Tax Breaks for Buying a Home

From mortgage interest deductions to closing cost write-offs, find out the tax relief benefits for homeowners.

Buying your first home is a huge step. When you leave the world of renting behind, you begin building equity in real estate. And Uncle Sam is standing by to help ease the pain of high mortgage payments.

The deductions available to you as a homeowner will likely reduce your tax bill substantially. And, if you have been claiming the standard deduction up until now, the extra write-offs from owning a home almost certainly will make you an itemizer. Suddenly, the state taxes you pay and your charitable gifts will earn tax-saving deductions, too.

Mortgage interest. For most people, the biggest tax break from owning a home comes from deducting mortgage interest. You can deduct interest on up to $1 million of debt used to acquire your home. Your lender will send you Form 1098 in January listing the mortgage interest you paid during the previous year. That is the amount you deduct on Schedule A. Be sure the 1098 includes any interest you paid from the date you closed on the home to the end of that month. This amount is listed on your settlement sheet for the home purchase. You can deduct it even if the lender does not include it on the Form 1098. If you are in the 25% tax bracket, deducting the interest basically means Uncle Sam is paying 25% of it for you. A $1,000 deduction will reduce your tax bill by $250.

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Points. When you buy a house, you usually have to pay "points" to the lender to get your mortgage. This charge is usually a percentage of the loan amount. If the loan is secured by your home and the number of points you pay is typical for your area, the points are deductible as interest if you paid enough cash at closing -- via your down payment, for example -- to cover the points. For example, if you paid two points on a $300,000 mortgage -- $6,000 -- you can deduct the points as long as you put at least $6,000 into the deal. And, believe it or not, you get to deduct the points even if you persuaded the seller to pay them for you as part of the deal. The deductible amount should be shown on your 1098 form. (A different rule applies if you pay points to refinance a mortgage. In that case, the expense must be gradually written off over the life of the new loan – 1/30th a year on a 30-year loan, for example. And it’s up to you to remember to take the deduction each year. The lender will not remind you.)Real-estate taxes. You can deduct the local property taxes you pay each year, too. The amount may be shown on a form you receive from your lender, if you pay your taxes through an escrow account. If you pay them directly to the municipality, though, check your records or your checkbook registry.

In the year you purchase your residence, you probably reimbursed the seller for real estate taxes he or she had prepaid for time you actually owned the home. If so, that amount will be shown on your settlement sheet. But you can include this amount in your real-estate tax deduction. Note that you can't deduct payments into your escrow account as real-estate taxes. Your deposits are simply money put aside to cover future tax payments. You can deduct only the actual real-estate tax payments made during the year from the account by your lender.PMI premiums. Buyers who make a down payment of less than 20% of a home's cost usually get stuck paying premiums for private mortgage insurance (PMI), an extra fee that protects the lender if the borrower fails to repay the loan. For mortgages issued after 2006, PMI premiums paid in 2011can be deducted by home buyers. This write-off phases out as income increases above $50,000 on married filing separate returns and above $100,000 on all other returns. As it stands now, the write-off expired at the end of 2011. It is unclear whether Congress will extend it for 2012.

Don't overestimate the value of your deductions. If buying a home will move you into the ranks of itemizers for the first time, be careful not to overestimate how much tax you'll save. Let's say you'll be paying $1,500 interest a month on your mortgage and $3,000 a year in property taxes. That's a total of $21,000 a year. If you're in the 25% tax bracket, you might think you'll save $5,250 a year. But remember, itemizing means giving up the standard deduction which is worth $11,900 for married couples in 2012. Only to the extent that your homeowner write offs plus other deductions (for charitable contributions and state income taxes, for example) exceed $11,900 do you get a tax benefit.

Penalty-free IRA payouts for first-time buyers. As a further incentive to homebuyers, Congress offers to waive the normal 10% penalty for first-time homebuyers who withdraw cash from traditional IRAs before age 59 1/2. At any age, you can withdraw up to $10,000 penalty-free to buy or build a first home for yourself, your spouse, your kids, your grandchildren or even your parents. That $10,000 is a lifetime limit, not an annual one. A husband and wife can each take $10,000 from IRAs penalty free.

To qualify, the money must be used to buy or build a first home within 120 days of the time it's withdrawn. And, get this, you don't really have to be a first-time homebuyer to qualify. You're considered a first timer as long as you haven't owned a home for two years. Sounds great, but there's a serious downside. Although the 10% penalty is waived, the money would still be taxed in your top bracket (except to the extent it was attributable to nondeductible contributions). That means as much as 40% or more of the $10,000 would go to federal and state tax collectors rather than toward a down payment.

