Homeowner Tax Deductions – A Housewarming Gift from Your Accountant

Purchasing a new home can be an exciting time, especially if it is your first. It can be a whirlwind—planning your budget, securing a loan and potentially improving the property. One thing that may get overlooked is how a new loan can affect your tax return. Properly deducting interest as well as other allowable expenditures can benefit you greatly over the course of a year, and although a potential reduction of taxable income is generally not an immediate relief on your wallet, homeowners can see valuable cost savings during tax time. The tax code can be complex, but we have detailed some general rules in this article that are good to know when managing your real property.

Home Mortgages
As a general rule, most people are able to deduct their home mortgage interest. To qualify, you must file Form 1040 and itemize personal deductions on Schedule A. In addition, the mortgage must be a “secured debt” for a “qualified residence” in which you have an ownership interest.

So what do we mean by a “secured debt” and a “qualified residence”? A “secured debt” is a debt, like a mortgage, where your home serves as the collateral towards the loan. A “qualified residence” is your main home or any home that you choose to treat as your second home. Generally, second homes are vacation homes that are not rented out to others, and interestingly enough, were added to the definition of qualified residences largely in part because members of Congress needed to have two homes—their main home and a second home near D.C. So, thank you, Congress! As a result, we can deduct interest on a mortgage from either one or both of the homes. The deduction is limited to interest paid on $1,100,000 of secured debt for qualified residences ($500,000 for those married filing separately).

Something else to be aware of: If proceeds from the loan are used on something other than the acquisition or improvement of the secured property, then only interest on a total of $100,000 of the total secured debt can be deducted as qualified home mortgage interest expense. Here are some examples to illustrate this point:

• You’re ready to purchase your first home, so you obtain a loan for $600,000 to buy it. The entire amount of interest paid annually on this mortgage is deductible.
• A couple years later, you get a home equity line of credit (HELOC) on this home and draw $100,000 to pay for your child’s college tuition. The entire amount of the interest paid on this HELOC is deductible annually as well.
• Five years down the road, you refinance your original mortgage and take out an additional $300,000 of equity. Your original HELOC of $100,000 is still outstanding. If the $300,000 is used to make substantial improvements to your property (remodel, additions, etc.), then the interest is deductible as qualified home mortgage interest. If the loan proceeds are used for something else, the associated interest is not deductible as qualified home mortgage interest expense, as you have already maxed out your $100,000 with the original HELOC.

Another deduction to put on your radar is your qualified mortgage insurance. This insurance can be deducted as home mortgage interest, but it must be in connection with the home acquisition debt, and the insurance contract must have been issued after 2006.

Vacation Homes
As discussed above, your mortgage interest on your second home may be deducted as well. The catch, however, is if the home is used as a rental property or not.

If your second home is both rented and used for personal use, then the expenses must be divided into personal use and rental use based on the number of days used for each purpose. The deductions are then applied accordingly. Personal-use property allows the deduction for home mortgage interest, casualty loss (i.e. damages resulting from theft, fire, storm, shipwreck etc.), and property taxes paid on Schedule A of your individual tax return. The portion of rental expenses allocated to rental use can be deducted from rental income in proportion to the number of days rented. When available, expenses that are directly associated with the rental of the vacation home can be fully allocated to the rental activity and not reduced on a per day/pro rata basis.

Should you only rent your personal residence for fewer than 15 days a year, a special rule applies where you do not have to report any of the rental income and do not have to deduct any expenses as rental expenses.

Rental Properties
Rental properties offer deductions galore! To start, mortgage interest paid in coordination with a rental property is not limited to the maximum $1,100,000 in loan proceeds as the qualified home mortgage interest is, so you can deduct all of your interest against rental income regardless of the loan size needed to obtain the property. These income-producing properties are granted deductions on Schedule E primarily for any reasonable expense incurred in the conduct, maintenance and managing of the rental property.

Some additional expenses that can be deducted against rental income include maintenance expenses, management fees, depreciation, lawyer fees and expenses incurred in connection with the determination, collection or refund of any tax. It is important to note, however, if you pay fees to a lawyer to defend title of property during a divorce, they are not deductible and are considered personal expenses related to the divorce.

One thing to watch out for is the difference between a repair and an improvement. Repairs can be expensed the year in which they were incurred, whereas improvements must be capitalized and depreciated each year. For example, a repair is understood to be anything that keeps the property in good operating condition such as painting or fixing a broken window. An improvement, on the other hand, increases the value or prolongs the life of the property and is often an addition to the structure, like a new roof or a swimming pool.

Now that we’ve discussed vacation homes and swimming pools, I could go for a vacation! When applying these general rules to your tax situation, please note that each taxpayer’s circumstances are unique and can lend to different results. It is best to discuss these items with your tax advisor, or please feel free to contact me at (805) 963-7811 or bforeman@bpw.com if you have any questions regarding the deductibility of your loan interest or other expenses.