Young families planning to buy a house in the new year should take time to learn about the tax breaks that come as a bonus of home ownership.
When you pay rent, the monthly check goes to your landlord and you cannot deduct the expense on your federal income tax return.But when you buy a house, you generally borrow money from a lender - a bank or savings and loan - who charges you interest. So your monthly check is used to reduce the amount of the loan and to pay off the interest.
The federal government allows you to take a tax deduction for the interest you pay on a home loan and you get state tax advantages as well. In the first five years that you have the mortgage, almost all of your monthly payment is interest, so the tax advantage is greatest then.
In some cases, the tax savings are so large that it actually makes financial sense to own rather than to rent.
For example, if you're paying $700 a month rent, plus utilities, you probably could save money by buying a house in the $100,000 range.
Say you made a $10,000 down payment on a house costing $100,000 and got a 30-year mortgage for the remaining $90,000 with an interest rate of 9.5 percent. Your monthly payments for principal and interest would be $756. Real estate taxes and home owner's insurance - expenses you didn't have as a renter - might add another $120 a month for a total monthly payment of $876.
Your total rental payments for the year would be $8,400. Your total payments as a home owner would be $10,512, or $2,112 more than you paid in rent.
But you probably would save $2,500 or more in federal income taxes through the deductions to which you would be entitled as a homeowner.
The actual amount of tax saved will vary, depending on your income, but most real estate agents can give you a close estimate. Once you buy the house, you can reduce the amount of federal income tax taken out of your paycheck so you get more money each month to handle the larger payments you're making.Many renters take the standard deduction on the federal tax forms because they don't have enough deductions to itemize. But the interest you pay on a mortgage generally is enough to allow you to itemize, which results in bigger tax savings.
When you buy a house, you also can a tax deduction for any "points" you paid the mortgage lender. Most lenders charge at least one point - each point being 1 percent of the loan amount - and you may pay three or four points, so this is a substantial deduction.
The tax accounting firm of Ernst & Young offers this advice on points in its 1991 tax guide:
"To get a deduction for points, make sure that the loan document clearly establishes that the points were not paid for any specific services that the lender performed . . .
"You should also write a check out of separate funds for the points. Do not have the points paid out of the mortgage proceeds or they may may become deductible only over the term of the loan."
Here are some other tax tips that relate to home ownership:
- According to Ernst & Young, points on a home mortgage and on some refinancings are among the 40 most easily overlooked deductions.
- Generally, points paid when you refinance a mortgage can only be deducted over the life of the loan, but a court ruling in 1990 made an exception to that rule. So in some cases, points on a refinancing may be fully deductible right away.
- The federal deduction for interest paid on credit cards and related debt is phased out entirely in 1991. Any interest you pay to VISA, Sears or MasterCard in 1991 is not deductible. But you can still deduct interest paid on a home equity loan.
- Income tax rates are changed for 1991 (this change relates to the money you earn in 1991 and the taxes you pay in 1992). In addition to the 15 percent and 28 percent brackets, there is a new rate of 31 percent that will apply to those with higher incomes ($82,150 of taxable income for married couples filing jointly.) Use these new brackets to figure out your home mortgage deductions.
- If you must pay capital gains on a real estate investment in 1991, the tax rate will be no more than 28 percent. The rate for some taxpayers in 1990 was as high as 33 percent.