Tax Benefits Of Home Ownership Explained

Most of us know that owning a home provides some tax benefits, but those benefits are often difficult to quantify. In this article, we venture to explain the two most significant tax benefits to owning a home – the mortgage interest deduction and capital gains exemption for principal residences.

Mortgage Interest Deduction

One of the primary tax benefits of owning a home is the mortgage interest deduction. This allows homeowners to reduce their taxable income by the amount of interest that is paid on a loan secured by the homeowner’s principal residence.

For example, if your taxable income for the year is $100,000.00 and you paid $15,000.00 in mortgage interest on your principal residence during the year, then you will only be taxed on $85,000.00. In California, your marginal tax rate at that income level is approximately 37%, meaning the deduction saved you over $5,500 in taxes (37% of $15,000, which would have otherwise been paid to the tax man).  Of course, the flip side is that you still paid a net of about $9,500 in interest – the question then becomes whether that expense over the lifetime of the loan is more or less than what you would have paid in rent.

The mortgage interest deduction is especially important for those who are lucky enough to earn income sufficient to quality for the Alternative Minimum Tax, or AMT. While the AMT phases out many of the itemized deductions that taxpayers are permitted to take, the mortgage interest deduction is one of the few deductions that is not phased out by the AMT, and as a result it is an extremely important deduction for “high income earners”.

Capital Gains Exemption For Principal Residence

Another significant tax benefit of home ownership is exemption from capital gains tax. Ordinarily, long-term capital gains are subject to a tax of up to 20%. However, individuals can claim an exemption of up to $250,000.00 for capital gains earned in connection with the sale of a principal residence. The exemption is doubled to $500,000 for married couples. In order to qualify for the exemption, the homeowner must have lived in the home for 2 out of the 5 years preceding the sale of the property. There is no limit to how many times the capital gains exemption can be used during one’s lifetime.

For example, if a married couple purchased a home in 2008 for $750,000 (they were smart enough to buy when prices were low), lived in it through the end of 2014, rented it out during 2015, and then sold it today for $1,250,000, they would be completely exempt from paying tax on the $500,000 profit. They can then turn around and buy another home, and in two years again sell the new home without paying any tax on the appreciation.

The added benefit of this exemption is that the tax-exempt earnings can be used for anything. Unlike many other tax exemptions, such as a 1031 exchange, the funds do not need to be re-invested into a “like-kind” new property or used to purchase a new home.

Other Benefits Of Home Ownership

The above tax benefits are tangential to the primary benefits of home ownership, which are not necessarily tax related. First, home ownership provides a level of autonomy that renting cannot provide. You own the home you buy, and you can modify it as you see fit, subject to government regulations. Second, it provides for a “forced savings” plan in that a portion of the monthly mortgage payment goes directly to paying down the loan balance and building equity in the property, and barring an economic crisis those funds can be accessed either through a home equity line of credit or sale of the property. Third, historically speaking, investing in real estate has almost always been a safe bet, and you are able to capitalize on the appreciation in value of the home.

In the end, deciding whether to purchase or rent is a highly personal decision. Financial incentives aside, some people prefer to rent in order to avoid the responsibility of maintaining a home and being obligated to pay a mortgage. On the other hand, some people despise the idea of paying someone else’s mortgage via their rental payments, and prefer to pay down a loan on a property that they own. While the above tax and non-tax factors should certainly be considered in the decision, the primary deciding factor should be the buyer’s personal sense of whether owning a home makes sense for them or not.

*Disclaimer – If you are looking for tax, legal, or accounting advice, please consult with your accountant and/or tax attorney. The above material has been prepared for informational purposes only, and is not intended to be tax, legal, or accounting advice.

If you would like to further discuss how Esquire Real Estate Brokerage, Inc. can help you in the Los Angeles real estate market, feel free to give us a call at 213-973-9439 or send us an email at info@esquirereb.com