How do I Calculate Homeownership Tax Benefits?

by on April 13, 2012Jason Van Steenwyk

If you’re buying your own home primarily for the income tax advantages, you may be disappointed. Yes, you do get to deduct the interest on up to $1 million in qualifying home mortgage debt against your income, in most cases. But you can only deduct the interest to the degree that the interest, together with your other miscellaneous itemized expenses, exceeds 2 percent of your annual income. What’s more, if you are subject to the alternative minimum tax, your home mortgage deduction could be disallowed if you used the proceeds for anything other than work on your personal home.

calculating home ownership tax benefitsFurthermore, don’t try deducting repairs, maintenance and upgrades on your personal residence – at least not in the current tax year. The IRS considers repair and maintenance of your personal residence to be personal expenses, not business expenses, and therefore these expenses are not deductible.

The home mortgage interest deduction isn’t much of a benefit at all once you’ve paid down your principal enough. If you’ve paid down your balance far enough, and you’re paying a low enough interest rate on your mortgage, your mortgage interest deduction may not be enough to bother itemizing. You may be better off taking the standard deduction.

In a low tax bracket? The tax deduction is worth even less. Same if you have low or no state income tax.

Calculating the Tax Benefit of Your Home Mortgage Interest Deduction

Calculating your deduction is simple: Take the amount of interest you paid on your personal residence or second home, as reported to you on your IRS Form 1098. You should receive this form each year from your lender. Then add that figure to your list of miscellaneous itemized deductions on your personal income tax return, Form 1040. Add it together with all your other itemized deductions. The more the merrier – you need all your deductions to add up to as much more than 2 percent of your income as you can.

But you’re not done yet. You then compare your home mortgage interest deduction to your standard deduction. As of 2012, the standard deduction is $5,950 for single individuals, and $11,900 for married couples filing a joint return. If the sum of your miscellaneous deductions is lower than your standard deduction, don’t itemize. Take the standard deduction.

It’s not a terrible thing to have happen, but it could come to pass that you buy a home as a single taxpayer in one year, and find yourself paying $11,000 per year in home interest, but you don’t have much in the way of other tax deductions. You could find yourself benefiting from the home mortgage interest deduction in one year, but if you get married, then your standard deduction doubles. If it’s more than you paid in interest, the deduction doesn’t do you any good.

The reason to own your own home isn’t for the mortgage deduction – why spend $10,000 in interest to save just $2,500 in taxes? – it’s for the long-term build-up of equity. You will eventually pay off your home mortgage, and owe no principal or interest – at least barring additional loans against your house. When you rent, you will be paying someone else’s mortgage and taxes for them – until you die.

The Capital Gains Exemption

The real tax benefit of owning your personal residence doesn’t come for a while, but it’s a doozy: The capital gains tax exemption on the sale of your home. Provided you’ve lived in the home for at least three of the previous five years (special rules apply for active duty military), the IRS allows you to exempt the first $250,000 of gains in your home from capital gains taxes. If you’re married and file a joint return, you can exempt up to $500,000. That chunk of tax-free change can go a long way toward enhancing your retirement lifestyle. When combined with the leverage effect of borrowing money (your borrowing costs are usually tax deductible), you can magnify the benefit of the capital gains tax exclusion.

What’s more, long-term gains over and above the exemption get taxed at long-term capital gains rates – maxing out at 15 percent.

The tax benefits of homeownership kick into turbo, though, when you get into owning other peoples’ homes. Yes, what you’ve long suspected is true: The game is rigged in favor of the landlord.

Tax Benefits of Rental Property

Yep, you still get the tax deduction for a rental property. Except it’s not called a “home mortgage interest deduction.” Instead, it’s treated as a business expense and is not considered a miscellaneous itemized deduction. If you haven’t incorporated a real estate business, then these expenses get recorded on the IRS Schedule E, Supplemental Income and Loss. And guess what!?  It’s not subject to the 2 percent threshold If you did incorporate, you still get the full deduction on your IRS Form 1120 or 1120S corporate income tax return.

