Tax Reduction Strategies for the Enterprising Homeowner

Industry Observer with ValuePenguin

Tax Reduction Strategies for Homeowners

Nobody likes it when Uncle Sam swoops in and takes a big bite out of your paycheck. This goes double for your home. While there's no way to get around taxes, there are a number of deductions that every homeowner should understand. Depending on the amount of time you've lived in your home and how hot the real estate market is in your area, these could save you tens of thousands of dollars in tax payments. Today, we cover the following.

  • Capital gains exemption on your home sale
  • Morgage interest deduction
  • Cost basis on your home


The Capital Gains Exemption

First-time homeowners might not be aware of this, but the capital gains exemption represents one of the largest amount of potential tax savings that the IRS will permit you to write off. Under the capital gains exemption, eligible single tax filers can write off up to $250,000 in capital gains on their home sale while eligible joint filers are eligible for as much as $500,000 in exemptions. 

To speak in relative terms, the savings vary widely, but can be massive, particularly if you've lived in a fast-growing area that's appreciated since you purchased your home. Long-term capital gains taxes on most investments can range from 15-20%, if you were to apply this to a home sale subject to the single exemption limit, can amount to as high as a $50,000 tax bite from the IRS. 

To be eligible for the exemption, your home sale must be of your primary residence which you've resided in and owned for a minimum of 2 of the past 5 years. Additionally, you must not have already claimed this exemption within the past 2 years. Keep in mind that the exemption is not permitted on rental/investment properties, so real estate investors will need to think of other ways to save on their tax bill.

Borrowers who might not qualify for the full exemption might still be eligible for a partial capital gains exemption, so check with a tax professional to see whether you qualify under the tax rules.  


Taking Advantage of the Mortgage Interest Deduction

While the rules have changed slightly for the 2018 tax year, the 2018 mortgage interest deduction remains a lucrative tax benefit that every eligible homeowner should take advantage of. Beginning in 2018, the IRS permits homeowners to deduct the interest on up to $750,000 in mortgage debt from their tax returns. This is down from the $1 million that was permitted under the previous tax law.

While this might not be as lucrative as the dollar-for-dollar write-off you receive under the capital gains exemption. This is a large deduction that can be exercised year-after-year, which can be particularly useful for homeowners with large mortgage balances.

It's worth doing the math on whether you want to itemize your deductions or take the standard deduction; as the new tax laws also increased the size of the standard deduction. Based on research provided by ValuePenguin, the breakeven for single tax-filers to take the itemized deduction stands at around $280,000 in mortgage debt in your first year of mortgage repayments.

Whether or not the breakeven figure applies to you will vary according to your financial profile. Keep in mind that your mortgage balance (should) decline over time, and consequently the amount of interest you can deduct will decrease every year. This makes it difficult to pinpoint a true breakeven figure.


Increasing the Cost Basis on Your Home

For those of us who own rental properties, or are even lucky enough to actually exceed the capital gains exemption limits, another way to reduce your tax liability is to factor in the costs of renovating and repairing your home to your "cost basis." To the uninitiated, your cost basis consists of the amount you paid to acquire your home, plus any costs incurred for repairs in addition to transaction fees to close on your home.

For example, let's say the purchase price on your home is $200,000. At the most basic level, that price will be used as your initial cost basis, and will be used to calculate any tax liability on your property. That means that if your home value rises to $300,000 after 5 years and you decided to sell your home, your capital gains liability could be $100,000 ($300,000 - $200,000).

However, let's say instead, you spent $50,000 on a gut job that added a new kitchen to your property. Assuming the property value increased to $300,000 as a result of your improvement, you could add the $50,000 in renovation expenses towards your home's cost basis, increasing it from $200,000 to $250,000. Subsequently, if you were then able to successfully sell your home at a price of $300,000, your new capital gains liability would then be $50,000 ($300,000 - $250,000).

On a separate note, homeowners who have an outstanding home equity loan, or are thinking of taking one out should think carefully, as new tax las in 2018 eliminate interest deductibility on home equity loans for non-qualifying expenses. Luckily, home renovation expenses (generally) remain tax deductible, but it's a good idea to check with a CPA to confirm whether the interest on your home equity debt remains tax-deductible.

In Summary

These are a few basic strategies that can be used to reduce the tax liabilities of both homeowners and real estate investors. While your situation might not be as clean as the examples we illustrated,  it's a good idea to monitor the requirements for each of these deductions to ensure that you'll maximize the amount you can save from the IRS.

A few parting words; always keep detailed records of all expenses incurred when purchasing or making substantial improvements to your home. Every dollar you document can represent significant tax write-offs when you finally sell your home. As always, make sure you consult with a CPA or other tax professional to confirm that you're eligible for the exemptions mentioned above. 


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Joe Resendiz

Jr. Research Analyst
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