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Have you heard this before? “When you rent, you’re throwing your money away! ” But what does it really mean?
It most often refers to the tax breaks a homeowner gains in the purchase of a home, whether as a primary residence or rental/investment property. But what are those deductions?
First, let’s define what constitutes a home or investment property. This can be a house, a condominium, a townhome, a co-op apartment, a mobile home or trailer, even a houseboat. Although in the case of something non-traditional like a houseboat, it must have sleeping quarters, as well as cooking and toilet facilities.
Even rental property or a second home can provide tax breaks for the owner, so long as you live in the home either 14 days out of the year or at least 10 percent of the number of days you rent the property – whichever is greater.
There are key tax breaks for those buying a home. The first is associated with “points.” While the concept may seem complex, it is important to understand how these deductions are calculated in order to claim these tax advantages.
Although all-cash home purchases are becoming more commonplace, most people still apply for a mortgage loan out of necessity and/or for the tax breaks. However, there are costs associated with that loan, some of which represent the “loan origination fee.”
This is usually a percentage of the loan amount, which is termed the “points.”
For example, if you borrow $200,000, one point on the loan would be $2,000. The points from the loan origination fee are tax deductible in the year they are paid. As with all tax deductions, there are important conditions and this applies particularly to points.
The mortgage loan must be secured by the home you are purchasing or building and you must live there as your primary residence. You may also be able to deduct points that the seller pays as part of the negotiated coverage of closing costs by the seller.
The IRS allows the buyer to deduct the points that the seller pays as part of the closing costs but the seller cannot claim them as deductions as well. The seller’s tax advantage comes in reducing the net gain on the home when calculating capital gains taxes, which are usually deferred.
There are other closing costs that can be deducted by the buyer: pre-paid interest and pro-rated property taxes. When you buy a home you can close any day of the month; however, your first mortgage payment is often not due until the first of the second month after closing. This payment applies to the prior month unlike rent, which is paid in advance for the month.
In your closing costs, you will “pre-pay” interest for the period leading up to the first of the month immediately following your closing date and this interest is tax deductible.
Property taxes are handled the same way. If the seller’s last property tax payment covers part of the time you will actually be the owner of the home, you will be charged this amount in the closing costs. These “prorated” property taxes are also deductible.
Buying residential property as a rental investment has its tax advantages as well for the property owner. Rental income is taxable, however, you can deduct expenses associated with preparing the property for rental and maintaining it.
There are important distinctions between improvements to the property and repairs or maintenance expenses. Improvements are actions that materially add to the value of a home or substantially prolong its life: room additions, adding a swimming pool, installing insulation. Repairs simply keep the property in good operating condition: replacing damaged windows or doors, fixing leaks, repairing appliances.
The cost of property improvements generally must be capitalized and depreciated over several years (by following IRS depreciation tables) rather than deducted in the year paid.
By contrast, the cost of repairs can be written off in the year you pay them. Consult with a tax adviser on what is actually a deductible expense.
If a new home is on your list of new year’s resolutions, make sure you are educated about the valuable tax advantages, as well as the associated conditions for each, in order to make the most of your financial investment. Talk to a mortgage lender or tax advisor early in the home- buying process. If you don’t have a trusted adviser, it’s a safe bet your agent will be able to make a recommendation.
Michael Blower is president of the Central Valley Association of Realtors and an agent with Grupe Real Estate. You can reach him at [email protected]