Level 22: Income Tax in Real Estate - Chapter 3: The Tax Implications of Acquiring a Home or Asset
Second or Vacation Home Tax Deductions
Before the TCJA, you could deduct the mortgage interest from a second or vacation home, but no longer. If it's not an income-producing property, you're out of luck. The $10,000 property tax deduction limit includes these taxes too. Ugh, it's just so hard to have a vacation home these days!
Refinancing Example 1
Cho and Cedric own a primary residence they bought in 2015. They originally took out a $900,000 loan (it's a real nice place). They've since paid it down to $800,000. They refinanced that remaining $800,000 this year. How much of their loan interest is tax-deductible? Because they closed on their loan before the TCJA went into effect on December 16, 2017, and because they refinanced for the amount left on their loan and no more (it was not a cash-out refi), their loan will be grandfathered in with the old tax-deductible mortgage interest limits of $1,000,000 for a married couple. So the interest from all $800,000 of their refinanced loan is tax-deductible.
Another Weird Thing About Points
Even though points help the buyer of a property get a better loan rate, sometimes a seller will pay them to help sweeten the deal. In this case, the buyer still gets to deduct the points from their taxes, not the seller. Sorry, seller. You got pointzed.
Common Tax Deductions for Homeowners
Here is a list of tax deductions most homeowners are eligible for: Mortgage interest tax deduction Property tax deduction Points Mortgage prepayment penalties Let's walk through them one by one and talk about how each one works.
Refinancing Example 2
Hermione and Ginny own a primary residence that they purchased in 2013. They currently owe $260,000 on the loan, and plan to refinance the loan for $300,000. They will spend the $40,000 in extra loan principal on a year-long ultra-deluxe around-the-world getaway. How much of the interest on their loan can they deduct from the their taxes? Because they are not using the cash-out portion of their refinance to buy, build, or substantially improve a primary residence, that $40,000 is considered home equity debt. Hermione and Ginny cannot deduct the interest from that portion of their loan from their taxes. The other $260,000 remains acquisition debt, and they can deduct the mortgage interest from that portion of the loan from their taxes.
Construction Loans
If you're building your primary residence, you may get a construction loan to finance the work. The interest on that loan is tax-deductible for 24 months, as long as you live in the house (as a primary residence) after it's built. If you're building a rental property, you can deduct the mortgage interest as a business expense before and after construction, but not during. Listen, don't be mad at me, I don't make the rules! During construction, the interest is added to your basis in the property and depreciated normally. When does construction begin, according to the IRS? When physical construction starts. So planning and getting permits = mortgage interest is deductible. As soon as the cool construction trucks show up and start doing cool construction stuff, you're doing physical construction, and the mortgage interest is no longer tax-deductible. Points on construction loans can be deducted as long as they meet the first six IRS qualifications (remember the list from before?).
The Property Tax Deduction
Is the government really going to ask you to pay taxes on money you used to pay taxes? The answer is yes! Before the TCJA, taxpayers could deduct everything they paid toward state taxes, local taxes, and ad valorem property taxes. (Ad valorem property taxes are based on the tax rate and the assessed value of the property.) Now, there is a $10,000 total cap on these deductions combined. That means that many New York State taxpayers will max out that deduction on state taxes before they even get to deducting property taxes. "We heard you like taxes, so here's some taxes on your taxes." — The government* *not actually a real quote from the government
Points Example
James buys a primary residence for $600,000, putting 20% down. He pays for three discount points to get that sweet, sweet interest rate. Assuming he meets all of the IRS requirements for points that are tax-deductible in the year they're paid, how much will he deduct from his taxes in points this year? So let's start with figuring out his loan amount. $600,000 x 0.20 = $120,000. That is the 20% he put down. If he put down $120,000, his loan amount is $600,000 - $120,000 = $480,000. Each discount point is worth 1% of the loan amount. $480,000 x 0.01 = $4,800. Each of James's points cost him $4,800. Since he bought three, he spent a total of $4,800 x 3 = $14,400. James can deduct the full $14,400 from his taxes this year.
