The First Time Homebuyers Guide to Property Taxes
There's nothing quite like purchasing your first home. You're on your own. You have a substantial financial investment. And you now have some different tax considerations. You're probably well-aware that home ownership affords you several new ways to save on the annual Internal Revenue Service bill.
"Home ownership is one of the best tax benefits that the federal government gives out," says attorney Robin Gronsky, principal of Gronsky Law Offices in Ridgewood, N.J. "People count on it. It's how they calculate their out-of-pocket costs in owning versus renting."
What you're probably less sure of is exactly how to go about taking advantage of all your new house-related tax breaks. Many first-time homeowners will definitely enter new tax-filing territory with the very first return they file after moving into their new abode. For other new owners, the filing changes might take a little longer to show up. But all will need to know some basic tax rules that could make their homes a great tax -- as well as an actual -- shelter. You survived the house search and the bidding process. Getting the mortgage on your new home was a piece of cake. But now you've got to file your tax return for the first time since you moved into your first home. Relax.
1. Welcome to Schedule A
As a homeowner, regardless of whether you're a first-timer or have owned many residences, you probably immediately think "deductions" when it comes to tax time. That's because you now have the chance to claim several expenses you didn't face as a renter. The big-three home-related deductions are mortgage interest, any points connected with the loan and property taxes. To claim these, you'll have to itemize. This deduction method, which requires filing the long Form 1040 and detailing your various deductible expenses on Schedule A, is often a new experience for first-time homeowners. However, before you rush off to download this new tax paperwork, take a few minutes to evaluate your overall filing circumstances.
While many homeowners do benefit by itemizing, that's not the case in every situation. You want to make sure that the deduction method you choose is the one that gives you the larger deduction amount. If you find that the standard deduction, which on 2007 taxes is $5,350 for single taxpayers and $10,700 for married couples filing a joint return, is greater than the total of your itemized expenses, then by all means take the standard deduction. Don't worry, you're not stuck using that method forever. You can alternate between the two deduction options every year or you can itemize for several years, claim the standard amount for a few more and then return to itemizing. The key is to always pick the deduction method that will give you the most tax savings for each filing year.
Making the most of mortgage interest
If you do find that itemizing is the way to go, your largest write-off is probably going to be the interest you paid on your mortgage. This is a particularly valuable tax break in the early years of a home loan, when most of your monthly payments go toward interest charges.
"Just make sure you count all of it," says Gronsky. "It doesn't have to be paid to an institutional lender. It can be a private loan."
A common private home-loan is one obtained through seller financing, where you make your monthly payments to the seller instead of a traditional lender. Interest paid to the seller is deductible, as long as the loan is established using the same guidelines as for a conventional bank mortgage. The same is true if you borrow money from a relative for your house purchase, says Gronsky. Again, you need to be sure this is documented properly (it's probably a good idea to have an experienced real estate lawyer help you set up this arrangement) and that an appropriate interest rate is charged. But as long as the money is secured by the house, says Gronksy, it's a mortgage, and the interest is deductible.
Hang onto your HUD-1
Regardless of who holds your mortgage, the lender should send you a Form 1098 or similar document in January. This will list all the interest you paid over the previous tax year. You report that interest amount on either line 10 or 11, depending upon the mortgagee, of your Schedule A. New homebuyers, however, shouldn't rely solely on that 1098 information.
"It is possible that for a new homebuyer, the amount on the form is not quite accurate," says Benny L. Kass, who practices law in the Washington, D.C., area with the firm Kass, Mitek & Kass PLLC. "You settle on July 10," says Kass. "Your first payment typically will be due Sept. 1. When you make that payment, you will pick up interest for the month of August. But since you borrowed on July 10, many lenders will charge interest from the 10th to the end of July. That amount covering those days in July is deductible."
Not all lenders, however, will include that initial adjustment of interest for that first month, July in this case, says Kass. "Make sure you pick that up." You'll find that added amount of interest on your closing statement, usually referred to as the HUD-1.
Points pay off at tax time
Your HUD-1, and probably the 1098 you'll get from your lender, will list any points you paid for your mortgage. A point is 1 percent of your loan amount. Buyers sometimes choose to pay points to obtain a lower interest rate. The IRS allows you to deduct points for the tax year in which you purchase the home. You include the points paid in the same section of Schedule A where you claim your mortgage interest.
