Congrats! After all those open houses, offers and rejections, you are finally a homeowner. But you didn’t just buy a home, whether you knew it or not. You also purchased an asset-accumulation machine.
Your new home comes with some really cool features, and we’re not talking about the energy-efficient windows and that just-remodeled full marble bathroom. It’s better than that, because we are talking about:
● The increase to your net worth that you get from simply paying down the mortgage; it’s not like rent, which disappears into a landlord’s bank account.
● Finally qualifying for itemized tax deductions. With your mortgage interest payments, private mortgage insurance premiums and real estate taxes, you are more likely to exceed the standard deduction (more on that later).
● Getting to take tax deductions on your home office if you’re self-employed, whether you itemize or not. You’ll qualify for a bunch of related deductions, including the office’s share of the utility payments.
Let’s look first at how building equity relates to building your net worth (it’s not exactly the same thing), then we’ll explore how owning a home benefits you on the tax front.
The Beauty of Building Equity
As hard as it might be to believe in the current market, home values do come down. Not often, mind you: The last dramatic downturns in the nationwide real estate market occurred from the late-1980s to the mid-1990s, and then again during the Great Recession about 15 years ago. Because home prices can drop and stay down for a while, remember you are buying your home to live in it, not primarily as an investment with a guaranteed positive return, like, say, a bond held to maturity.
That said, a home can be a real boon to your net worth. The obvious way is that for every dollar you pay in principal on your mortgage, your equity in the house will rise by that amount (you’ll owe the mortgage lender less money when you sell the home).
Remember that every cent that goes to paying down your mortgage has to come from somewhere, and that somewhere is usually your checking account. So building equity isn’t the same as building your net worth. But compared to renting, you’re gaining by the amount of the principal payments. Now you own an asset that can grow in the market, and when that happens, as it so often does, it is absolutely directly boosting your net worth.
The Monthly Math of Owning a Home
Understanding mortgage payments and equity will be essential as a homeowner, so here’s an example of how they work.
If you bought a home today at the national median price, you’d pay roughly $410,000. For argument’s sake, let’s say about 10%, or $40,000 of that, was a down payment, leaving you with a mortgage of about $370,000. With a 30-year fixed-rate mortgage at 3.75%, your monthly housing expenses in a random jurisdiction could look something like this:
● Principal: $600
● Interest: $1,130
● Taxes: $440
● Homeowners insurance: $100
● Private mortgage insurance (PMI): $150
Remember, the principal you pay each month is effectively “forced savings.” If your house were to be sold later for the exact amount you paid, you’d get your down payment plus all your principal payments back in that transaction. In this example, if the house were to be sold for the same $410,000, at closing you’d be credited with the $40,000 down payment amount plus all your principal payments, which might total over $7,000 for each year you owned the house. Nice!
Should You Itemize Deductions or Take the Standard Deduction?
While building equity is the most obvious advantage of owning versus renting, it’s not the only one, by far. The tax advantages that come with owning will play a more prominent role in your life, because you’ll see the returns every year at tax time, as opposed to just once, many years later when the house is sold.
How does this work? Let’s go back to our example of monthly mortgage payments. If you exclude the principal payment and the homeowners insurance, you’d be paying $1,130 in interest, $440 in real estate taxes and, until you built enough equity in the home, $150 in PMI every month. (For details on avoiding PMI, read “What’s the ‘Right’ Downpayment on a House?”)
The IRS sets standard deductions every year for personal taxes, meaning that if you don’t itemize your deductions, you can write off one simple number. The standard deductions for 2022 are set at $12,950 for individuals, $25,900 for married couples filing jointly and $19,400 for the head of a household. In order for it to be worth itemizing your deductions, you would need to exceed the level that’s appropriate for you. (Remember that you can also itemize deductions for non-home-related expenses, such as charitable donations and long-term care insurance premiums. Some deductions may surprise you.)
If, in our example, you paid $1,130 each month throughout the year, that’s $13,560. Apply the same to the real estate taxes and that’s another $5,280. The PMI premiums? $1,800. Add those up and you’re at $20,640. So, in this example, if you’re an individual or head of household for tax-filing purposes, you’d want to itemize. If you’re married and these numbers reflect your situation, you’d need to top up your real estate deductions with something else, but you’d be very close.
That’s just in this example. More expensive homes with higher interest payments and property taxes would make it easier to itemize. (Note: There is a $10,000 cap on how much money you can deduct in property taxes, state and local income taxes and sales taxes combined.)
● A tool to help from the IRS. The U.S. tax code being the U.S. tax code, not everything is simple, but the IRS has a tool to help you find and itemize deductions for mortgage-related expenses here. If lists work better for you than tools, click here.
