Income Tax Breaks for Homeowners

The U.S. government has a long standing history of including incentives in the income tax code to encourage home ownership.  This is because of the positive impact home buying has on the economy – consumer spending makes up over two-thirds of the U.S. economy.  Purchases of homes, especially new construction, creates a ripple of consumer spending in the form of TVs, furniture, washers/dryers, and other home appliances.  Demand for housing keeps home values rising, which increases the equity available for borrowing to support even more consumer spending.

There are three income tax breaks available to homeowners today that have been around for a long time.  The first two – mortgage interest and real estate taxes – were impacted by the Tax Cuts and Jobs Act (“TCJA”) passed late in 2017, in a move that perhaps starts to wean American taxpayers off of housing subsidies.

Mortgage interest deduction

For taxpayers who itemize deductions rather than take the standard deduction, those taxpayers can still deduct interest paid on home mortgages, although there are new limits imposed by the TCJA.  Loans taken out to buy, build or improve a primary home or second home qualify, as long as they are secured by that main home or second home.  Home equity loans, home equity lines of credit and second mortgages still qualify if they meet the buy-build-improve criteria, whereas prior to TCJA those loans could be used for any purpose.  The aggregate amount of loans on which you can deduct interest payments is $750,000.  Interest on any loan amount above this limit cannot be deducted.

Limited deduction for real estate taxes

Like mortgage interest, real estate taxes paid on your residence are ongoing costs of home ownership that can be deducted when you file your income taxes.  However, the TCJA severely limits your ability to do so.  The deduction for state and local taxes cannot exceed $10,000.  Included in this calculation are your real estate taxes and your state and local income taxes.  Most working individuals will quickly max out the $10,000 annual cap.  Especially hard hit will be people living in high income tax states such as New York or California.  It will be interesting to see if this change in tax policy has an impact on where people choose to live and work in the future.

Capital Gains on home sales

A major tax break for homeowners comes when they sell their primary home (second homes are another story).  In general, the U.S. taxes growth on assets that are bought and sold.  There have long been exceptions for a primary residence, although the rules have changed throughout the years.  The current rules carry over from previous tax law and did not change under the TCJA.  Single taxpayers are not taxed on the first $250,000 of gain, calculated as the difference between (1) the selling price, and (2) the price you paid for your home plus the cost of any substantial improvements.  For married taxpayers the limit increases to $500,000.

With these high thresholds, most taxpayers will not pay tax on the increase in their home’s value.  Let’s assume a married couple buys a home for $300,000 and it appreciates 3% a year, basically tracking inflation.  It would take more than 30 years to have a large enough gain to trigger a capital gain tax, assuming you have not made any substantial improvements to the home.  However, not all real estate markets are the same across the country.  It is still a good idea to keep records of any improvements (i.e., remodeling or room additions) you make during the time you live in your home.

To qualify for this capital gain tax break, you must have owned your home and used it as your main residence for at least two out of the last five years before you sell.  Also, you can exclude only one home sale every two years.  Younger buyers who tend to trade-up more often and those relocating for their jobs should be particularly aware of this time requirement.  Congress considered increasing the length of time to make the law more restrictive, but the final version of the TCJA did not change the two out of five year requirement.

In the end, home ownership is both a financial decision and lifestyle decision.  It helps to know what income tax breaks are available when buying a home but in most cases should not drive the decision.