"For a purchase of a principal residence, you can choose to amortize or deduct the points all at once," says Gary Garwitz, CPA and partner at BKD LLP in Springfield, Mo. "Most people, and usually first-time buyers, are going to fall into the category of claiming it all at once."
This means if you paid 1.5 points on a $200,000 home loan, that $3,000 will go directly toward your itemized deduction amount. You'll find points on lines 801 and 802 of the HUD-1, says Gronsky. But don't be concerned if you don't see the term "points" on the settlement sheet. "This amount could be called 'loan origination fee,' 'loan discount fees' or 'points,'" says Kass. "The name is not important. What is important for most loans is they are fully deductible by the new homebuyers as long as they are reasonable and consistent in the area where you bought the home."
The tax law requirement that points be in line with your real estate market is yet one more reason to avoid lenders who charge exorbitant amounts. "Ten points is probably not consistent or reasonable anywhere," says Kass, "but some loan sharks are charging that." Another nice tax feature of points: Even if the seller paid them, the buyer generally gets to claim the deduction.
The tax-deduction value of property taxes
The third major home-related tax deduction is real estate taxes. This can get complicated, depending on when you bought your house and your jurisdiction's tax year. For example, your tax year runs January through December and you buy July 1. Taxes are due in March, says Kass. "When you closed on your home, the seller had already prepaid taxes in March for the full year," he says. "So at closing, the buyer would reimburse the seller for the amount from July 1 to Dec. 31. That amount the buyer reimbursed will be shown on the HUD-1 and the buyer can deduct that for income tax purposes." But there might be other taxes shown on the HUD-1 that aren't immediately deductible.
Most people escrow real estate taxes, says Garwitz. Here you give your lender a portion of your annual property tax bill each month along with your payment of principal and interest on your loan. At closing on a home, lenders usually collect from you, the buyer, a portion of your coming tax bill (around three to six months' worth is typical) for the escrow account. When your property taxes are due, the lender takes that money and uses it to pay your local tax collector. In the example above, you cannot write off this amount on your first tax return after purchasing the house, because, even though it's designated for deductible property taxes, the amount was simply collected, not actually paid.
When your lender does pay your property tax bill the next year with that escrowed money, then you'll get to deduct the amount on the returns you file for that tax year. Financial institutions usually report the amount of property taxes paid on your behalf on the Form 1098. It's a good idea, though, to double-check your actual property tax bill to make sure the correct amount was paid, says Garwitz. The county should send you, the owner, a copy of the bill that it sends to your lender for payment.
Timing is everything
Now that you know all the new-home-related deductions you can claim, you've probably already gone to Bankrate's tax form library to download a Schedule A. Not so fast. With taxes, timing is everything. While in most cases homeowners will benefit from itemizing, the time of year when you actually closed on your house could make a big difference in your deduction method choice. "Not everybody should consider itemizing," says attorney Kass, who also writes the weekly "Housing Counsel" column for The Washington Post. "If you settle later in the year, you'll have very few deductions for mortgage interest and taxes, so it might be better to use the standard deduction amount."
Gronsky says new homebuyers should "run it both ways" to see if, by itemizing their deductions, they will exceed the standard deduction amount. "Most of the time, when they just purchased the house, because the mortgage payment is mostly interest and very little principal, typically itemizing is better," she says. "But if they got into the house in November, for 2007 taxes it may not be better. "On the other hand if they got in January or February, itemizing probably will be better."
When calculating your itemized deductions, also be sure to count other nonhousing items. For example, you can now take tax advantage of any charitable contributions you made in the year that you bought your house. "Young people buying their first home usually don't worry about keeping records of charitable donations because they've been using the standard deduction for years," says Garwitz. "Now they can add those contributions to the deductible costs associated with their new home to come up with a larger itemized deduction amount."
And remember those points you paid? If you find that you can't itemize for the year you bought your home, you can take Garwitz's advice and amortize them. You'll simply spread the points over the life of the loan and deduct the appropriate amount in each future year you itemize your deductions. If you have a 30-year mortgage, that $3,000 in points, in the example cited earlier, would give you $100 to deduct each tax year that you itemize.
