If you own a home, you’re eligible for several special tax breaks. But many of these rules changed over the past few years, especially after the Tax Cuts and Jobs Act was signed in December 2017. Here are some of the key tax benefits of owning a home, and how homeowners can make the most of the new rules.
- New rules for deducting mortgage interest.
- Limited deduction for home-equity loans.
- Deduction cap for property taxes.
- Home-office deduction for self-employed only.
- Tax exclusion for home-sale profits.
New Rules for Deducting Mortgage Interest
The tax deduction for mortgage interest is one of the most valuable tax breaks for homeowners. But the Tax Cuts and Jobs Act reduced the amount you can deduct. If you bought your home before Dec. 16, 2017, you may be able to deduct the interest paid on up to $1 million in mortgage debt (or up to $500,000 if you’re married filing separately). But if you bought your home after that date, you can only deduct the interest paid on up to $750,000 in mortgage debt (or up to $375,000 if you’re married filing separately).
If you refinance your mortgage, your cut-off is based on the date you originally purchased the house. “If you are merely refinancing the outstanding home acquisition debt that was obtained before Dec. 16, 2017, the new mortgage is essentially treated as the old one. In other words, you can use the old $1 million limit,” says Barbara Weltman, author of “J.K. Lasser’s 1001 Deductions & Tax Breaks 2021.”
You may also be able to deduct the mortgage interest paid on a second home, up to the $750,000 or $1 million limit for both loans combined. “If you have a second home, you have to add the two mortgages together, and it’s the combined total,” says Cari Weston, director of tax practice and ethics for the American Institute of CPAs.
You’ll receive Form 1098 reporting the mortgage interest you paid during the year. For more information about the calculation, see IRS Publication 936, Home Mortgage Interest Deduction.
Another hurdle to cross: You can only deduct mortgage interest if you itemize your deductions, and fewer people itemize now that the same tax law doubled the standard deduction. If all of your itemized deductions for 2020 add up to less than $12,400 if you’re single, $18,650 for head of household or $24,800 for married couples filing jointly, then you’d take the standard deduction instead of itemizing. (The standard deduction is higher for taxpayers age 65 and older.)
Limited Deduction for Home Equity Loans
In the past, you could deduct the interest you paid on up to $100,000 in home equity debt, no matter how the money was used – whether you used the loan to pay for college, or to pay off high-interest credit cards or to renovate your home. But now you can only deduct interest on a home equity loan if you use the money to buy, build or substantially improve the house. The interest is deductible on up to $750,000 of qualified residence loans, which includes both your mortgage and a home equity loan used for home improvements.
For example, the interest can be tax-deductible if you use the money for major home improvements, such as adding a deck or renovating your kitchen. “You want to get an appraisal before you start and after you’re done, so there’s no question that it increased the value of your home,” says Weston. Maintenance, such as painting a room, doesn’t count. “If you put a new roof on, added a deck or if you knocked a wall down and expanded your kitchen, the things that change the structural value of your home are improvements,” she says.
You can still take out a home equity loan for other reasons, such as to pay off credit card bills or college tuition, but the interest won’t be tax-deductible.
Deduction Cap for Property Taxes
Another big change from the Tax Cuts and Jobs Act was the property tax deduction. In the past, your property taxes were deductible if you itemized. Starting in 2018, you can only deduct up to $10,000 in all of your state and local taxes combined. This limit includes property taxes, as well as state and local income taxes that were withheld from your paycheck or made through estimated payments, or state and local sales taxes.
“If you’re in a state with high property taxes or income taxes, such as Illinois, New York or California, you may have been able to deduct much more in the past, but now you’re limited to $10,000,” says Michael Landsberg, a CPA financial planner in Atlanta and member of the American Institute of CPAs’ financial literacy commission. Also, you can only take this deduction if you itemize rather than take the standard deduction.
Like many provisions of the Tax Cuts and Jobs Act, this limit is scheduled to expire after 2025, but Weston says this is one of the provisions that could be changed before then. “I would not be surprised if it got backed out or increased,” she says.
