Death & Taxes

Taxes and Your New Home

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By Roy Lewis
September 6, 2002

In this article we're going to talk about the tax issues associated with buying a home. (Please also see The Motley Fool's Home Center area for more help with the non-tax aspects of home buying.) We're talking about the purchase of your principal or primary residence here, the property where you live and hang the "Home Sweet Home" sign over the front door.

We're not talking about rental properties, investment properties, vacation home properties, second homes, or anything else. While the basic concepts may be similar for all properties, they are not exactly the same. So, if your purchase is something other than your principal residence, use this article for some basic background and then do the appropriate research to find out how your specific purchase will be affected.

When you begin your home purchase, you'll be dealing with a third party to help you close the deal. Depending on where you live, this third party could be an attorney, an escrow company, a title company, or some other person or company. This third party is charged with making sure that the property's title is properly transferred to you, that your loan is in place, and that all of the costs and expenses associated with the purchase are properly allocated.

You'll be charged various fees to purchase your property, such as closing fees, title fees, transfer fees, transfer taxes, homeowner association fees/assessments, etc. You might even be charged prorated interest, property taxes, and loan "points."

Generally, with the exception of the prorated interest on the loan, property taxes, and points (which we'll discuss in a few moments), the other expenses you are assessed to purchase the property are not deductible anywhere on your tax return.

They really represent expenses required to purchase your property, so they are treated as an additional cost of the property (an addition to the tax basis of the property, if you will). Think of these expenses as you would broker commissions that you pay when you purchase stock. Those broker commissions are also not deductible, but attach themselves to the cost of the stock. Your closing costs work exactly the same way -- not currently deductible, but they increase the tax cost (or basis) of the property.

So, the only way you'll receive any tax benefit for these charges is to sell the property. When you sell, you'll use these purchase costs as an addition to your tax basis, and compute your gain or loss on the difference between your net sales price and your cost basis (plus any improvements you've made to the property).

As you are likely aware, the new rules regarding the exclusion of the gain on the sale of a principal residence for qualified taxpayers might mean that you'll not receive any tax benefit for these costs. But I'm sure that you'll gladly trade off the tax-free gain treatment on your subsequent sale against these closing costs. (If you are unsure how the gain exclusion rules actually work, see my multi-part discussion of this issue entitled "Home Sale Exclusions" -- Part I, Part II, and Part III.)

Qualified first-time homebuyers can use IRA funds to pay the required closing costs for a recent purchase -- and those IRA funds can be removed without penalty (but not without tax). For a detailed discussion of this, please see my article entitled "IRA Withdrawal for Homebuyers."

So, you've now determined that your closing costs are not deductible, but what about the other items we mentioned -- prorated property taxes, interest, and loan points? Well, the news gets a little bit better regarding those expenses.

Prorated property taxes
When you purchase your property, you'll very likely get hit with some prorated property taxes. Why? Because, for federal income tax purposes, the seller is treated as paying the property taxes up to the date of sale. You (the buyer) are treated as paying the taxes beginning with the date of sale. This applies regardless of the lien dates under local or county law.

Generally, this information is included on the settlement statement you get at closing. You and the seller each are considered to have paid your own share of the taxes, even if one or the other paid the entire amount. You can each deduct your own share as a Schedule A itemized deduction, assuming you itemize, in the year the property is purchased.

But if part of your deal has to do with delinquent taxes, beware. Delinquent taxes are unpaid taxes that were imposed on the seller for an earlier tax year. If you agree to pay delinquent taxes when you buy your home, you cannot deduct them. Instead, those delinquent taxes are treated as part of the cost of your home, just like the other non-deductible closing costs discussed earlier.

Prorated mortgage interest
It's very likely that you'll get hit with a few dollars of interest for your new home loan on your closing statement. Assuming that you are able to deduct your mortgage interest (under the home mortgage interest rules), you'll be able to also deduct this interest as an itemized deduction on your Schedule A.

Generally, this interest (along with all of the other interest that you paid on your home mortgage) will be reported to you at the end of the year (via Form 1098) by your mortgage holder, but make sure that these interest payments are actually included in your year-end report from your lender. Many times, your mortgage loan will be sold or transferred to another mortgage lender soon after your closing, and sometimes these interim interest expenses get lost in the shuffle. So, it's your responsibility to determine if these prorated interest charges are reported to you properly.

The rules regarding deductible home mortgage interest are really pretty easy to understand, but a bit outside the scope of this article. To read more about deductible mortgage interest on your new principal residence, check out IRS Publication 936 at the IRS website.

Loan points
The term "points" is used to describe certain charges paid, or treated as paid, by you to obtain a home mortgage. Points may also be called "loan origination fees," "maximum loan charges," "loan discount," or "discount points."

The general rule is that you can't deduct the full amount of points in the year that they are paid, because they are nothing more than prepaid interest. Accordingly, you are required to deduct (or amortize) them over the life of the mortgage. But don't panic.. As with most tax issues, the general rule is only the starting point, and you'll want to learn more about the exceptions. So, here they come:

You can fully deduct points in the year paid if you meet all of the following tests:

  1. The loan is secured by your principal residence.
  2. Paying points is an established business practice in the area where the loan was made.
  3. The points paid were not more than the points generally charged in that area.
  4. You use the cash method of accounting. (This means you report income in the year you receive it and deduct expenses in the year you pay them. Most individuals use this method.)
  5. The points were not paid in place of amounts that ordinarily are stated separately on the settlement statement, such as appraisal fees, inspection fees, title fees, attorney fees, and property taxes.
  6. You use your loan to buy or build your principal residence.
  7. The points were computed as a percentage of the principal amount of the mortgage.
  8. The amount is clearly shown on the settlement statement (for example, Form HUD-1) as points charged for the mortgage. The points may be shown as paid from either your funds or the seller's funds.
  9. The funds you provided at or before closing, plus any points the seller paid, were at least as much as the points charged. The funds you provided do not have to have been applied to the points. They can include a down payment, an escrow deposit, earnest money, and other funds you paid at or before closing for any purpose. You cannot have borrowed these funds from your lender or mortgage broker.

If you meet all of the above criteria, you'll find that your points are deductible in full in the year of closing, and you can use them as an itemized deduction on your Schedule A.

Points, especially points paid by the seller in the transaction, can get tricky. So you'll want to read more about them in IRS Publication 936.

There you have it -- the basic tax issues involved with buying your principal residence. But these are not all of the issues involved, by any means. If you are buying a home, you'll want to read more about the related tax issues in IRS Publication 530.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.

This forum and the information provided here should not be relied on as a substitute for independent research to original sources of authority. The Motley Fool does not render legal, accounting, tax, or other professional advice. If legal, tax, or other expert assistance is required, the services of a competent professional should be sought. In other words, if you get audited, don't blame us.