In my opinion, there are only four instruments remaining accessible to the average citizen that provide the opportunity for significant tax savings/advantages. These four instruments are listed below:
- Retirement accounts (401ks, Traditional IRAs, SEP IRAs, and Roth IRAs) – see My Money Blog – IRA Posts and My Money Blog – 401k Posts)
- Owning your own business – see My Money Blog – Starting Your Own Business
- Education savings accounts – see My Money Blog – Give Your Child A Financial Head Start in Life
- Home ownership
Note: While trusts can be a very effective shield against Uncle Sam’s “claw” reaching in your wallet, they are generally only used by wealthy people. As such, they will be the subject of a future post.
As you can see, most of the instruments above have been discussed in previous posts. However, I have yet to describe all of the fantastic tax advantages that come from owning your own home that are definitely NOT available to us as renters. This will be the topic of today’s post.
So, just what are the tax benefits of home ownership? As it turns out, there are two categories of benefits – short term and long term. Let’s look at the short-term benefits first.
Short Term Tax Benefits of Homeownership
The main short term tax benefit associated with purchasing a home relates to the mortgage “points,” or pre-paid interest, that is paid at the time of closing on a home mortgage loan. These can be deducted from your taxable income the year that you first get your mortgage.
In addition, you can also obtain tax credits for “green” building/home improvement initiatives, such as the current 2011 home improvement tax credit.
Long Term Tax Benefits of Homeownership
- Tax free capital gains
- As a refresher, capital gains taxes are taxes that the government charges on profits made on investments such as stocks, mutual funds, etc. For these instruments, if you sell your shares for a profit after holding it for less than a year, you have to pay 30% of the proceeds in taxes (15% if held for longer than 1 year).
- Primary Residence Rule – Under the current tax law, if you sell your primary (place where you have lived at least 2 years out of the last 5 years – this means that you don’t have to have lived there consecutively) residence, you don’t have to pay ANY capital gains taxes to the government on the first $250,000 in profits ($500,000 for married couples filing jointly).
- Rental Property Rule – Fortunately, the government has also created a way to avoid having Uncle Sam taking out capital gains taxes from selling rental property. This is made possible by what’s called a “1031 tax free exchange.” The rule states that you will not be charged any capital gains taxes if you use all of the proceeds from the sale of a rental property to buy another rental property within 180 days of closing on the previous property.
- And, the icing on the cake is that you can do this multiple times, as long as you follow the primary residence rule above. This means that you can sell your house, move to a larger one, and use your old home as a rental property!
- This is a very powerful thing! Let’s take a look at a quick example.
- Let’s assume that Bob and Kat (married) purchase good size home in 1970 for $80,000. They sell the house 40 years later in 2010 for $550,000. This represents a profit of $470,000. Not too shabby, right? Under the current tax law, they will pocket the entire amount. However, if they did have to pay long-term capital gains taxes, they would only receive $399,500. Which $ value would you prefer………?
- In addition to tax free capital gains, capital expenses can be added to the “basis” (or cost used for official tax purposes) of your property. Capital expenses are permanent improvements made to the property. Examples would include building a pool, adding on another room to the house, etc. And, by increasing the cost of the property for tax purposes, this then decreases the profit that you must pay taxes on when you sell the property (if it exceeds the tax exempt values stated previously).
- Mortgage interest
- Mortgage interest is 100% federal tax deductible on the 1st $1,000,000 of your home mortgage. For the common consumer, whose house will undoubtedly be less than $1,000,000, this means that you can deduct ALL of your mortgage interest on your home! This is quite a gift from Uncle Sam!
- Property tax
- Additionally, 100% of property tax payments for your home are also tax deductible. While the exact property tax rate changes depending on location, the national average property tax is 1.5% of the property value every year.
So, let’s take a look at how much these benefits would save you on a 15 or 30 year fixed rate mortgage. To investigate this, we’ll take the mortgage amortization schedule that we created in a previous post (see link below), and adapt it slightly to demonstrate the savings in taxes that are available.
- Click on the following link to access the customizable tax benefits calculator I created – Google Docs – Tax Benefits of Home Ownership Calculator
- Click – File –> Download As –> Excel file in the Google Docs page that comes up. This will enable you to save a copy that can be customized to your situation.
- Enter the loan term, interest rate, down payment amount, purchase price, property tax rate, and assumed price appreciation for your home (or just use default values). Additionally, you will need to enter your income tax rate as well.
- Once you have entered your information, you will then need to use the Solver function in Excel to calculate your monthly payments. For details on how to perform this Excel function, please see the following link: My Money Blog – Create Your Own Amortization Schedule.
- The spreadsheet will then automatically calculate the tax savings you will experience each payment period by multiplying your income tax rate by the total mortgage interest payment + property tax paid each month. The tax savings in each period can be seen in Column K.
- The total tax savings you will experience over the 30 year period is calculated automatically in Cell B2 (pink highlighted cell).
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