RTS #030 “I bought a house, that helps with taxes right?”
Round 2 of our deduction game: home ownership.
Once we move past the general desire to deduct “everything”, expecting a home purchase to have a tax impact is one of the more common misconceptions around tax deductions for individuals. The real problem with home ownership and income tax is how large the standard deduction is.
Heading into 2024, the standard deduction is up to $29,200 ($27,700 in 2023) for married couples filing jointly and $14,600 ($13,850 in 2023) for single filers. Property taxes and mortgage interest are potentially deductible, but in addition to needing more than $29,200 in total deductions to itemize (which ~90% of tax payers are unable to do), property taxes are included in the $10,000 State and Local Tax (SALT) limits. For property taxes this mean they go on the same line of Schedule A as state income tax resulting in no additional benefit for a large portion of taxpayers.
And on the mortgage interest side, there are limits on just how much can be included based on the size of the mortgage (generally, only interest on the first $750,000 of debt can be deducted). With these limitations, it is still important to report the amounts each year because there are states with different rules on itemizing deductions.
Another way this question comes up is a taxpayer rents a portion of their home and reports it on Schedule E. If there is income being generated by the property we have more options but still need to be careful. The IRS does not like double dipping or creative allocations. Taxpayers renting a portion of their home should use the square footage being rented as a percent of their total square footage to determine how much of their ownership and upkeep expenses can be deducted. A portion of property taxes and mortgage interest can absolutely go on Schedule E if part of the home is being rented, but that portion then has to come off of Schedule A.
A potentially powerful tax planning opportunity related to home ownership is the ability to exclude a large portion of any capital gains from the sale of a main home from your tax return. There are, of course, rules, but they have changed over the years, so when it comes time to apply them to your situation or that of a client, it’s important to be up to date. From a high level, $500,000 for a married couple or $250,000 for a single taxpayer of the gain on the sale of a home that meets two important criteria can be completely excluded from income (which can mean six-figure savings in some cases). To use the exclusion you have to have owner and used the home as your main home for at least two years out of the five years leading up to the sale. The ownership and use does not have to be continuous but does have to total two years, and you have to have not used this rule in the two-year period leading up to the sale. There are no requirements on what you do with the proceeds of the sale (this used to be a rule, so questions often come up). There are exceptions where a portion of the exclusion can be applied if the home has been owned and used for less than two years, so even if a taxpayer doesn’t automatically qualify, it’s still worth asking questions.
BONUS: For advanced tax payers taking advantage of the Augusta rule (check out the RTS email newsletter from October 13, 2023, for more on this planning opportunity): there are NO expenses that you can deduct against income generated from renting your own home. More accurately, there are no ADDITIONAL expenses that can be deducted. When the Augusta rule is reported, the full amount of income generated is reported on the first line of Schedule E and then is completely offset by “Other Expenses”. The IRS does not allow taxpayers to create passive losses through the Augusta Rule.
What can you do about it?
Your clients need to know that you want to be involved in every money decision BEFORE they make it. The best advisors create a relationship where their clients are proactively reaching out to share what’s coming up in their lives. To be effective, most tax planning has to happen preemptively and not as an afterthought. Advisors who help their clients get ahead on taxes are the ones who make it a year-round discussion. Tax topics, like tax rules around home ownership, make for great reminders in client newsletters.
Happy Tax Planning!