Home Buying and Taxes: What You Need to Know

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Along with financial responsibilities, homeownership also offers financial advantages. You get a chance to build equity in your home and you may have access to a host of tax benefits.

Understanding the various tax deductions available to homeowners can help you maximize your tax benefits and reduce your overall tax liability. Here’s a rundown of important points to consider as you prepare to purchase a home.

Home buying and taxes: the basics

When you buy a home, you become eligible for several tax deductions that can lower your taxable income. The most common mortgage-related tax deductions include discount points, property taxes, mortgage interest, and mortgage insurance premiums.

Knowing how to leverage these deductions can make a big difference in your annual tax return, but keep in mind that this article is only for educational purposes. You should always seek professional tax advice if you have any questions when it comes time to file.

Discount Points

Discounts points, or mortgage points, are a form of prepaid interest that homeowners can purchase to reduce the interest they pay on their mortgage. Each discount point you purchase costs 1% of the loan amount and lowers the interest rate (though the exact amount may vary by lender). Since discount points are considered prepaid interest, they are also tax-deductible. You can deduct discount points in the year they were paid if the mortgage is for your primary residence and meets certain conditions. Some conditions are:

• You can’t use funds from your lender. However, discount points paid by the seller are treated as being paid by you as long as you deduct the amount of the seller-paid points from your purchase price.
• Paying discount points is an established practice in the area.
• The mortgage is for your primary residence.
• The amount shows as discount points on your settlement statement.
• The discount points paid were in line with the amount charged in the area.

Hold on to your closing disclosure form, which details the points paid, as it will be necessary to claim this deduction.

Homeowners who meet the IRS’s conditions for discount points and itemize their deductions may be eligible to deduct the full amount of discount points in the year paid or deduct them over the life of the loan. Those who don’t itemize may need to spread the discount points over the life of the loan and claim appropriate deductions each year.

Property taxes

State and local governments in the U.S. tax homeowners on the value of real property. Property taxes paid at settlement, closing, or to a taxing authority are deductible. The deduction for state and local taxes, including real estate taxes, is limited to $10,000 ($5,000 if married filing separately. You can claim a deduction on property taxes paid on both your primary home and a vacation home but remember that you need to itemize your deductions on your tax return. Homeowners receive property tax bills twice a year from the government, but they can also make payments through an escrow account.

Mortgage Interest and Tax Deductions

When you take out a mortgage to buy a home, the interest paid on the loan is tax-deductible. This deduction applies to interest paid on loans secured by your primary residence and a second home, though conditions may apply. Homeowners can deduct interest on the first $750,000 of mortgage debt ($375,000 if married filing separately). The mortgage interest deduction can be substantial, especially in the early years of the mortgage when interest payments are typically higher.

Note that you can only deduct home mortgage interest to the extent that your loan was used to buy, build, or substantially improve your property. This means if you secure favorable refinance rates and use the cashed-out funds to consolidate debt or make a purchase unrelated to home improvements, the interest may not be entirely deductible.

A late payment charge on your mortgage payment or a prepayment fee paid by homeowners who manage to pay off their mortgage ahead of schedule can be deducted, provided these charges aren’t for a specific service related to your mortgage loan.

How to Claim Tax Deductions on Your Mortgage

Claiming tax deductions on your mortgage requires homeowners to stay on top of their records and documentation. Consider these steps to help you maximize your tax benefits.

• Form 1098: The 1098 form Mortgage Interest Statement and its variants report amounts paid by a borrower of $600 or more in interest, mortgage insurance premiums, or discount points during the tax year. Your mortgage lender will send you Form 1098 as it is essential for claiming your deductions.
• Itemize deductions: To claim mortgage-related tax deductions, you must itemize your deductions on your tax return using Schedule A (Form 1040). This means forgoing the standard deduction.
• Closing disclosure form: At the closing of your home purchase, you will receive a closing disclosure form. This document details all the costs associated with your home purchase, including property taxes, mortgage points, and any prepaid interest. Refer to this form when filling out Schedule A (Form 1040).
• Fill out form Schedule A (Form 1040): To deduct real estate taxes, you can enter the amount of your deductible state and local real estate taxes on Schedule A (Form 1040), line 5b. For mortgage interest and discount points, go to line 8a of Schedule A (Form 1040) and enter the home mortgage interest and points reported to you on Form 1098. Homeowners who didn’t receive a Form 1098 may enter their deductible interest on line 8b, and any deductible points on line 8c. Submit your return on or before the filing deadline.
• Maintain records: Keeping meticulous records of all property tax payments, mortgage interest payments, and mortgage insurance premiums is very important as these records will support your deductions in case of an IRS audit.

Disclaimer: Article content is intended for information only. It may not reflect the publisher nor employees’ views. Consult a mortgage professional before making financial decisions. Publishers or platforms may be compensated for access to third party websites.