How does buying a home impact taxes and your paycheck?
If you’re thinking about buying a home, one advantage homeowners get is qualifying for money-saving tax benefits. Laura answers a listener question and covers various ways buying a home can improve your financial life compared to renting.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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Lynsey B. says, “Hi Laura, I recently discovered your podcast. I’m a 30-something who doesn’t speak the financial language and gets overwhelmed, but I am trying to educate myself. I appreciate that you break topics down into short, digestible episodes! I recently listened to your shows on buying a home and mortgage points. Can you please explain how buying a home impacts taxes and my paycheck?
Thanks for your great question, Lynsey! Becoming a homeowner can change your financial life in many ways, including your tax liability. In this episode, I’ll review seven ways buying a home cuts taxes and improves your overall finances so you can factor them into your decision to purchase real estate, or not.
Hello, friends, and thanks for joining me this week! My name is Laura Adams, and I'm a personal finance expert who's been hosting the Money Girl Podcast since 2008. I'm also the author of several books, including my most recent title, which was a No. 1 Amazon New Release, called Money-Smart Solopreneur–A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers. If you're building a business or want to earn more income, I hope you'll grab a copy of the paperback, ebook, or audiobook today!
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OK, let’s dive in and answer Lynsey’s question.
The first way buying a home cuts taxes is by claiming the mortgage interest tax deduction.
A tax deduction is an amount you’re allowed to subtract from your taxable income, reducing the amount of tax you owe. To incentivize homeownership, the government offers a mortgage interest tax deduction. It allows you to deduct interest paid, up to certain limits, on funds you’ve borrowed to buy, build, or remodel a home.
Let’s say you get a fixed-rate mortgage of $250,000 for 30 years with a 6% interest rate to buy a condo. Your payment for principal and interest would be close to $1,500 a month or $18,000 a year. In the first year, your mortgage payments would break down into about $3,000 paid toward the principal debt balance and $15,000 for interest.
If you claim the mortgage interest deduction, that’s $15,000 you get to deduct from your taxable income and avoid paying tax on. Depending on your income and average tax rate, that deduction could cut your tax bill or increase your tax refund by thousands!
However, you must meet two conditions to be eligible for the mortgage interest deduction: 1) filing IRS Form 1040 and itemizing deductions on Schedule A, Itemized Deductions, and 2) having secured debt on a home you own.
Itemizing means you choose to list individual deductions instead of taking a standard deduction on your tax return. If they exceed the standard, you come out ahead. You can choose the method that gives you the lowest tax liability in any tax year. But you can't itemize and claim the standard deduction.
For 2022, the standard deduction is:
So if you’re single and the total of your annual eligible tax deductions, such as mortgage interest, charitable contributions, and a certain amount of medical expenses, exceeds the standard deduction of $12,950, you’ll come out ahead by itemizing using Schedule A.
Going back to my example of having paid $15,000 in mortgage interest for the year, that expense alone would make it worthwhile for a single homeowner to itemize and claim the mortgage interest deduction.
I also mentioned that your mortgage must be a secured debt on a home you own. A debt is “secured” when you sign a legal document, such as a mortgage, deed of trust, or a land contract, allowing the lender to sell the property if you don’t repay them as agreed. It includes loans secured by your main home or a second home, including first or second mortgages, home improvement loans, home equity loans, home equity lines of credit (HELOCs), or refinanced mortgages.
If you took out a loan to buy, build, or substantially improve your home before December 15, 2017, you can deduct mortgage interest paid on up to $500,000 of debt or $1 million if you’re married and file taxes jointly. However, for home-secured loans after December 15, 2017, you can deduct interest paid on up to $375,000 of debt or $750,000 for couples filing jointly.
In addition to interest, you can also deduct late payment charges, prepayment penalties, and prepaid interest, such as points or loan origination fees. Plus, you can deduct up to $5,000 or $10,000 if you’re married and file joint taxes for state and local real estate taxes.
Also, if you pay mortgage insurance premiums (because you put down less than 20% for a home purchase) and got your loan after 2006, you can deduct them or a reduced amount depending on your adjusted gross income.
A common question about home-related tax deductions is what happens if you own a home with someone who isn't your spouse. In that case, you can claim a deduction for the portion you paid. So, if you own a portion of a home, keep good records to take every deduction possible and reduce your taxes.
Note that homeowners have many expenses that are never deductible, including homeowners and flood insurance, homeowners association dues, most closing costs, forfeited earnest money, depreciation, repairs, and interest accrued on a reverse mortgage. If you’re unsure which home expenses qualify for tax benefits, speak with a qualified tax professional.
The second way being a homeowner can reduce taxes is by claiming home-related tax credits.
In addition to home-related tax deductions, you may qualify for tax credits. Here’s how they work. Instead of decreasing your taxable income, tax credits cut the dollar amount of tax you owe.
For instance, if you owe $1,000 in taxes and have a $750 tax credit, you’d only owe the government $250. That can make them even more valuable than deductions!
