Find tax breaks at home

Your house can be a constant budget drain. But it can also yield plenty of deductions.

By Berkeley Rice
Senior Editor

Some people think of their homes as financial castles, tangible evidence of their success. For others, they're bottomless pits that suck up money for mortgage payments, taxes, insurance, and repairs.

But since some of those expenses are deductible, your residence can also be a source of substantial tax savings. For starters, of course, you can save plenty by deducting property taxes. Here are some more ways you can use your house to put money in your pocket:

Deduct mortgage points and penalties

The interest part of your monthly payment isn't all you can deduct. Many lenders charge points on mortgage loans, each point representing 1 percent of the principal. If you use the loan to buy or improve your primary home, you can generally deduct the points in the year they're paid.

Points on vacation homes are considered prepaid interest that's deductible on a prorated basis over the life of the loan. Points aren't deductible, however, if they're charged for services such as appraisals, notaries, deed preparation, or recording.

If you pay off your mortgage early and the lender socks you with a penalty, you can also deduct that amount.

Write off the interest on a home improvement loan

If you take out a home improvement or construction loan, you can deduct the interest on up to $1 million of principal, provided you're single or married and file a joint return. (If you're married but you and your spouse file separately, each of you can deduct the interest on up to $500,000.) However, the work must take place within 24 months of the date of the loan; the house must become your principal or second residence when it's completed; and the construction or remodeling must add to the value or prolong the life of the property, not just pay for repairs.

If you take out a home equity loan on a first or second home, the interest is still deductible, but only on up to $100,000 of principal, or on $50,000 each for married persons filing separately. The loan must be secured by the house, but otherwise the rules are less restrictive than those for home improvement loans. As long as you don't owe alternative minimum tax, you needn't use the proceeds to buy or improve the home.

Postpone selling

Staying in your home for at least two years can save you a bundle. Until a few years ago, the tax law allowed those 55 or older only a one-time exclusion of up to $125,000 of the net profit from the sale of a primary residence; married persons filing separately could exclude up to $62,500 each. Now, the law allows an exclusion of up to $500,000 for joint filers ($250,000 for singles), even if they've already claimed the exclusion for a prior sale.

To qualify for this huge break, you must meet several conditions: You or your spouse must have owned the home and both of you must have lived in it for at least two of the five years before the sale; and neither of you can have taken an exclusion on the sale of another home within the two years preceding the current sale.

Under certain conditions, you can bypass the two-year minimum and still qualify for a partial exclusion. If you have to sell because you're moving for business or health reasons, you can prorate the exclusion based on what percentage of the two years you were in residence. In other words, if you moved after only one year in the house because of an illness, you can qualify for 50 percent of the exclusion.

Maximize the adjusted basis, just in case

Though the liberalized rules may well mean no tax due when you sell your home, it's possible you'll have profits that exceed the exclusion maximums. To minimize the taxes those profits trigger, you'll need to track costs that add to your home's adjusted basis. That's the amount you paid for the house, including closing costs, plus the costs of improvements.

When you buy a home, keep a record of the checks you write for closing or settlement costs. Among the expenses to include: legal fees, title search and title insurance costs, survey fees, recording fees, transfer taxes, and any amounts the seller owes that you agree to pay, such as real estate taxes, back interest, charges for repairs, or sales commissions. For many buyers, those items can add up to several thousand dollars.

You should also keep records and receipts for all improvements that add to your home's value or prolong its life.

Take advantage of refinancing rules

If you refinance your mortgage on a first or second home, the interest will be fully deductible as long as the principal balance on the new loan is no higher than it was on the original loan (and it doesn't exceed the $1 million/$500,000 limits mentioned earlier).

If you borrow more than the previous outstanding balance, however, the deductibility of the interest on the additional principal depends on the amount borrowed and how you use it. Assuming you spend the extra money to build or substantially improve a first or second home, the interest is deductible. However, if you use it for any other purpose, like paying off credit card debts or your child's college tuition, the extra money is considered a home equity loan. Then, only the interest on up to $100,000 ($50,000 if you're married but file separately) is deductible.

You can deduct points paid to the lender on a refinanced mortgage, but the deduction must be prorated over the term of the new loan. If you use part of the refinanced loan for home improvements on a principal residence, however, you can deduct a proportionate amount of the points for that year.

Qualify for a home office deduction

To take deductions for a home office, you must use the space "regularly and exclusively" for professional activities such as dictating chart notes, reading journals, making referrals, or calling patients and other doctors. If your practice is based in your home, or if you're hospital-based and have no other office, it's easy to meet this standard. But if you use a spare room for work that could be done at your office, don't get your hopes up.

If your home office qualifies for a deduction, you can calculate a proportionate share of such expenses as real estate taxes, home insurance, utilities, and depreciation.

 

Berkeley Rice. Find tax breaks at home. Medical Economics 2001;22:34.