There's a Roth IRA corollary to this rule, too, and it makes the Roth IRA a great way to save for a first home. First, you can always withdraw your contributions to a Roth IRA tax and penalty free at any time for any purpose. And, once the account has been opened for at least five years, you can also withdraw up to $10,000 of earnings tax and penalty free to buy a first home.

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First-time homebuyer credit. If you received the $7,500 first-time homebuyer credit for the purchase of a home in 2008, starting in 2010 you had to begin repaying the credit by adding $500 each year to your tax bill – for 15 years. The $8,000 credit for first-time buyers and $6,500 credit for long-time residents who bought homes in 2009 and 2010 does not have to be repaid…unless you stop using the home as your principal residence within three years of the time you bought it. If you move out of the place before those 36 months are up, you have to repay the credit with the tax return for the year you leave the house. Note: You never have to repay more than the profit on the sale of the home; so if you sell the home for a loss during the first three years, you don’t have to repay the credit.

There are a few other exceptions to the repayment requirement, too. It's waived in the case of death, for example, or if the home is "involuntarily converted" from your principal residence (i.e. destroyed in a storm) and you buy a new principal residence within two years. Another exception waives the repayment requirement if the owner transfers the home to a spouse or former spouse incident to a divorce. And, service members who cease using the home as a principal residence within three years as a result of being deployed more than 50 miles away from the home for more than 90 days or indefinitely do not have to repay the credit.If none of the exceptions apply, however, someone who sells or ceases to use the home as his or her principal residence during the first 36 months after purchase would be required to repay the credit by adding it to the tax due for the year of the sale.

D.C. homebuyer's credit. Although the nationwide first time homebuyer credit has expired, first-time buyers in the nation's capital could earn a $5,000 federal credit for buying a home in 2011. That's the same as having Uncle Sam kick $5,000 into your down payment. Even if you owned a home somewhere else (including the D.C. suburbs), you can qualify for this sweet tax break if the house you bought was the first one you own in D.C. In fact, you can qualify even if you have owned a home in D.C. before ... as long as you have not been an owner for at least one year.

This tax break phases out as income rises between $70,000 and $90,000 on single returns and between $110,000 and $130,000 on joint returns. As of now, the credit does not apply for 2012, although Congress may vote to extend it to 2012 sales. If you’re thinking of buying in D.C., watch this point carefully.

Home improvements. Save receipts and records for all improvements you make to your home, such as landscaping, storm windows, fences, a new energy-efficient furnace and any additions. You can't deduct these expenses now, but, when you sell your home, the cost of the improvements is added to the purchase price of your home to determine the cost basis in your home for tax purposes. Although most home-sale profit is now tax free, it's possible for the IRS to demand part of your profit when you sell. Keeping track of your basis will help limit the potential tax bill.

Energy credits. From time to time, Congress enacts tax credits to encourage Americans to make their homes more energy efficient. For 2011, for example, you could earn a credit wroth 10% of the cost qualified energy efficiency improvements such as adding insulation, energy-efficient exterior windows and doors and certain roofs. The cost of installing these items does not count. The credit had a lifetime limit of $500, of which only $200 could be used for windows. If the total of non-business energy property credits taken in prior years since 2005 was more than $500, for example, the credit may not be claimed on 2011 returns. The credit expired at the end of 2011 and, as of this writing, had not been extended. There is a separate credit, however, that covers 30% of the cost of solar, geothermal and wind energy generating systems, with no dollar limit. This credit is available through 2016.

Tax-free profit on sale. Another major benefit of owning a home is that the tax law allows you to shelter a large amount of profit from tax if certain conditions are met. If you are single and owned and lived in the house for at least two of the five years before the sale, then up to $250,000 of profit is tax free. If you're married and file a joint return, up to $500,000 of the profit is tax free as long as at least one spouse owned the house as a primary home for two of the five years before the sale and both husband and wife lived there for two of the five years before the sale. Thus, in many cases, homeowners won't owe any tax on the home-sale profit. (If you sell for a loss, you cannot deduct the loss.)

You can use this exclusion every time you sell a primary home, as long as you owned and lived in it for two of the five years leading up to the sale and have not used the exclusion for another home in the last two years. If your profit exceeds the $250,000/$500,000 limit, the excess is reported as a capital gain on Schedule D.

In certain cases, you can treat part of your profit as tax free even if you don't pass the two-out-of-five-year tests. A partial exclusion is available if you sell your house before passing those tests because of a change of employment or a change of health or because of other unforeseen circumstances such as a divorce or multiple births from a single pregnancy. A partial exclusion does not mean you can exclude part of your profit; it means you get a part of the $250,000/$500,000 exclusion. If you qualify and have lived in the house for one of the five years before the sale, for example, you can exclude up to $125,000 of profit if you're single or $250,000 if you're married -- 50% of the exclusion of those who meet the two-out-of-five-year test.

ALSO SEE: Home Buyer's Survival Guide

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