Home Equity Debt Example 1
Let's look at an example to see how this works. Married couple Harry and Ron have a $500,000 mortgage on their primary residence. They've decided they want to build a guest cottage out back for Ron's big family. Their tax guy assured them this counts as a substantial improvement. They take out a $300,000 home equity loan to pay for the improvements (it's got to be big enough to fit the whole clan). How much of their home equity loan interest is tax-deductible and why? Because Harry and Ron are using the home equity loan to substantially improve their primary residence, it counts as acquisition debt. However, because $500,000 in original debt plus $300,000 in home equity debt = $800,000 in total debt, their loan amount now exceeds the maximum allowable for mortgage interest deduction. Therefore, they can deduct the interest from the first $750,000 of their loan their taxes, but not the interest on the last $50,000.
Property Tax Deduction Example
Let's say Lily is a Manhattanite making $100,000 a year. She owns her apartment (it's a cute little one-bedroom fifth-floor walkup on a tree-lined block in the East Village, not that it matters). At tax time, Lily pays $6,650 to New York State. She pays another $3,876 to New York City. Her property taxes are $6,500 a year. Her total state, local, and property taxes are $6,650 + $3,876 + $6,500 = $17,026. What's the total she can deduct? $10,000. The other $7,026 is not eligible to be deducted. The only people who can deduct the full amount of state, city, and property taxes are people whose total is $10,000 and below.
Home Equity Debt Example 2
Neville is a taxpayer filing singly with a $250,000 mortgage on his primary residence. He takes out a $50,000 home equity loan. He's going to use $25,000 of it to do kitchen upgrades, and the other $25,000 to take flying lessons. How much of his home equity loan interest is tax-deductible? Because the first $25,000 of Neville's home equity loan is being used to substantially improve his primary residence, that half of his loan is acquisition debt, and the interest is tax-deductible. The flying school half of the loan is not being used to buy, build, or substantially improve anything but his pilot skills, so it is home equity debt. None of the second half of his loan's interest is tax-deductible.
Mortgage Pre-Payment Penalty
Okay, moving on from points (finally). This is an easy one. If you are penalized for pre-paying your mortgage (which is pretty rude, if you ask me), that penalty is tax-deductible. Boom, there you go, common tax deductions for homeowners.
Home Equity Debt vs. Acquisition Debt
Okay, now let's talk about another common type of financing: home equity loans and home equity lines of credit, or HELOCs. A home equity loan is sometimes called a second mortgage, and it's a way of borrowing money against the equity your home has accrued without having to sell it. Like a primary mortgage, it uses your home as collateral for the loan. A home equity line of credit is similar to a home equity loan but it is a revolving line of credit. Like a credit card, but secured by your home. Home equity loans and HELOCs generally offer a better rate than unsecured loans like credit cards and personal loans, because they are secured by the collateral of your home. The downside is that if you fail to pay them, your home can be foreclosed upon. Plusses and minuses, am I right? People take out home equity loans for all kinds of reasons: to remodel their homes, to pay for college, to fund a wedding, to start a small business, to enact elaborate revenge schemes. Whether or not the interest on a home equity loan or HELOC is tax-deductible depends on what you're using it for. An important concept to understand here is the difference between acquisition debt and home equity debt. Perhaps you'd assume that taking out a home equity loan produces home equity debt — I mean come on, it's right there in the title — but you would be wrong. Home equity loans can be acquisition debt. Acquisition debt is money borrowed to buy, build, or substantially improve a property. Remember from Chapter 1 that the IRS defines a substantial improvement as something that: Adds to the value of your home Prolongs your home's useful life Adapts your home to new uses Everything else is home equity debt. Why does it matter? Because the interest from acquisition debt is tax-deductible up to the $750,000/$375,000 limit (that's total between all of your loans), while the interest from home equity debt is not. Before the TCJA was passed, the IRS allowed taxpayers to deduct the interest from up to $100,000 of home equity debt, in addition to $1,000,000 in acquisition debt. That deduction was eliminated when the new tax bill passed, with no grandfathering — people with home equity debt were suddenly stuck paying tax on the interest. Now taxpayers can only deduct the interest from a total of $750,000/$375,000 in acquisition debt across all loans.
