Many of the costs of owning a home are deductible from individual federal income taxes, and tax savings from these deductions may reduce homeownership costs. In addition, there are tax benefits when a home is sold.
The interest portion of mortgage monthly payments is deductible. Each year, the borrower receives a statement from the lender indicating how much interest was paid for the tax year. This amount should be included on schedule A of the 1040 tax form. In addition, for the year of purchase, discount points paid to the lender may qualify as interest payments. When they are a customary in the area, paid with a separate check, and not considered an origination fee, points should be deductible. When an origination fee is charged, it normally is only a portion of the discount point payment. Check with the lender to see how much is designated as a fee. Each point is one percent of the amount borrowed. For example, if three points were paid on a $100,000 loan, the total charge would be $3,000. Suppose one point was considered a fee and the rest discount points. An amount of $2,000 could be deducted as interest in the year of purchase.
Interest on up to $1,000,000 of mortgage debt to construct, acquire, or substantially improve a home or a second home is fully deductible. Interest on up to $100,000 of home equity debt is generally fully deductible for taxpayers who itemize deductions.
In most cases, these taxes are paid by the lender from an escrow account kept current by part of the monthly payments. The annual statement from the lender will indicate how much was paid in taxes for the year. If you paid taxes directly, you will have a statement from the local taxing authority to indicate the amount of taxes paid. When you sell the home, do not forget to include any prorated taxes you may have paid to the buyer.
These benefits also apply to a second home, but not to any additional homes you may own. If you own houses as rental property, a different set of rules apply.
When you buy your first home, the purchase price becomes the property's basis for calculating capital gains. At resale, taxes may be required on any profits realized. A profit is indicated if the sales price exceeds the basis. However, the cost of selling (commissions, advertising, etc.) may be deducted from the sales price. Major improvements, not just repairs, to the home while you own it may be added to the original basis. All of these things help to reduce the taxable capital gain.
As an example, suppose a home was purchased for $50,000 in 1970. In 1979, a second bath was added at a cost of $5,000. The house is sold in 2003 for $80,000. The seller paid a commission of $4,000 and $1,000 of the buyer's closing costs.
Capital gains taxes may be deferred if a replacement home is purchased within 24 months of the sale. The 24-month period may extend before or after the sale. The cost of the new home must be at least as much as the net sales price of the home sold. No tax is due in the year of sale but the basis the new home is reduced by the amount of gain deferred. Suppose the seller of the home above buys a new home for $85,000. The new basis is $85,000 minus the $20,000 of gain deferred, or $65,000. As long as the procedures are followed, deferral of capital gains taxes can go on indefinitely, each time reducing the basis by the taxes deferred. After the age of 55, a homeowner may sell and receive an exemption of $125,000 in deferred gain. This can be elected only once in a lifetime.
The internal rate of return (IRR) is usually defined as the rate at which the present value of investment outflows and investment inflows are equal. As it relates to the subject property, the periodic cash flow is the annual after-tax cash flow and any after-tax proceeds from resale, while the investment amount is the cash down payment plus subsequent cash payments.
On the matter of reinvestment assumption, after-tax cash flows from the investment must be reinvested at the internal rate of return for the rate to be a valid indicator of investment profitability.
When an individual considers acquiring real estate, he or she should analyze the potential costs and benefits of that property. Real estate investments can be lucrative by providing cash flow, appreciation, and a hedge against inflation. However, drawbacks include complex transactions, a need for business and management skills, and a potentially high risk of loss especially with financial leverage, and illiquidity. Careful analysis can increase the likelihood of a successful investment.
Source: Barron's Real Estate Handbook, Third Edition