There are some excellent tax credits to incentivize the installation of alternative energy equipment, such as the residential energy efficient property credit. It offsets taxes for certain expenses like installing solar electric panels, solar water heaters, geothermal heat pumps, small wind turbines, and fuel cell property expenses in your primary residence and a second home.
For 2022, the credit equals 26% of the cost, including installation. It steps down to 22% for 2023 and then expires. There’s no maximum credit for solar, wind, and geothermal equipment; however, it’s nonrefundable, allowing you to lower your tax liability to zero but not giving you a tax refund.
You can learn more and claim the credit using Form 5695, Residential Energy Credits.
Also, if you need to borrow money for sustainable home improvements or to purchase an electric vehicle, using an eco-friendly lender such as Tenet is a great way to cut your interest rate and monthly payments by hundreds of dollars.
The third money-saving benefit of homeownership is getting capital gains tax exclusions.
In addition to home-related tax deductions and credits, one of the most significant tax savings for homeowners happens when you sell the property. Generally, your gain is taxable when you sell an asset for a profit. However, many homeowners qualify for exclusion and get to keep their gain tax-free!
Here’s how it works: If you lived in the home for two of the previous five years before the sale, you qualify to exclude up to $250,000, or $500,000 if you file taxes jointly with a spouse, of profit from taxation. This fantastic benefit is available no matter your age and as often as you sell a primary residence in your lifetime.
There are some situations where you don’t have to meet the five-year test, including being on official duty in the government, getting separated or divorced, and having the death of a spouse. So speak with a certified tax professional if you have questions about the real estate capital gains tax exclusion.
You must complete Schedule D, Capital Gains and Losses, and Form 8949, Sales and Other Dispositions of Capital Assets, to report your home sale and avoid taxation.
The fourth tax benefit you might be eligible for is claiming the home office tax deduction.
You can claim your home office expenses if you have part- or full-time self-employment income and work from home. Note that the deduction is available for renters, too, if you use a space in your home regularly and exclusively for business. But you're not eligible to claim a home office if you work remotely as an employee.
To claim the standard deduction, use Form 8829, Expenses for Business Use of Your Home, to determine the expenses you can deduct and then file it with Schedule C, Profit or Loss From Business.
Related: Your Guide to Claiming a Legit Home Office Tax Deduction
The fifth way being a homeowner saves money is by hedging against inflation.
While this benefit isn’t related to taxes, I think staying protected from inflation is an often-overlooked financial advantage of owning a home.
Consider this: If you have a fixed-rate mortgage, the price you pay to have a roof over your head can’t change—no matter what happens to interest rates or the economy. The cost of your home gets locked in for the term of your loan, such as 15 or 30 years.
Even an adjustable-rate mortgage or ARM comes with an interest rate cap, so you know the maximum potential mortgage payment you could ever have to pay.
As inflation causes the price of goods and services to go up, rent prices can skyrocket, which we’ve seen in many large cities. That makes owning a home much more affordable when inflation rears its ugly head.
The sixth way being a homeowner can save money is by paying less than renting.
This benefit is unrelated to taxes but owning a home is still less expensive than renting in many parts of the country. Even though interest rates are higher than they’ve been in many years, they’re still in the single digits and reasonable.
Over the long run, owning an affordable home can be cheaper than renting, even when you factor in expenses such as a down payment, closing costs, property taxes, homeowners insurance, homeowners association fees, repairs, and maintenance.
And the final, seventh way buying a home helps your finances is by building equity.
Again, not a specific tax perk, but most homeowners who keep a home for at least five years will enjoy building equity. That’s the value of a property, less what you owe for it. For example, if your home’s market value is $350,000 and you owe $100,000 for a mortgage and $50,000 on a home equity line of credit, you have $200,000 in equity.
What's excellent about fixed-rate mortgages is that each payment comprises a principal and interest portion. Each monthly payment automatically reduces your outstanding loan balance by a slightly larger amount, which is known as amortization. Therefore, every payment allows you to own more of your home and owe less. That's different from paying rent, which is a pure out-of-pocket expense.
Although real estate values can go up and down, over the long term, they have appreciated. If your home value goes up while your debt goes down, it’s a powerful combination for building equity.
Should You Buy a Home or Rent?
Lynsey, I hope this helps you understand the financial benefits of buying a home. As I covered, some are directly related to cutting your taxes, but others improve your financial life differently.
If you’re not sure if the time is right to become a homeowner, ask yourself the following questions:
If you answer “yes” to these questions, you’re probably in an excellent position to consider buying a home seriously.
Are you like Lynsey and also have a money question or a topic suggestion? It’s easy to visit LauraDAdams.com and email me using my Contact Page–or leave a voice message at 302-364-0308. When you’re at LauraDAdams.com, you can also learn more about my work, books, and money classes.
If you haven't joined my free private Facebook Group, called Dominate Your Dollars, I'd love to have you! It's a fantastic group of people asking great questions, helping others, and reaching their financial goals. Just search for Dominate Your Dollars on Facebook.
That's all for now. I'll talk to you next week. Until then, here's to living a richer life.