Refi Points Example
Okay, so let's say our old friend James has been in his home for a few years and wants to refinance. (James just loves optimizing his interest rate — it's important to have hobbies). He's paid his original $480,000 loan down to $440,000 and is going to take out a 30-year fixed-rate loan for that amount. He's buying another three points this time (James also loves buying points. Just a real big low-interest-rate-head, this guy.) Assuming he meets the IRS requirements for points deducted ratably over the life of the loan (remember, only points on refinance money used to improve one's home can be deducted in the year they're purchased), how much in points will he deduct from his taxes this year? First we figure the cost of each point, which is 1% of the loan amount. $440,000 x 0.01 = $4,400. He bought three points. $4,400 x 3 = $13,200. He can deduct that $13,200 over the 30-year life of the loan. $13,200 ÷ 30 = $440. James deducts $440 every year for 30 years, or until he sells the house. When he sells, he can deduct the remaining amount that year.
Investment Properties
On the other hand, the mortgage interest and property taxes on investment properties are fully tax-deductible, with no upper limit. Federal government, making it rain tax deductions for investors.☔️ 💵
Refinance Points
Points work differently when you're refinancing a loan. If you're using part of the refinance money to improve your primary residence, then they may be deductible in the year you paid them (if they meet the first six criteria in the list for deducting points in the year paid). Otherwise, refinance points are deducted over the life of the loan. For example, if you have a 30-year loan, you divide the amount you paid in points by 30, and then deduct that little tidbit every year for 30 years. Hey, every little bit helps! You can deduct the remaining balance in the year you sell the home. Is there a list of criteria refi points have to meet in order to be deducted over the life of the loan? Of course, this is the IRS we're talking about! Lists of criteria are like their #1 hobby. Here it is, straight from IRS Publication 936: You use the cash method of accounting. The loan is secured by a home. Your loan period isn't more than 30 years. If your loan is more than 10 years, the terms of the loan are the same as other loans offered in your area for the same or longer periods. Either: Your loan amount is $250,000 or less. If your loan period is 15 years or less, you paid four or fewer points. If your loan period is more than 15 years, you paid six or fewer points. These are the same criteria all points deducted over the life of a loan must meet, by the way.
Points
Remember points? You remember points. Just in case you're fuzzy, discount points are interest a borrower pre-pays on their loan to lower their interest rate, and origination points are fees associated with getting a loan. Each point is 1% of the total value of the loan. Now here's the good news: Most points are tax-deductible in the year they're paid! Hooray for points! Most closing costs are added to a home's adjusted basis, so they are sort of tax-deductible when a homeowner sells the home, since they offset potential taxable capital gains. But not points. Nuh-uh. Points are coming off those taxes right away. Here are the IRS requirements for points to be tax-deductible in the year they're paid: The loan is secured by the home. Paying points is an established business practice in the place the loan was made. The points weren't more than are generally paid in an area. The cash method of accounting was used (if you don't know what that is, you are almost certainly doing it). The points weren't paid in lieu of other common closing costs, like title fees or appraisal fees. The homebuyer didn't use money from the loan itself to pay the points. The loan is being used to buy or build a primary residence. The points appeared on the closing disclosure as points paid for a mortgage. The points were computed as a percentage of the loan's principal. That sounds like a lot of requirements, but most points will qualify. The only thing to keep an eye on with deducting points is that if you have exceeded the limit for the mortgage income deduction with your loan, you can't deduct all of your points, either. Only an amount proportional to the first $750,000 in value. For example, if you take out a $1,000,000 loan, only $750,000 of that mortgage interest is tax-deductible. Therefore, you can only deduct 75% of the points you paid. If your points don't meet all of the qualifications for tax-deductibility in the year they were paid, you can usually deduct them ratably over the life of the loan. We'll talk more about how that works in a minute.
