Death and Taxes: A Homeowner’s Guide to Tax Reduction
The year 2018 was an eventful one when it came to taxes. For one, the Tax Cuts and Jobs Act enacted in late 2017 finally went into effect and the Fed’s went on the move with their rate hikes. With congressional dissent at its highest in years and the federal deficit quickly approaching $1Tril, there’s no telling when Uncle Sam might come knocking with a larger tax bill.
This makes it crucial for average Americans to do as much as they can to shield their hard-earned paychecks using sensible tax-avoidance strategies. The tax savings you obtain from your annual deductions alone can total thousands of dollars, while capital gains taxes on a home sale in today’s appreciated market, could easily account for hundreds of thousands of dollars in exempt earnings in large cities.
In the face of the coming tax season, we’ve outlined a few key strategies people should know to (legally) shield their hard-earned nest eggs from the dreaded tax man.
Mortgage Interest Deduction Under the New Tax Law
As of 2018, new home buyers can deduct the interest on mortgage balances of up to $750K annually, this is down from the previous allowance of $1M. Anyone who purchased a home after Dec. 15. 2017, is subject to the new tax law on mortgage interest deduction, while homeowners who purchased their homes prior to that date can still take advantage of the original $1M interest deduction.
To illustrate the savings impact: under the old tax law, borrowers with at least $1M dollars in outstanding mortgage debt could achieve around $17K in tax savings in the first year of mortgage payments alone, assuming they took out a 30-year mortgage at a 4.5% interest rate. Under the new tax law, this figure drops to roughly $12.7K tax savings in year one, down almost 25% from the previous allowance.
Naturally, most homeowners are deciding whether it’s better to take the itemized tax deduction, or instead choose the standard deduction on their tax filings this year. For most of America, where the average price of a home stands between $200K – $250K, it’s likely that the standard deduction is more attractive.
Based on our research, we found that the breakeven mortgage amount needed for most single tax filers to reap the benefits of itemizing stands at around $280K in mortgage debt. Depending on where you are in your repayment schedule and whether you have any other tax-deductible debt outstanding, like student loans or certain investment income, it may still make sense to itemize even if you fall between the breakeven.
Homeowners in high-cost areas, like New York, California, and New Jersey, where the average price/per square foot for a home can be $500 or more, were harmed most by the new tax rules. In some areas, housing prices have dropped by 10% – 20% from 2015. While it’s true that much of this decline can be blamed on rising interest rates, overbuilding and slowing demand, large urban areas are more likely to be negatively impacted by the new tax laws, thanks to the historically high home prices in these areas.
Can You Keep All the Gains from Your Home Sale?
Even though your personal income tax bracket might have shifted, the laws surrounding the Capital Gains Exemption on home sales remain the same. Eligible married couples filing jointly can still exempt up to $500K in capital gains on their home sale, while single filers are eligible for up to $250K in exemptions.
These can add up to enormous savings when compared to long-term capital gains taxes which absorb 15% or 20% of your appreciated value. Those savings are further magnified when viewed in relation to short-term capital gains taxes, which are based on your personal tax bracket and can pilfer as much as 40% of the total return on your investment.
Even if you don’t qualify for the full tax exemption, you might still be in luck, as the IRS is fairly lenient when it comes to granting partial exemptions, especially when the sale is the result of uncontrollable circumstances. Homeowners seeking to sell their homes should consult a tax professional to see whether they qualify for a partial exemption.
Case in point, properties in some areas of the country have seen home values skyrocket by a factor of 30% or more over the past 5 years. If you’ve lived your entire life in sizzling real estate markets like Brooklyn or San Francisco, it’s not inconceivable for long-term homeowners to hit the capital gains exemption cap on their home sale.
Write-Offs and Deductions for DIY-ers
Home flippers would do well to understand the concept of “cost basis;” loosely defined as the price that you paid to acquire your home, your initial cost basis consists of the acquisition price on your property.
Homeowners can then add expenses incurred for repairs, home renovations, and transaction fees paid to acquire the property. All of these count under the IRS definition of cost basis. Collectively, the increase in cost basis reduces the size of any subsequent capital gain, thereby offsetting your tax liability.
The concept of cost basis is especially important if you’ve exceeded the capital gains exemption cap, or otherwise aren’t eligible for any of the tax exemptions described above.
The benefits here are obvious, every dollar you spend on home repairs can lead to a dollar-for-dollar decrease in your capital gains liability, which is not only a good way to recoup your costs, but allows you to make worthwhile improvements to your home by leveraging your future home value. Anyone who’s installed a brand new kitchen knows that home renovation expenses can easily run you $15K or more.
Finally, homeowners who are thinking of taking out a new home equity loan may want to think twice, as the new tax law also eliminates interest deductibility on home equity loans and HELOCs in all instances aside from home improvement purposes.
Complying With the Tax Regulations
In summary, there’s a big difference between tax avoidance (which is perfectly legal) and tax evasion. There’s nothing wrong with trying to reduce the size of your tax bills, in fact, there exist many investment strategies built solely around ways to maximize your after-tax income. By contrast, deliberately underpaying or hiding tax liabilities from the IRS is categorically illegal, and falls under the umbrella of tax evasion.
It’s a good idea to consult with an attorney or CPA to make sure you check off all the necessary boxes before claiming these exemptions on your tax forms. To stay on the safe side, keep all receipts from your home renovation projects, and maintain a detailed record of your loan expenses so you can have a clean paper trail if the need ever arises. Homeownership can be a headache at the best of times; there’s no need to complicate the process further by failing to abide by the tax code.
The writer of this piece is not a qualified tax advisor. The contents of this article are meant for informational purposes only and should not be construed as tax or legal advice. Make sure you consult with a reputable tax attorney, CPA, or tax consultant to confirm that you qualify for the deductions/exemptions mentioned above.