What are my tax deductions when I become a homeowner?

When owning a home, your income tax reporting deductions arise out of three types of expenditures:

• the interest paid on your purchase-assist and equity mortgages;

• the premiums paid on mortgage insurance (MI) when your down payment is less than 20%; and

• the property taxes and bonded assessments you pay on the home.

Federal housing policy by design uses the tax code to encourage leveraged homeownership. The code permits a personal deduction for interest paid on mortgage debt incurred to acquire a home for your family use — called the mortgage interest deduction (MID). You are allowed to reduce your federal and state income taxes by use of
the MID when you finance the purchase of a principal residence or vacation (second) home. You may deduct interest accrued and paid on:

• purchase or improvement mortgages up to $1,000,000 principal; and

• home equity mortgages up to $100,000 principal.

Ownership of a personal residence and second home allows you to itemize accrued mortgage interest you have paid and deduct the amounts from your adjusted gross income (AGI), with limitations on the very wealthy.

The amount of tax reduction you experience is based on the amount of your AGI and tax bracket.

When financing the purchase of your principal residence, loan points (origination fees) and MI you or the seller pay to originate the mortgage are a type of interest payment
you also itemize and deduct from your AGI. All other lender closing charges are non-recurring costs that are part of the cost of acquisition of your home and may not be written off as a deductible expense.

Property taxes you pay based on your home’s assessed value are also itemized and deducted from your AGI to further reduce your income taxes. Deductible property taxes are often prepaid at closing to reimburse the seller for the portion they paid that accrues after the date you acquire ownership. Any supplemental property taxes paid due to reassessment are also deductible.

Annually, you itemize and deduct each year’s property taxes paid on the home whether paid directly by you or indirectly through the lender under an impound account arrangement.

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Stella Bonin
Associate Broker

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Coldwell Banker Residential Brokerage (Arizona)
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Get Leverage Working for You

Leverage is an investment term that describes the use of borrowed funds to control an asset; sometimes referred to as using other people’s money. Borrowed funds can affect the investment in your home positively.

For instance, if you had a $100,000 rental property, collected the rents and paid the expenses and had $10,000 left, you would earn a 10% return (divide the $10,000 by the $100,000.) With no loan on the property, there is no leverage.

If you decided to get an 80% mortgage at 8%, you would owe an additional $6,400 in expenses leaving you only $3,600 net. However, your return would grow to 18% because your investment is now $20,000 in cash (divide the $3,600 by $20,000.)

Leverage, the use of borrowed funds, causes the return to increase in this example. While, most people associate leverage with rental properties, it also applies to a home. The larger the mortgage, the more leverage you have. A FHA mortgage with a 3.5% down payment has more leverage than an 80% loan.

Assume we’re looking at a $295,000 purchase price with 3% closing costs and a 4.5% mortgage for 30 years with a five-year holding period. The following table shows the return based on different down payments and appreciation rates. The initial investment is the down payment plus closing costs. The equity build-up at end of year five is the result of normal principal reduction and appreciation.

Down Payment 1% Appreciation 2% Appreciation 3% Appreciation
3.5% 21% 28% 34%
10% 12% 17% 21%
20% 7% 10% 13%

Another way to look at the 3.5% down payment example with 3% appreciation would be to say that a $10,325 down payment plus $8,850 in closing costs could grow into $82,482 of equity in a five-year period producing a 34% rate of return on the initial investment.

Estimate what your initial investment could grow to using this Stella.Bonin