So You're Buying a Home: Tax Benefits of Homeownership

Homeownership is a great financial decision for lots of reasons: Leveraged investment, forced savings, and the opportunity for rental income. This is only compounded by the fact that there are a number of tax benefits to owning your own home. Here are some details on the two most important ones, and a very short listing of some of the others. (Titles link to relevant IRS publications.)

Mortgage Interest & Real Estate Taxes Paid Deductions

Mortgage interest and real estate taxes can be deducted from income with very few qualifications on Schedule A, Itemized Deductions. (The most relevant limitation is that the mortgage can't be for greater than $1 million.*)  For individuals with sizable mortgages, this can represent a substantial tax savings, especially in the first few years of the mortgage, when much of the payment is interest.

Tax for example a fictional taxpayer living in Washington DC who makes $80,000 per year and pays $2,000/month in rent. Taking the standard deduction, and absent any other complicating circumstances, this person would owe approximately $13,150 in federal taxes and $4,600 in DC taxes. Total tax bill: $17,750.

Now, swap out that rent payment for the monthly payment on a $400,000 mortgage at a fixed interest rate of 4.5%, which is just a bit higher: $2,025. Most of that monthly payment is interest early on: In the first year of paying that mortgage, the taxpayer will pay just under $18,000 in interest. She'll also pay about $2,600 in property taxes. All of that is deductible, both at the federal and local level! Her new federal taxes owed will be about $8,750, and DC taxes owed would be about $3,350. Total tax bill: $12,100. Tax savings of over $5,600!

Added bonus: Because our taxpayer is now itemizing her deductions, all her charitable giving will be deductible. When she was renting, only charitable giving over $1,700 would have had tax benefits to her, because she would have been using the standard deduction up until her giving reached that level.

(*The Trump Tax plan will reduce that limit to $750,000 starting in 2018. The Trump tax plan will also limit state and local tax deductions, including real estate taxes, to $10,000 in deductions total. More on the Trump tax plan in a later blog post. None of that would affect the taxpayer in this example, but would have lots of real-world consequences.)

Zero Capital Gains Tax on Appreciation of Your Home

For most assets (stocks, bonds, mutual funds, and even collectibles) if you buy low and sell high, you have to pay taxes on your profit. The capital gains tax rate is advantageous compared to the tax rate on "regular" income*, but it's still substantial: 15-20%.

But congratulations homeowners! The first $250,000 of capital gains ($500,000 if married filing jointly) on your first or second home avoids tax entirely. The only requirement is that you have owned and lived in the home two out of the last five years. 

So compare levered investing in a home with investing in the stock market. Let's say you have $80,000 saved, and you can either put it towards a down payment on a $480,000 home, or can invest in the stock market. Let's also make up investment return rates: Investments in the stock market increase in value at a rate of $10% per year, and investments in real estate increase in value at a rate of 4% per year. 

Stock market: At the end of 5 years, your $80,000 investment in the stock market would have grown over 60%, and turned into almost $130,000. Congratulations! But when you sell the stock, you owe 15% of the $50,000 profit you made, or $7,500. So your net profit is only $42,500. Still, not bad.

House purchase: At the end of 5 years, your home has only grown in value about 22%. But because your home was worth $480,000 (since you only put 20% down), it has increased in value by nearly $105,000. And when you sell your home, all of that is net profit, because there is no capital gains tax due. That's more than $60,000 more than you would have made in the market.

Even making adjustments for leveraging your stock market investment, or for home purchase and home sales costs, there is rarely a scenario where stock market investing is as profitable as investing in your own home.

(*For most middle-income taxpayers, a flat 15% rate applies to the sale of assets held over one year. If you make more than $425,000 per year, the 20% rate applies.)

An Incomplete Listing of Other Tax Benefits of Homeownership

• Penalty-free withdrawal from tax-advantaged accounts
• Energy Efficiency upgrade tax credits
• Deductions on interest paid on home equity loans used to improve/upgrade your home
• Mortgage Interest Credit (for qualified holders of Mortgage Credit Certificates issued by states)
• First-time homebuyers credit (some states)