When you bought your home in the calendar year matters as well. If you bought the house deeper into the year, it may make sense to wait until after the next calendar year to itemize—because your payments for a few months won’t likely be higher than the standard deduction.
What Can’t I Deduct?
Every silver lining comes with a cloud, and that’s true in the case of homeownership, too. Here are some items that aren’t tax-deductible:
● Homeowners and fire insurance premiums
● Payments to domestic help
● Depreciation
● Utilities and similar costs if you’re not self-employed and working from home
● Homeowners association fees, including co-op fees
● Trash collection and landscaping costs
How Do Mortgage Points Work With Taxes?
Speaking of calendar years, for the year of the purchase, you also get a tax break on what you paid in “points” to close on the house. Mortgage points are equal to 1% of your loan, and they come in two flavors: origination points and discount points.
● Origination points paid go to the lender.
● Discount points are a form of prepaid interest on the mortgage, and the higher the discount points, the lower your interest rate over the life of the loan.
Commonly, paying two points, or 2% of a loan, might lower the interest rate in our example above from 3.75% to 3.25%. Not only are these points tax-deductible, but if you’re in the property long enough, you can recoup the money over time versus paying the higher rate. Prepaying interest may actually turn out to be profitable for you.
Self-Employed? Help Yourself
If you’re self-employed, the plot thickens, in a good way. Self-employed individuals—itemizing or not—are able to write off their dedicated home office and even a percentage of their utility payments, including for the internet, a landline, electric and heat. If your dedicated space isn’t attached to the main home, say, what was originally a garage, studio or barn, that’s acceptable, too.
As for how much you can deduct for your home office, start by getting out a yardstick, so that you can measure the square footage of the office. Then, you can take the IRS up on its “simplified option,” which amounts to $5 per square foot up to a maximum of 300 square feet, or $1,500.
To deduct so-called indirect home office expenses, such as a percentage of your utility and internet payments, you’ll also need to know the total square footage of your home, so you can figure out what portion of that total square footage the home office represents. If the home office measured 15 feet by 15 feet, or 225 square feet of the home, that’s 2,250 square feet in total, so you’d be able to deduct 10% of those indirect expenses.
You can also write off expenses related to your work equipment—computer hardware and software, work smartphones, printers and office supplies—in a home office. Need to brush up on the latest advances in your field? Continuing education is deductible. Want business cards? Deductible. If you are self-employed and have no health insurance from any employer, you can deduct that, too, for your entire family, as long as your business is making a profit. (For more, check out our graphic, “Taxes: They’re Different With a Gig.”)
What If You Have an Investment Property?
You don’t even have to live in a home you own to get a tax advantage from it. If you own a home and rent it out, you do have to pay ordinary income tax on the rental income. You can, however, deduct mortgage interest on the property, advertising fees, legal fees, depreciation, certain repairs and more, including fees related to tenants’ incoming digital payments. Make sure you keep records of all these costs. (Be aware: You may owe short-term capital gains taxes at your ordinary income rate should you flip the property too soon.)
If you’ve purchased a historic property and are fixing it back up to the glory it used to be, you may qualify for a historic rehabilitation tax credit, though note that the income-producing property cannot be for personal use.
Other Home-Related Tax Advantages
Here are three additional tax-related benefits that would depend on your health, your finances and your location.
● Health-related improvements. Medically necessary home improvements are also tax-deductible. The government may frown on an attempt to deduct a new outdoor oven (even if you’re on the so-called pizza diet), but it will look favorably on deductions for home improvements that make the house more accessible.
● HELOCs. A home equity line of credit, also known as a HELOC, is a nifty way for home purchasers to come up with a 20% down payment when they otherwise might not be able to. This is significant because the 20% equity threshold allows the buyer to avoid PMI premiums. Often, the HELOC will be part of a so-called 80-10-10 purchase. In that equation, 80% is financed with a mortgage, 10% through a down payment in cash and another 10% through the HELOC. The interest on such a HELOC is tax-deductible. (Meanwhile, once you own a home, you can still take out a HELOC, and as long as you use it for home-related improvements, you can deduct the interest on the loan.)
● Disaster-area benefits. If you are the beneficiary of a state housing finance agency’s Hardest Hit Fund, Emergency Homeowners’ Loan Program or Homeowner Assistance Fund, you may still be eligible for tax benefits relating to your mortgage payments.
For more information on taxes and your new home, consult with a tax professional. In many cases, accountants will provide new clients with a free introductory meeting where you can ask about these details and any other tax-related concerns you have.
Andy Sobel is a freelance writer and editor. He has held senior editing positions in The Wall Street Journal's New York and Brussels newsrooms and was managing editor of American Banker. A graduate of the University of Missouri and Union College, he now lives in Nashville, TN.
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