Home-Office Deduction for Self-Employed Only
So many people have been working remotely and set up home offices over the past year. These expenses may be tax-deductible if you’re self-employed but not if you’re an employee – the Tax Cuts and Jobs Act eliminated the deduction for unreimbursed employee business expenses, including home-office expenses for employees who work from home for an employer.
But people who are self-employed or have any freelance income can still qualify for the home-office deduction if they use part of their home “regularly and exclusively” for business. Your home office doesn’t need to be in a separate room, but it has to be in an area of your home where you don’t do anything else. You may be eligible for the break even if you just do some freelance work on the side, or you may be able to take the deduction for a few months if you were self-employed for part of the year while looking for a full-time job. “You don’t have to be full-time self-employed, as long as you’re really using that place regularly and exclusively for business,” says Weston.
You can either take the deduction based on your actual expenses, or you can take the simplified deduction.
If you take the deduction based on your actual expenses, you can deduct a portion of your rent or mortgage interest, homeowners or renters’ insurance, and utilities (such as electricity, gas and water) based on the percentage of your home’s total area that is used for your home office. For example, if your home office is 1/10th of the total square footage of your home, you can deduct 10% of those expenses. Don’t forget to include other expenses for your home, such as a portion of the cost of a pest control service or homeowners association dues, says Weston. You can also deduct the full cost of maintenance and repairs to your home office, such as the cost of painting that room.
The other option is to take the simplified version of the home office deduction, which is a lot easier but may result in a smaller deduction. Instead of using your actual expenses, you can deduct $5 per square foot of your home office, up to 300 square feet, up to a maximum deduction of $1,500. For more information about the home office deduction, see IRS Publication 587, Business Use of Your Home.
Tax Exclusion for Home-Sale Profits
Many people can exclude their home-sale profits from taxes – and they don’t realize they’re eligible for this tax break. If you live in your home for at least two out of the five years before the sale, then you can exclude up to $250,000 in home-sale profits if you’re single or up to $500,000 if you’re married filing jointly. This is the profit, not just the sale price – so a married couple who buys a house for $200,000 and lives there for at least two years won’t have to pay taxes on their profits unless they sell the house for more than $700,000, for example.
If you haven’t lived in the home for two years, you may be eligible for a partial exclusion if you moved because of certain life-changing events, such an eligible change of employment or change in health, based on the number of months you lived in the home. For example, if you’re married and moved after one year because you started a new job that was more than 50 miles away, you could exclude up to $250,000 in home-sale profits from taxes (half of the $500,000 exclusion).
If your home-sale profits are larger than the exclusion or if you didn’t meet the two-year requirement, you may be able to reduce the tax bill by adding certain expenses to the cost basis. The basis is generally the amount you paid for the house, but you can also add a few other expenses that can help reduce your taxable gain. For example, you can add the cost of home improvements that substantially increase the home’s value to the basis, says Landsberg. “People need to be very vigilant and keep meticulous receipts,” he says. If you add a deck or remodel your kitchen, for example, keep the receipts in your tax files even if you don’t plan to sell the house for a long time – so you’ll have the records and can add the cost to your basis if you do end up with a taxable gain. “You always want to make sure everything is recorded, just in case. It’s easy to scan in the receipts and put them in PDF form,” says Landsberg.
You can also add some of the closing costs and other expenses to the basis, including recording fees, owner’s title insurance, legal fees, surveys, transfer taxes and sales commissions paid, he says.
The $250,000/$500,000 exclusion only applies to your primary residence, but some people move into their second homes for two years before they sell so they can qualify for the exclusion, says Weston. “There’s no exclusion for a second home, but what you often see is if someone is using the second home as a rental, if they know they want to sell it in advance, they move into the second home for two years and then they can exclude it after two years,” she says.
Also, since you must live in the home for two out of the past five years, if you lived in the home a few years ago then started to rent it out, keep an eye on the calendar and consider selling the house before the five-year period is over so you can qualify for the exclusion.