Buying your first home is a huge step. When you leave the world of renting behind, you begin building equity in real estate. And Uncle Sam is standing by to help ease the pain of high mortgage payments.
The deductions available to you as a homeowner will likely reduce your tax bill substantially. And, if you have been claiming the standard deduction up until now, the extra write-offs from owning a home almost certainly will make you an itemizer. Suddenly, the state taxes you pay and your charitable gifts will earn tax-saving deductions, too.
Mortgage interest. For most people, the biggest tax break from owning a home comes from deducting mortgage interest. You can deduct interest on up to $1 million of debt used to acquire your home. Your lender will send you Form 1098 in January listing the mortgage interest you paid during the previous year. That is the amount you deduct on Schedule A. Be sure the 1098 includes any interest you paid from the date you closed on the home to the end of that month. This amount is listed on your settlement sheet for the home purchase. You can deduct it even if the lender does not include it on the Form 1098. If you are in the 25% tax bracket, deducting the interest basically means Uncle Sam is paying 25% of it for you. A $1,000 deduction will reduce your tax bill by $250.
Points. When you buy a house, you usually have to pay "points" to the lender to get your mortgage. This charge is usually a percentage of the loan amount. If the loan is secured by your home and the number of points you pay is typical for your area, the points are deductible as interest if you paid enough cash at closing -- via your down payment, for example -- to cover the points. For example, if you paid two points on a $300,000 mortgage -- $6,000 -- you can deduct the points as long as you put at least $6,000 into the deal. And, believe it or not, you get to deduct the points even if you persuaded the seller to pay them for you as part of the deal. The deductible amount should be shown on your 1098 form. (A different rule applies if you pay points to refinance a mortgage. In that case, the expense must be gradually written off over the life of the new loan – 1/30th a year on a 30-year loan, for example. And it’s up to you to remember to take the deduction each year. The lender will not remind you.)
Real-estate taxes. You can deduct the local property taxes you pay each year, too. The amount may be shown on a form you receive from your lender, if you pay your taxes through an escrow account. If you pay them directly to the municipality, though, check your records or your checkbook registry.
In the year you purchase your residence, you probably reimbursed the seller for real estate taxes he or she had prepaid for time you actually owned the home. If so, that amount will be shown on your settlement sheet. But you can include this amount in your real-estate tax deduction. Note that you can't deduct payments into your escrow account as real-estate taxes. Your deposits are simply money put aside to cover future tax payments. You can deduct only the actual real-estate tax payments made during the year from the account by your lender. PMI premiums. Buyers who make a down payment of less than 20% of a home's cost usually get stuck paying premiums for private mortgage insurance (PMI), an extra fee that protects the lender if the borrower fails to repay the loan. For mortgages issued after 2006, PMI premiums paid in 2011can be deducted by home buyers. This write-off phases out as income increases above $50,000 on married filing separate returns and above $100,000 on all other returns. As it stands now, the write-off expired at the end of 2011. It is unclear whether Congress will extend it for 2012. Don't overestimate the value of your deductions. If buying a home will move you into the ranks of itemizers for the first time, be careful not to overestimate how much tax you'll save. Let's say you'll be paying $1,500 interest a month on your mortgage and $3,000 a year in property taxes. That's a total of $21,000 a year. If you're in the 25% tax bracket, you might think you'll save $5,250 a year. But remember, itemizing means giving up the standard deduction which is worth $11,900 for married couples in 2012. Only to the extent that your homeowner write offs plus other deductions (for charitable contributions and state income taxes, for example) exceed $11,900 do you get a tax benefit.
Penalty-free IRA payouts for first-time buyers. As a further incentive to homebuyers, Congress offers to waive the normal 10% penalty for first-time homebuyers who withdraw cash from traditional IRAs before age 59 1/2. At any age, you can withdraw up to $10,000 penalty-free to buy or build a first home for yourself, your spouse, your kids, your grandchildren or even your parents. That $10,000 is a lifetime limit, not an annual one. A husband and wife can each take $10,000 from IRAs penalty free.
To qualify, the money must be used to buy or build a first home within 120 days of the time it's withdrawn. And, get this, you don't really have to be a first-time homebuyer to qualify. You're considered a first timer as long as you haven't owned a home for two years. Sounds great, but there's a serious downside. Although the 10% penalty is waived, the money would still be taxed in your top bracket (except to the extent it was attributable to nondeductible contributions). That means as much as 40% or more of the $10,000 would go to federal and state tax collectors rather than toward a down payment.
There's a Roth IRA corollary to this rule, too, and it makes the Roth IRA a great way to save for a first home. First, you can always withdraw your contributions to a Roth IRA tax and penalty free at any time for any purpose. And, once the account has been opened for at least five years, you can also withdraw up to $10,000 of earnings tax and penalty free to buy a first home.