Other deductions, thanks to your home
Some new homeowners also might elect to take out a small home equity loan or line of credit in connection with their new residences. While going into more debt that is tied to your residence is a personal financial decision that you must consider carefully, if you do get such credit, at least be sure to take advantage of its tax breaks. Interest on a home equity line or loan of up to $100,000 is deductible. It doesn't matter if you used the money to buy furniture for your new house, upgraded the kitchen in your fixer-upper or purchased a car. As long as the loan is secured by your residence, its interest is deductible. Did you buy the house after moving to take a job? Then you also might be able to write off some relocation expenses. "If the move was either to start a new job or your current office relocated you to a new location more than 50 miles from your old job," says Gronsky, "some of those expenses might be deductible."
Alternatively, if you are self-employed and working out of your house, home office deductions might apply. And if you make any improvements to your home to alleviate a medical condition, such as the installation of a ramp or central air conditioning to alleviate allergies or asthma, says Gronsky, these also might help boost your itemized deduction amount.
What's not deductible
But don't get carried away with writing off any and everything connected to your home. Many things you'll see listed on your HUD-1, such as appraisal charges, title insurance, credit report fees, and state and local "recordation" transfer taxes (as some states call them), are not deductible on your federal tax return, says Kass. Wait a minute. Recordation taxes? Aren't taxes connected with your home deductible? Yes, as long as they are real estate taxes. Recordation taxes or stamp taxes or whatever name your region gives them are basically administrative fees connected with your purchase and are not deductible.
Neither is private mortgage insurance that your lender might have required you to purchase -- unless you took out the loan (or refinanced) on or after Jan. 1, 2007, when a new law took effect which enables some homeowners to deduct PMI. Homeowners association fees are not deductible, however. "That's simply a personal cost you'll have to absorb," says Garwitz. "The one exception to that is if your homeowners association pays some property taxes for common areas. You can deduct your pro rata portion of those taxes," he says. "It's usually not very much, might be only $50, but hey, I want every buck!"
Not federal, but tax-related
You also need to pay attention to some more local tax matters connected to your home. Property-tax exemptions, for example, could help lower your annual property tax bill. While this will mean less to deduct when you file your annual federal tax return, that's usually a trade-off homeowners will gladly make in order to have more money in their personal accounts the rest of the year.
"Exemptions have to do with how much property tax you're ultimately paying," says Gronsky. "The taxes are assessed on the value of your house. It may be worth $200,000, but if you get a $40,000 exemption for being a veteran or every homeowner gets that amount, you will be paying taxes on just $160,000 of value." The types and amounts of homeowner real-estate-tax exemptions vary greatly across the United States. Check with your local officials about what's available and what you need to do to qualify for the exemptions. "Even before you buy, you should find out from your settlement attorney, real estate agent or county officials what exemptions and deductions you do get," says Kass.
After you finish your first tax return as a homeowner, use it to plan for the next one. In early December, Kass says, "ask yourself, 'Do I need more deductions this year?' 'Am I making more money this year or will I next year?' 'Can I prepay my January (mortgage) payment and real estate taxes in December?'" "At the end of the year, if you feel you can use an added mortgage interest deduction this year instead of the next year, as long as you make the payment early (by Dec. 31), you can deduct it. The same with property taxes. Pay them this year to deduct them on your next return."
Also be sure to hang onto your HUD-1 sheet. Remember all those charges you couldn't deduct on your return? They can be added to your home's basis. The basis, which is the total of your purchase price plus closing costs plus any substantive improvements you make to the residence, is what you subtract from the sales price you receive to determine your profit. "Capital improvements are things like putting on a new roof, redoing the kitchen, remodeling the bathroom," says Gronsky. A lot of people do these things even before they move in. "They're not deductible this year but might help you when you sell the house in terms of how much capital gains you have to pay."
If you're single, you can make up to a $250,000 profit on your home and not owe any taxes on the money as long as you've lived in the house two out of the last five years prior to the sale. Couples who file jointly get twice that exclusion amount. If your home's value appreciates substantially, the items added to the basis, if you keep track of it, could help you keep your profit in the tax-free range. "Set up a record-keeping system that helps you track your home-related costs and does so in a way you can retrieve the information if the IRS wants to get a look at it," says Garwitz. Also, Kass says to "absolutely hang onto to HUD-1 for three years after you sell your last house." That's how long the IRS has to come back and look at your return. But even if you have no audit concerns whatsoever, it's a good idea to hold onto this document since it's a record connected to what's probably your largest personal investment.