Tax Benefits of Home Ownership
In tax lingo, your principal residence is the place where
you legally reside. It's typically the place where you spend most of your time,
but several other factors are also relevant in determining your principal
residence. Many of the tax benefits associated with home ownership apply mainly
to your principal residence-- different rules apply to second homes and
investment properties. Here's what you need to know to make owning a home
really pay off at tax time.
Deducting mortgage interest
One of the most important tax benefits that comes with owning a home is the fact that you may be able to deduct any mortgage
interest that you pay. If you itemize deductions on Schedule A of your federal income tax return, you can generally deduct the
interest that you pay on debt resulting from a loan used to buy, build, or improve your home, provided that the loan is secured by
your home. In tax terms, this is referred to as "home acquisition debt." You're able to deduct home acquisition debt on a second
home as well as your main home (note, however, that when it comes to second homes, special rules apply if you rent the home
out for part of the year).
For mortgage debt incurred prior to December 16, 2017, up to $1 million of home acquisition debt ($500,000 if you're married and
file separately) qualifies for the interest deduction. If your mortgage loan exceeds $1 million, some of the interest that you pay on
the loan may not be deductible.
For mortgage debt incurred after December 15, 2017, up to $750,000 of home acquisition debt ($375,000 if you're married and file
separately) qualifies for the interest deduction. If your mortgage loan exceeds $750,000, some of the interest that you pay on the
loan may not be deductible.
A deduction is no longer allowed for interest on home equity indebtedness. Home equity used to substantially improve your home
is not treated as home equity indebtedness and can still qualify for the interest deduction.
For more information, see IRS Publication 936.
You can generally treat amounts you paid during 2021 for qualified mortgage insurance as home mortgage interest, provided
that the insurance was associated with home acquisition debt, and was being paid on an insurance contract issued after 2006.
Qualified mortgage insurance is mortgage insurance provided by the Department of Veterans Affairs, the Federal Housing
Administration, the Rural Housing Service, and qualified private mortgage insurance (PMI) providers. The deduction is phased
out, though, if your adjusted gross income was more than $100,000 ($50,000 if married filing separately).
Starting in 2022, amounts paid for qualified mortgage insurance are generally not deductible.
Deducting real estate property taxes
If you itemize deductions on Schedule A, you can also generally deduct real estate taxes that you've paid on your property in the
year that they're paid to the taxing authority. However, for 2018 to 2025, individuals are able to claim an itemized deduction of up
to only $10,000 ($5,000 for married filing separately) for state and local property taxes and state and local income taxes (or sales
taxes in lieu of income taxes). Previously, there were no dollar limits.
If you pay your real estate taxes through an escrow account, you can only deduct the real estate taxes actually paid by your
lender from the escrow account during the year. Only the legal property owner can deduct real estate taxes. You cannot deduct
homeowner association assessments, since they are not imposed by a state or local government.
If you're subject to the alternative minimum tax (AMT) in a given year, your ability to deduct real estate taxes may be limited.
That's because, under the AMT calculation, no deduction is allowed for state and local taxes, including real estate tax.
Deducting points and closing costs
Buying a home is confusing enough without wondering how to handle the settlement charges at tax time. When you take out a
loan to buy a home, or when you refinance an existing loan on your home, you'll probably be charged closing costs. These may
include points, as well as attorney's fees, recording fees, title search fees, appraisal fees, and loan or document preparation and
processing fees. You'll need to know whether you can deduct these fees (in part or in full) on your federal income tax return, or
whether they're simply added to the cost basis of your home.
Before we get to that, let's define one term. Points are certain charges paid when you obtain a home mortgage. They are
sometimes called loan origination fees. One point typically equals one percent of the loan amount borrowed. When you buy your
main home, you may be able to deduct points in full in the year that you pay them if you itemize deductions and meet certain
requirements. You may even be able to deduct points that the seller pays for you. More information about these requirements is
available in IRS Publication 936.
Refinanced loans are treated differently. Generally, points that you pay on a refinanced loan are not deductible in full in the year
that you pay them. Instead, they're deducted ratably over the life of the loan. In other words, you can deduct a certain portion of
the points each year. If the loan is used to make improvements to your principal residence, however, you may be able to deduct
the points in full in the year paid.
What about other settlement fees and closing costs? Generally, you cannot deduct these costs on your tax return. Instead, you
must adjust your tax basis (the cost, plus or minus certain factors) in your home. For example, you'd increase your basis to reflect
certain closing costs, including:
- Abstract fees
- Charges for installing utility services
- Legal fees
- Recording fees
- Transfer or stamp taxes
- Owner's title insurance
For more information, see IRS Publication 530.
Tax treatment of home improvements and repairs
Home improvements and repairs are generally nondeductible. Improvements, though, can increase the tax basis of your home
(which in turn can lower your tax bite when you sell your home). Improvements add value to your home, prolong its life, or adapt it
to a new use. For example, the installation of a deck, a built-in swimming pool, or a second bathroom would be considered an
improvement. In contrast, a repair simply keeps your home in good operating condition. Regular repairs and maintenance (e.g.,
repainting your house and fixing your gutters) are not considered improvements and are not included in the tax basis of your
home. However, if repairs are performed as part of an extensive remodeling of your home, the entire job may be considered an
Residential energy-efficient property credit
You may be able to claim the residential energy-efficient property credit when you acquire alternative energy equipment for use in your home (e.g., solar hot water heater or solar electric system). This credit has been extended through December 31, 2023, with a gradual step-down in the credit each year.
See IRS Form 5695, Residential Energy Credit, for more information.
Exclusion of capital gain when your house is sold
If you sell your principal residence at a loss, you
can't deduct the loss on your tax return. If you sell your principal
residence at a gain, you may be able to exclude some or all of the gain from
federal income tax.
Generally speaking, capital gain (or loss) on the sale of
your principal residence equals the sale price of the home minus your adjusted
basis in the property. Your adjusted basis is typically the cost of the property (i.e.,
what you paid for it initially), plus amounts paid for capital improvements, less any depreciation and casualty losses claimed for tax purposes.
If you meet all requirements, you can exclude from federal
income tax up to $250,000 ($500,000 if you're married and file a joint return)
of any capital gain that results from the sale of your principal residence.
Anything over those limits is generally subject to tax. In general, this exclusion can be used only once every two years. To
qualify for the exclusion, you must have owned and used the home as your
principal residence for a total of two out of the five years before the sale.
For example, you and your spouse bought your home in 1981 for $200,000. You've lived in it ever since and file a joint federal
income tax return. You sold the house yesterday for $350,000. Your entire $150,000 gain ($350,000 - $200,000) is excludable.
That means that you don't have to report your home sale on your federal income tax return.
What if you fail to meet the two-out-of-five-year rule or if you used the capital gain exclusion within the past two years with
respect to a different principal residence? You may still be able to exclude
part of your gain if your home sale was due to a change in place of employment,
health reasons, or certain other unforeseen circumstances. In such a case,
exclusion of the gain may be prorated.
Additionally, special rules may apply in the following cases:
- If your principal residence contained a home office or was otherwise used partially for business purposes
- If you sell vacant land adjacent to your principal residence
- If your principal residence is owned by a trust
- If you rented part of your principal residence to tenants, or used it as a vacation or second home
- If you owned your principal residence jointly with an unmarried individual
Members of the uniformed services, foreign services, and intelligence community, as well as certain Peace Corps
volunteers and employees may elect to suspend the running of the two-out-of-five-year requirement during any period of qualified
official extended duty up to a maximum of ten years.
Consult a tax professional for details.