In order to deduct Medical and Dental Expenses, the expenses must be more than $7,500 (7.5% of $100,000). So, if you spent $8,000 in out-of-pocket Medical and Dental Expenses, you can deduct $500, which is the difference between the $8,000 and $7,500. When you factor in that extra hoop of having to beat your Standard Deduction, you can see why it is very difficult for most people to be able to deduct their Medical and Dental Expenses without something else that falls on the Schedule A.
The next section on the Schedule A is for Taxes. I'm not talking about the taxes they take out of your paycheck (or at least, most of them), but the other taxes you pay. If your state has a State and/or Local Income Tax, you can deduct those taxes here. For the past five years (and likely more, if Congress keeps being sympathetic with states that don't have an income tax), you have been able to take a deduction for Sales Tax paid during the year, in lieu of the State and Local Income Tax. Other taxes you can take a deduction for in this section include Real Estate Tax on homes or land that you own, Foreign Income Tax, State Disability or Unemployment taxes taken out of your paycheck (not if it's pre-tax or your employer pays it), and Personal Property Tax. The most common example of Personal Property Tax is on your vehicle registration. Be careful here to take the portion your Department of Licensing charges based on the value of your vehicle, as opposed to the total fee.
From here, we move on to Mortgage Interest. The IRS allows you to take a deduction for mortgage interest you pay on your first or second home, as long as the original loan amount is less than $1 million. Furthermore, if you have a home equity loan, and did not use the money from that loan to buy, build or improve your home, the loan amount must be $100,000 to deduct the interest here.
Along with Mortgage Interest, you can deduct Points paid on the purchase of your home, as well as Mortgage Insurance Premiums on a mortgage obtained after December 31, 2008. Points are loan origination and discount fees paid at the time of closing your mortgage. Keep in mind that not everybody pays these, and also that you will only be able to defend the deduction to the IRS if the amount is specifically labeled Loan Origination Fee or Loan Discount Fee on your HUD-1 Settlement Statement at closing.
While we're on the subject of Points, let's talk about refinancing your home, from a tax perspective. Regardless of what your mortgage expert tells you, that person is most likely not a tax expert, and you can not take a full deduction of your closing costs on your tax return. If you pay property taxes at closing when doing a refinance, you can deduct those. Otherwise, the only other item you can deduct are the points, which must be amortized over the life of the loan. This means that if you refinance into a 30 year loan, you can deduct approximately 1/30 of the points you paid each year until the loan is paid off.
The next "big" deduction is Charitable Contributions. This includes both donations of money and items (household goods, old clothes, etc.). I have prepared over 1000 tax returns in my lifetime, and have only encountered one taxpayer with enough charitable contributions to get over the Standard Deduction on their own, so this is another one of those deductions you can pretty much thank your mortgage interest for.
The deduction for Casualty and Theft Losses has so many barriers to it that people can rarely get it. For one thing, you can only take a deduction for the difference between what the item was worth before and after destruction or theft, less any insurance reimbursements. In addition, you have to subtract $100 per incident and then take the difference between the amount leftover and 10% of your income. Unless you suffered the loss or destruction of something extremely valuable, getting the medical and dental deduction will be easier to try for.
Finally (sort of, I'm not getting into Gambling Losses here), you get to the Miscellaneous section. This is where people get excited about taking deductions for the miles they drive to work, as well as other things they spend on work and don't get reimbursed for. There are two aspects here that are similar to the Medical and Dental Expense: the expenses must be out-of-pocket (and not paid back by your employer), and there is another Adjusted Gross Income (AGI) threshold to get over. In this case, you can deduct the difference between your Miscellaneous deductions and 2% of your AGI.
As you can see, most of these deductions are unlikely to get over the Standard Deduction amount on their own, or even combined, without the big ticket amounts from Mortgage Interest and Real Estate Tax, which come from owning your home.
New for 2008 and 2009: the First Time Home Buyer's Credit
I am not going to get into whether or not I agree with this credit, but part of the Economic Recovery Acts passed by Congress in late 2008 and early 2009 include a First Time Home Buyer's Credit. There are some minor differences between the two years, but the bare bones of the credit are identical: you must be a First Time Home Buyer (defined as someone who has not owned a home in the past two years), and the maximum credit is 10% of your purchase price, up to a maximum of $7,500 (for homes purchased in 2008) or $8,000 (purchased in 2009).
If you were a First Time Home Buyer and bought in the last half of 2008, you were eligible to take a credit that added up to $7,500 to your tax refund for 2008, provided your income was less than $95,000 ($170,000 if married filing jointly). The only caveat to this was that the credit is actually a 15 year interest-free loan that you repay in $500 annual installments at tax-time, reducing your tax refunds. Many people chose not to take the credit for this reason, while others were more than happy to take an interest-free loan from the government.
First Time Home Buyers in 2009 (as long as the home closes before December 1, 2009), get a few extra perks: their credit goes up to $8,000, it is basically a gift they do not have to pay back (unless they sell the home within three years), and they can actually get the credit when they file or amend their 2008 tax return.
Just make sure to be careful not to take the credit before your home actually closes. Many in the lending industry are recommending that people amend their 2008 tax returns for the credit, so they can use the $8,000 for downpayment on the new home. Aside from the fact that the IRS instructions state to claim the credit after the home has closed, you could run into problems with the loan or house that delay you from closing before December 1st. Then, you will owe the government $8,000, most likely with interest. To me, this has "bad idea" written all over it.
Final Thoughts
Buying a home can unlock many tax deductions for many people. I hope I have illustrated here that the mortgage interest and property tax are usually the items that push people over the Standard Deduction, either on their own or in conjunction with the other deductions available on the Schedule A. Rarely do people have enough of the other deductions to get over the limit on their own. Aside from the benefits owning your home gives you from an investing perspective, owning your home is a fantastic way to save money on taxes.
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