STRATEGIC SAVINGS GUIDE: PART 1 – MAKING THE MOST OUT OF YOUR TAX RETURN
Most people are aware that you can’t write off home improvement expenses as tax deductions. While this is true by and large, you might be surprised at just how many actions you may be taking now that can lead to positive tax benefits both in the short and long terms. In this first installment of our four-part Strategic Savings Guide for Tax Return, we take a look at the three major categories of tax benefits available to homeowners throughout the United States and point you towards the resources that will help you to take advantage of the same.
Three Types of Tax Benefits For Homeowners
This past January, the IRS issued its annual Tax Information For Homeowners A careful perusal of the document along with other forms provided by the agency reveals three classes of benefits offered by the Federal Government that can assist buyers and sellers In making the most out of their respective investments. Knowing about these benefits before you proceed to settlement could prove a significant boon towards reducing your taxes. The benefit classes include Tax Deductions, Tax Credits and the Home Sale Exemption.
A. Tax Deductions For Homeowners
Deductible expenses allowed by the IRS mostly come in the form of taxes paid in connection with the purchase and sale of your home and interest on mortgage payments made for its acquisition. Additionally, certain home improvement expenses may actually qualify for deduction as long as they were made for installing or upgrading portions of your home not intended for residential use, such as a home office, rental quarters or a for-profit production studio. Finally, there are specialized deductions designed to assist veterans, ministers and persons with medical disabilities. Here’s a quick breakdown of how these deductions work and what you’ll need to do to take advantage of them. In some cases, restrictions may apply so make sure to visit the link to IRS Pub 530 posted above, as well as any other links provided throughout this article.
1. Real Estate Taxes
You can write off any real estate taxes covering the most recent fiscal year that you paid to a taxing authority at the time of settlement or closing. This applies whether you paid directly or with an escrow account. You’ll want to carefully examine your settlement statement with a tax professional to determine which taxes actually fall into this category and which do not. Transfer taxes, for example, are not eligible for deduction but can be rolled into your cost basis (see below) or can be deducted from your realized profit depending on whether you are the buyer or the seller.
2. Home Mortgage Insurance
It’s always a wise idea to make necessary improvements for a new home at the time of purchase. This is because interest paid on these additional acquisition costs dedicated to home improvement can be included in your Mortgage Interest Deduction and written off accordingly. Interest paid on home improvement loans is fully deductible up to $100,000. Interest accrued on Home Equity Line of Credit (HELOC) loans is also deductible so long as the loan isn’t worth more than the value of the house.
3. Mortgage Insurance Premiums
If you put less than 20% down when purchasing your home, the mortgage has to be insured. Referred to as “Private Mortgage Insurance” (PMI), you can deduct any associated premiums so long as your adjusted gross income does not exceed $100,000 or $50,000 if you’re married filing separately.
4. Home Mortgage & Refinancing Points
“Points” is a term referring to the origination and discount fees included in your mortgage loan. The IRS treats these as a type of prepaid interest, thus rendering them deductible expenses. 1 point equals 1% of the loan. You’ll want to check out the 9-part checklist on Page 5 of Publication 530 to see if you qualify for a one-time total deduction, but the basic rule of thumb is that first time home buyers can take all deductions at once whereas purchase of additional homes or taking out a refinance loan will typically require you to spread out the deductible interest over the lifespan of the mortgage.
5. Home Office Deduction
If you dedicate a portion of your home for regular and exclusive use as part of a legitimate business, improvements on that part of your house are 100% deductible as business expenses.
An additional benefit arises when you consider that you can make improvements that effect the entire house and can write these off up to the percentage of use for the home office. For instance, if your home office uses 10% of your home’s energy output, then you can write off 10% of your energy bill as a business expense. This can be a Godsend for professionals whose home offices require large amounts of power such as visual/audio production studios and workshops with 3D printers.
6. Home Rental Deduction
Employing one or more rooms in your home for rental triggers a similar result to the home office deduction since you are utilizing those rooms to turn a profit. While the same general deduction guidelines apply, there are some nuances related to frequency and extent of rental use throughout the year. Nolo has a nice article that can provide an overview and point you towards further resources if this option appeals to you.
7. Minister & Military Housing Allowance Deduction
If you are a member of the clergy or the armed forces, and have receive a housing allowance, you can deduct home mortgage interest payments even if you do not pay these personally. For more information, please see IRS Publication 517 (Social Security and Other Information for Members of The Clergy) or Publication 3 (Armed Forces Tax Guide)
8. Medical Necessity Deduction
Installation costs for medically necessary home upgrades such as entry and exit ramps, handrails, widening bathrooms, among others can all be deducted as long as they are reasonable and are not intended for aesthetic/architectural enhancement.