How Refinancing Works
So what happens if you refinance your loan? If the original loan was all acquisition debt, made before December 16, 2017, and you are refinancing for the same amount of principal or less, you can deduct up to $1,000,000/$500,000 worth of mortgage interest. If the original loan was all acquisition debt, made after December 16, 2017, and you are refinancing for the same amount of principal or less, you can deduct up to $750,000/$375,000 worth of mortgage interest. If the original loan was acquisition debt, but you are refinancing for more than the remaining principal (sometimes called a cash-out refinance), the interest on the extra money you borrow will be tax deductible up to the new $750,000/$375,000 limit if it's used to buy, build, or substantially improve a property. If not, none of the new debt has tax-deductible interest. If you are refinancing home equity debt, the interest is not tax-deductible even if the original loan was made before December 16, 2017. No home equity debt interest is allowed to be deducted from a taxpayer's taxes, starting in tax year 2018.
Tax Cuts and Jobs Act of 2017 Redux
The Tax Cuts and Jobs Act (TCJA), passed in late 2017, changed how a few of the most common tax deductions taken by homeowners work, starting in tax year 2018. It was the biggest change to tax code in over 30 years, and changed the mortgage interest tax deduction for the first time since 1987. It was kind of a big deal. As you may remember from Chapter 1, the TCJA was intended to simplify the filing process for most taxpayers. In pursuit of that goal, the TCJA almost doubled the standard deduction. When taxpayers file their taxes they can either itemize their deductions or take the standard deduction. Itemizing is when taxpayers list out their deductions separately (so, itemize them) instead of just taking the "standard" deduction that's available to everybody. To take advantage of any of the real estate tax deductions, a taxpayer must itemize. But it only makes sense to itemize if your combined itemized deductions are more than the standard deduction (unless you really like doing taxes for some reason?) A larger standard deduction means fewer people will exceed the standard deduction with their itemized deductions. Before 2017, the standard deduction for single filers was $6,350 and for joint filers was $12,700. Those numbers are now $12,000 and $24,000. The non-partisan Tax Policy Center predicts that 27 million fewer taxpayers will itemize in 2018, down from 30% to about 10%. So it's not just that the amount of possible deductions from buying or refinancing have changed, it's that fewer people will see a direct tax benefit from home ownership. Of course, that is just for homeowners. For real estate investors, most tax deductions remain unchanged, and that fancy new 20% deduction on "pass-through income" will mean that many small investors will see a reduction in their tax liability.
The Mortgage Interest Tax Deduction
The mortgage interest tax deduction, or MID, is the biggie. Amortized loans are structured so that borrowers pay mostly interest at the beginning of the loan, slowly increasing the amount of principal they pay as the years go by. Being able to deduct the interest on a mortgage is a big tax break for most borrowers. To be eligible for this tax deduction: The taxpayer must be legally responsible for the debt. (So for example, you can't deduct rent even though your landlord is probably using it to pay their mortgage.) The loan must be a secured debt, with the home as collateral. The loan must be for a primary residence. Before the TCJA, interest on loans up to $1,000,000 (for people filing jointly) or $500,000 (for people filing singly) was tax-deductible. Those numbers are now $750,000 and $375,000, though any loans made before December 16, 2017 (or in a binding contract before December 16, 2017 and closed before April 1, 2018) are grandfathered in with the old amounts. Grandfathered loans can be refinanced and retain the $1,000,000/$500,000 limit, as long as they aren't refinanced for more than the remaining original principal. We'll talk about why in a minute.
Tax Incentives for Buying and Financing Real Estate
As we talked about in Chapter 1, there are many tax incentives baked into the process of purchasing real estate. There are also tax deductions you can take when refinancing, financing improvements, and doing other real estate-related activities. In this chapter, we're going to take a deeper dive into the tax implications of all kinds of real estate purchases and financing. I know, I know. It's almost too much excitement. Try to control yourself, Mustafa.
