Ellen and Doc Stephens, REALTORS® - Ellen's Team

Interest and Property Tax Deduction Limitations

The 1986 Tax Reform Act made consumer interest and sales taxes non tax-deductible. In 1987 the tax code was changed to further limit the deduction of mortgage interest, allowing you to deduct interest only on the first $1,000,000 you owe on the first mortgages on a ‘main’ and second home, and a maximum of $100,000 on home equity lines that finance consumer debt (car loans, boat loans, credit cards, etc,). This limit can be exceeded if you demonstrate that you used the equity line to purchase other real estate or to improve your current home. Most people don’t know that cash-out monies received in refinances count towards this $100,000 home equity debt limit. This is true even when the new loan doesn’t exceed your original loan amount! An exception to the cash-out rule happens in the case of a divorce, when one ex-spouse refinances with a larger loan to pay for the other ex-spouse’s equity. The interest on that new loan is fully tax deductible.

Lot loan interest is not tax-deductible, even when you purchase the lot with the intention of building your primary residence on it. If you sell the lot, you can have the interest cost offset your profit to reduce your tax bill, but that’s about it. So the ‘tax-smart’ strategy would be to use a home equity line to buy the lot. Then the lot financing becomes deductible! Since the equity line is used to purchase real estate, the interest deduction is not subject to the $100,000 limitation. Construction loan interest for a period of up to 24 months for your future primary residence is tax deductible up to the limits, even if the loan was used to also pay for the lot.

You can deduct property taxes when they are PAID (not your escrow payments), late payment charges, and any prepayment penalties. You can’t deduct the cost of your homeowner’s insurance. Homeowner’s association fees and local municipal charges for trash, sewer, etc. are not deductible, especially if they are itemized on your tax bill. Also, special assessments are not deductible. If the assessment was for capital improvements, you can then add it to your home’s cost basis to reduce your profit when you sell.

PMI is now tax-deductible

Which closing costs can I deduct?

The points and origination fees paid at closing, on your main home, are deductible in the year you incur them. This is allowable as long as these fees are shown as a percentage of your loan amount and other ‘normal’ closing costs appear on your settlement statement. This rule prevents your lender from ‘converting’ the normal fees into points. When you buy a second home or investment property, you always have to ‘spread’ the points paid at closing over the life of the loan. In other words, you can only deduct a portion (say 1/30th for a 30 year loan) each year. You can deduct the remaining portion of the points when you sell the property (ex: 23/30th for a 30 year loan if you sell in year 7).

In 1991 the IRS ruled that even if the seller pays the points, the homebuyer could also deduct them, but only if the buyer brings more cash to closing, down payments included, than the points charged. To balance this out in the tax code, the buyer reduces their effective cost or ‘basis’ by the amount of the seller-paid points. While this increases the profit homeowners show when they do sell, it usually doesn’t affect one’s overall tax position, because most homeowners can take advantage of the tax-free gain provided by the ‘two-year rule’. Many times loan points and interim interest are not reported on the 1098 form that you receive from your lender, especially if your loan was sold at or just after closing. I recommend that you carefully cross-check this form with your settlement statement and your loan’s amortization schedule to make sure you arenot missing any deductible amount.

When you refinance any type of property, you can not deduct points paid at closing in the year you incurred them. The points need to be ‘spread’ over the life of the loan.  One exception to this rule happens when you refinance a construction loan for your primary residence. Then the new loan is treated as a purchase loan and you can immediately deduct all of the points. Another exception occurs if part of the refinance proceeds paid for home improvements. Then that portion of the loan points is immediately deductible. Any points for cash-out amounts need to be ‘spread’ over the life of the loan. When refinancing for a second time, or paying a loan off early, you may then deduct all of the not-yet-deducted points you paid for the previous mortgage at that time.

Interim interest and pro-rated property taxes are the only other closing costs that are deductible. Escrow establishment, transfer taxes, homeowner’s association fees, surveys, attorney’s fees, and all other closing costs are not deductible. Some of these one-time costs may be added to your basis and used to reduce your taxable profit when you sell.

A loss on the sale of a primary residence is not tax deductible, and expenses incurred for making repairs to your primary residence within 90 days of a sale are no longer deductible.

Other deductible expenses

Moving expenses are deductible, but only if you meet two criteria. First, your new workplace must be 50 miles farther from your old home than the old workplace. Secondly, you must move within one year before or one year after you start the new full-time job. Fortunately you don’t have to have the job lined up before the move. The deductions that fall under moving expenses are lodging, traveling costs (excluding meals), and moving company charges. Surprisingly, expenses from a pre-move house-hunting trip are not deductible.

You can rent out your second home for a limited amount of time without incurring a tax liability for the income. Casualty or theft losses are deductible if they were not covered by insurance, subject to a 10%-of-income limitation. The Alternative Minimum Tax may limit the total of all the itemized deductions that you can claim. You’ll need to look into this if your adjusted gross income is over $75,000.

All of these little nuances tell you that the ever-changing tax code is extremely complicated; having many more provisions than can be explained in just one article. To make sure that your tax return is in full compliance with the tax code, I strongly recommend that you seek the advice of a qualified accountant who is familiar with the real estate tax laws.