Repairs. Not deductible if you live in the house. Repairs are, however, deductible for landlords.

Depreciation. Congress knows buildings and their contents don’t last forever. You will eventually have to overhaul or replace them. The IRS accounts for the gradual wear and tear or obsolescence of the structures and their contents, including everything from the walls and floor to the furniture, through a process called depreciation. How does this work? You get to deduct a chunk of your investment in the property every year, even though you haven’t replaced the building yet. In theory, the IRS is helping you save money so that it’s available when you finally do replace those buildings.

Doug Jones, a realtor in San Jose, California, uses the following example:

  • Imagine you paid $300,000 for a property generating $2,000 per month in revenue, or $24,000 per year.
  • Let’s assume you have $13,000 per year in taxes, mortgage interest, upkeep and other expenses of managing the property, so you have a net cash flow of $11,000 per year.
  • Using a “straight-line” method of depreciation, you get to depreciate your investment over 27.5 years. Well, $300,000/27.5 years is $10,909 per year.
  • The IRS lets you subtract $10,909 from your income each year, just for depreciation.
  • So instead of paying taxes on $11,000 in income, the real estate investor pays taxes on $81.

That depreciation doesn’t come free, though. The deductions you take are also subtracted from your tax basis – which increases your tax bill when you sell the property. But long-term capital gains are taxed at lower rates than operating income, so you still come out ahead, even when you account for the effect of depreciation on your tax basis at the time of sale. To claim depreciation, fill out a Form 4562.

Renovations and Improvements. You kind of get a break on your taxes if you renovate or improve your personal residence. You just have to wait – it gets subtracted from your tax basis, and the IRS subtracts your investment in renovations from your gains when it eventually calculates capital gains tax liability. But unless you gained more than $250,000,or $500,000 if you’re married, it’s not much of a break, since you already get that much in the capital gains tax exclusion.

If you own investment property, though, you can take a deduction for renovating it. Not right away – you have to capitalize it over the expected useful life of the structure, meaning you have to spread your deduction out over time.

{ 6 comments… read them below or add one }

Jacob Ding October 10, 2014 at 2:08 am

The mortgage interest tax deduction is one of the most cherished American tax breaks. Realtors, homeowners, would-be homeowners and even tax accountants tout its value. In truth, the myth is often better than the reality.
According to data compiled by the 2005 President’s advisory panel on federal tax reform, only 54% of taxpayers who pay interest on their mortgages receive a tax benefit. That leaves a hefty 46% of homeowners paying interest, but receiving no benefit at all. Even those who do receive a benefit are likely to receive far less than they expect.
Of course, there’s always the argument that you could make more money by paying the interest and investing the rest of your money in the stock market.
Since there is no investment out there that will guarantee better returns than the amount you would save by avoiding interest payments altogether, the conservative choice is clear. Avoid making interest payments if you can. Pay the house off quickly if you cannot.


Myra February 7, 2014 at 6:26 pm

Hi i was wondering don’t you get too write the interest and taxes off on your mortgage


Billy Jalbert January 17, 2014 at 10:38 pm

I’m not sure the example from Mr. Jones is correct. I believe the depreciation is only on 80% of the value of the home, not the land…Consult a tax professional before any of this!


Jason Van Steenwyk January 21, 2014 at 7:26 pm

It is true, the land itself does not depreciate. So you must back out the value of the land. Mr. Jones was illustrating a hypothetical property in a classroom setting, and so was leaving out some layers of complexity. This was not intended to refer to an actual property.


Prospective Home buyer January 21, 2013 at 2:41 pm

Do itemized deductions get reduced by 2% for all taxpayers? From what I’m reading, it only applies to people with an AGI above a certain level. In 2006, this amount was $150,500.


Perth Investment April 16, 2012 at 3:59 pm

Thank you for the educational post! Bookmarked!


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