If you’re planning to do some home shopping this summer, it pays to do
some tax calculations before you start touring subdivisions.
Taxes can be a pivotal factor in many of the decisions you’ll need to make in buying a home.
How much home you can afford to buy may well depend on how much you can count on the tax system to subsidize your monthly payments.
If you already own a home, the minimum amount to spend on a home is likely to be governed by what it takes to avoid getting clobbered right away with a big capital gains tax on the sale of your old home.
Homes remain one of the most lucrative tax shelters left in the tax code. But many people overestimate the value of those benefits. What’s more, the long-term survival of homeowner tax breaks has been put into question by proposals on Capitol Hill to overhaul the tax system.
– Upfront costs. Most closing costs aren’t deductible. Up until last year, a limited amount of closing costs could be written off as a job-related moving expense. But under the 1993 tax law, costs incurred in selling your old home or buying a new one are no longer eligible for the moving deduction.
Don’t throw out your receipts in disgust. Most closing costs-including appraisals, attorney fees, title insurance, abstract fees and transfer taxes-can be added to the cost “basis” of your residence, which will reduce your taxable gain when you sell the home.
– Mortgage “points.” About the only upfront costs that are immediately deductible are mortgage interest and certain real estate taxes paid at closing.
“Points” paid to a mortgage lender also can be deducted right away. Points are the one-time fees that are routinely assessed on mortgage loans to boost the effective yield to the lender. These charges often run thousands of dollars.
Until a few years ago, homeowners had to pay the points upfront in cash if they wanted to be able to deduct the payments immediately. If the lender wrapped the points into the loan, the deductions had to be spread over the life of the loan.
But the IRS relaxed the rules and now allows home buyers to fully deduct the points even if the points are tacked onto the loan balance. The only proviso is that your cash payments at closing must be at least equal to the point charges. That should be no problem since the down payment alone usually far exceeds any point charges.
– How much home to buy. Most homeowners are eligible to write off all their mortgage interest and property taxes, which can substantially reduce the out-of-pocket cost of monthly house payments. But it’s important to actually make the calculations so you have an accurate assessment of how much the tax code will really help.
For example, say your mortgage payments run $1,200 a month and your property taxes add another $300 a month. If your combined federal and state tax burden puts you in the 30 percent tax bracket, your mortgage and property tax deductions would produce tax savings of about $414 a month. That would effectively reduce the actual out-of-pocket cost of your $1,500 monthly house payment to $1,086 a month.
The tax savings aren’t nearly as great for those in the bottom tax bracket, which applies to the vast majority of households. If your federal-state tax burden places you in the 17.5 percent tax bracket, the tax savings would only reduce the out-of-pocket cost to $1,258 a month.
– Higher-income homeowners. The calculations are more complicated for higher-income homeowners. Those with six-figure incomes will find they can’t deduct all their mortgage interest and property taxes. The reason: Most itemized deductions, including those for mortgage interest and property taxes, are reduced by 3 percent of the amount by which your adjusted gross income exceeds $114,700.
Affected homeowners need to keep these cutbacks in mind when shopping for a new home because the impact can be significant. For example, an individual with adjusted income of $275,000 would lose more than $4,800 in itemized deductions.
Affluent homeowners also need to keep another figure in mind: $1 million. That is because the tax law permits interest deductions on only the first $1 million in mortgage debt used to acquire and improve a first and second home.
– Deferring tax on sales. For existing homeowners, the minimum amount to spend on a new home is often determined by how much it will take to avoid being taxed on profits from the sale of their old home.
Capital gains tax on the sale of a principal residence can be deferred indefinitely so long as you buy a replacement home within two years that costs at least as much as you realized from the sale.
But many homeowners assume that if you sell a home for $180,000, then you need to spend at least $180,000 on a new home. That’s rarely true. When figuring how much you’ll need to invest in a replacement home to defer tax on your entire gain, many of the costs incurred in selling your home, including sales commissions, are subtracted from the sales price.
Thus, if you sell your home for $180,000, but you had $11,000 in selling expenses, you only need to spend $169,000 on a new home to defer tax on your gain.
– Senior citizen break. Retirees who want to move to a smaller home generally don’t need to worry about being hit with a big capital gains tax bill. Homeowners age 55 and over can permanently escape tax on up to $125,000 in profits from the sale of a principal residence. This special tax break is available only once in a lifetime.
– Tax reform. The political prospects for an overhaul of the tax system are uncertain, but Deductions for mortgage interest and property taxes would be imperiled under virtually all the leading tax-overhaul proposals. As a result, home buyers should estimate the potential impact on their monthly payments.