B. Tax Credits
Tax credits are another type of benefit you may be eligible for. These benefits tend to have a shelf-life and are generally offered to encourage economic stimulus or as an incentive for homeowners to get behind a federal government initiative. The two classes of tax credits presently available have to do with energy usage and housing market stimulus. Since the latter of these is currently being phased out, it will not be addressed here but if you purchased your first home after the market crash of 2008, you can find information pertaining to credits for which you may be eligible on the IRS’ website.
1. Energy Efficiency Tax Credit
If you made your home more energy-efficient by installing Insulation, windows, storm doors or upgrading your heating or cooling systems this past year, you can claim a $500 credit, with up to $200 maximum allowance for windows. This credit expired on December 31, 2016 so the energy-saving upgrade will need to have been made prior to that date.
2. Renewable Energy Tax Credit
You can receive 30% off the cost of qualifying geothermal heat pumps, solar water heaters, solar panels, small wind turbines, or fuel cells employed for service in a new or existing home. This credit is good through 2016 for all equipment except for solar, which is valid through 2019. After that, it will be reduced by half for each year until it is phased out in 2021. Fuel cells must be installed in your primary residence but all other equipment can be installed in secondary or vacation homes and still qualify. There is no cap on equipment costs including labor & installation except for fuel cells. This credit must be claimed for the year the equipment was placed in service and be accompanied by the Manufacturer’s Certificate Statement.
C. The Home Sale Exemption & Capital Improvements
One of the better known avenues for homeowners’ tax relief is the seller’s ability to reduce taxes owed on realized profits at the time of sale. In recent years, the federal government has allowed an exemption from taxation on the first $250,000 of profit earned from the sale. This has led to the presumption among many sellers that they don’t need to track their receipts for home improvements since they do not expect to make a quarter million dollar profit from the sale. But if you intend to live in your current home for a long time, those receipts can begin to add up. This is especially true if the market value of your home rises during the years you live in it.
To understand why this is so, let’s take a quick look at how your home improvement expenses can help to offset your tax burden in the first place.
When you purchase a house for your primary residence, the amount you pay at the time of closing (including lawyer’s cost, inspection fees and other costs required for transfer of title) is referred to as your “cost basis.” Any subsequent improvement that increases the value of your home or prolongs its useful life is called a “capital improvement,” and can be added to your cost basis. The resulting total is your “adjusted cost basis.” This is the figure you would subtract from your realized profit to determine the amount of taxes you owe.
A Real Life Example
Let’s say you buy a home for $200,000 and live in it for 25 years before you decide to sell. Over the years, economic conditions and development of the surrounding property may cause a rise in the fair market value of the house. Suppose you spent $60,000 during that time on installing a new kitchen, bathroom and basement. You go to sell the house for $450,000. You would owe a 15% capital gains tax on the $250,000 profit you made. However, if you count the $60,000 you spent on capital improvements against your realized profit, you’ve really only made a $190,000 profit and won’t have to pay any tax on it.
Capital Improvements vs. Repairs
Capital improvements may Include such items as additions, a new roof, swimming pool, storm windows, water heaters, wiring upgrades, decks, fencing, landscaping upgrades, a new or second driveway or a new kitchen or bathroom. For the complete list, check out Page 9 of IRS publication 523, Selling Your Home, that we linked to earlier in this article.
It’s important to understand that not all home renovations qualify as capital improvements. Standard repairs don’t increase your basis since their purpose is to restore a damaged part of your home to its prior condition. However, the need for a repair often creates opportunity for making a capital improvement. If the repair enhances the overall value of the home to an amount greater than its pre-loss condition, then the repair will enjoy the status of an improvement and can then be deducted from your sales profit for tax purposes.
One exception to this rule comes into play if your home is damaged by fire or natural disaster, in which case any expenses paid to restore it to its prior condition are treated as capital improvements.
Conditions Still Apply
Home improvements must meet the criteria set forward by the IRS in order to be counted towards your basis. For instance, the improvement must still be part of the home at the time of sale to count towards your basis. If you install a patio and later have it converted to a porch, you can no longer claim the patio as a capital improvement. Nevertheless, the argument could be made that the patio was simply the first step in constructing the porch. In that case, it may be possible to aggregate the two expenses into one.
As with all matters pertaining to taxes, it is always best to consult a specialist to help you determine the exact nature and number of benefits for which you may qualify. In the meantime, we hope this brief primer has proven useful in providing you with actionable tips for both your short and long-term tax savings strategies.