Reduce Taxes with Expense and Loss Deductions
An investment in knowledge pays the best interest.-Benjamin Franklin
Ben Franklin spoke the truth, especially if you own real estate. Knowing how to use expense and loss deductions properly can increase your after tax return. You can even start at home. This is convenient because the first significant real estate purchase most people make is their home. The second is a rental property. Fortunately, the Internal Revenue Code provides tax incentives to both homeowners and rental property investors. These tax benefits can enhance your return when the real estate market is good and may be your only return on investment when the real estate market is in a slump.
Here we focus on many of the expenses and deductions that make home and rental property ownership so enticing. However, if you are a real estate investor you will also need to carefully read the next chapter where we cover perhaps the most significant tax deduction – depreciation.
Principal Residence Expenses and Deductions
In this section we outline some the most commonly used expenses and deductions available to homeowners, including home mortgage interest, points and home office expenses. We also discuss the difference between making improvements and repairs to your home and what that means to your bottom line.
Deducting Mortgage Interest
One of the biggest reoccurring tax advantages of owning a home is the ability to reduce annual income taxes by deducting home mortgage interest payments. Generally, home mortgage interest is any interest you pay on a loan secured by your principal residence or a second home. Home mortgage interest can come from a home purchase mortgage, a second mortgage, a home equity loan, or a line of credit as long as it meets certain tests. Home mortgage interest specifically excludes interest paid on personal loans. Personal loans include automobile financing and credit cards.
Home Mortgage Interest v. Personal Loan Interest: The possibility of interest deductions, and lower interest rates, are why many advisors recommend paying off nondeductible interest on automobile loans and credit card debt with a home equity loan.
The initial tests you must pass in order to be able to deduct home mortgage interest are:
You must File Form 1040 and itemize deductions on Schedule A;
You must be legally liable for the loan; and
The mortgage must be a secured debt on a qualified home.
Form 1040 is the U.S. Individual Income Tax Return. Schedule A is for taxpayers who itemize their deductions, rather than take the standard deduction.
As the rule says, you must be legally liable for the loan. You cannot deduct interest payments you make for someone else (like a family member) unless you are legally liable to make them.
Family Loans: Interest paid to a family member through an intra-family loan is deductible as long as the loan arrangement reflects a true debtor-creditor relationship and the amount of interest paid can be definitely determined.
In addition, the loan must be a bona fide debt that is intended to be repaid and it must be secured by a qualified home in which the taxpayer has an interest.
A qualified home can be a house, cooperative apartment, condominium, mobile home, house boat or any other property that has basic living accommodations such as a sleeping space, a toilet, and cooking facilities. If you are building a home, you may treat it as a qualified home for up to 24 months provided it becomes a qualified home when it is ready to be occupied.
Next repayment of the loan must be secured by the qualified home. To be secured the taxpayer must have signed a legal document, typically a mortgage or deed of trust, that: (1) makes the home security for repayment on the loan; (2) provides that the taxpayer’s home could be used to pay-off the debt in the event of default; and (3) is recorded or otherwise perfected based on local and state law.
If these tests are satisfied, most people are able to deduct the full amount of all of their home interest payments. However, there are limitations. Your home mortgage interest deduction is limited to the total of the:
1. maximum allowable home acquisition debt;
2. maximum allowable home equity debt; and
3. grandfathered debt.
Home acquisition debt is a loan secured by a qualified home, taken out after October 13, 1987 and used to buy, build or substantially improve the qualified home. Only debt that does not exceed the cost of the home plus improvements can be home acquisition debt. The maximum home acquisition debt allowed (including your primary home and a second home) is $1 million ($500,000 if married and filing separately). This limit is reduced by grandfathered debt which we will explain, and is not necessarily a bad. Plus, if you have excess home acquisition debt you still may be able to deduct some or all of your interest payments if it qualifies as home equity debt.
Home equity debt is a loan taken out after October 13, 1987 that: (1) does not qualify as home acquisition debt or as grandfathered debt; and (2) is secured by your qualified home. Excess home acquisition debt and loans used for purposes other than buying, building, or substantially improving a home may qualify as home equity debt. Home equity debt (on your primary home and second home) is limited to the smaller of $100,000 ($50,000 if married and filing separately) and the total of each home’s fair market value minus home acquisition and grandfathered debt.
Finally, grandfathered debt is debt on your home taken out before October 14, 1987. It also includes refinancing of those loans to the extent the refinanced debt does not exceed the principal balance on the original debt. To the extent it does exceed the principal balance it could still be home acquisition or home equity debt. Grandfathered debt is not limited. All interest you pay on grandfathered debt is fully deductible home mortgage interest. However, grandfathered debt reduces your $1 million home acquisition debt and potentially the limit for your home equity debt.
What do you do if your mortgage is above the limits? You may consider selling or cashing out some of your other investments to pay down your home mortgage so that you meet the qualified mortgage limitations.
Deducting Mortgage Points
Another potentially valuable deduction is the points paid in obtaining a home mortgage. The term “points” is used describe certain fees paid by a borrower. Points can also be known as loan origination fees, loan discount points or just discount points. Points are usually expressed as a percentage of the loan. For example, 2 points means 2 percent of the loan balance. Generally, you cannot deduct the full amount of points in the year paid. Points are typically considered prepaid interest and therefore deducted over the term of the loan. However, there is an exception. Those who buy or build their primary home and meet the following tests can fully deduct the points in the year paid.
1. The loan is secured by your main home.
2. Paying points is an established business practice in the area where the loan was made.
3. The points paid were not more than points generally charged in the area where the loan was made.
4. The points paid were not paid in place of amounts that ordinarily are stated separately on the settlement statement, such as appraisal and inspection fees.
5. The funds you provide (other than those borrowed from the lender or mortgage broker), plus any points the seller paid must be at least as much as the points charged.
6. The loan is used to buy or build your main home.
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.
Points paid on home improvement loans for your main home can also be fully deducted in the year paid, if tests 1-5 are met. However, points paid on loans secured by a second home cannot be fully deducted in the year paid. Points for second homes must be amortized over the life of the loan. Similarly, points paid to refinance a mortgage must usually be amortized over the life of the loan. However, if test 1-5 are met and part of the refinance proceeds are used for improvements to your main home, then you may be able to fully deduct the portion of the points related to the improvement in the year paid.
If you do not qualify to or do not choose to deduct the points in the year paid, then you can deduct them equally over the life of the loan provided you meet all of the following tests:
1. The loan is secured by a home.
2. The loan period is not longer than 30 years.
3. If the loan period is longer than 10 years, the terms of your loan are the same as other loans offered in your area for the same or longer period.
4. Either the loan amount is $250,000 or less or the number of points is not more than 4 for loan periods of 15 years or less or 6 for loan periods of more than 15 years.
Note that points paid by the seller in connection with the buyer’s home mortgage loan are considered points paid by the buyer. In addition, the buyer’s basis in the home is reduced by the amount of the points paid by the seller.
Deducting Home Office Expenses
The Internet and computers have enabled a work-at-home work force. However, just because you check your email after dinner does not mean you can (or should) start deducting expenses associated with the business use of part of your home.
Watch Out! Claiming a home office deduction is a common trigger for an IRS audit. If you plan to claim a deduction for business use of your home be sure you meet the strict requirements.
The IRS starts from the premise that homeowners cannot deduct expenses such a mortgage interest and real estate taxes as business expenses. However, if you can meet certain strict tests you may be able to qualify for certain exceptions and deduct some expenses related to the business use of part of your home. To qualify to deduct expenses for the business use of your home, you must use part of your home:
regularly and exclusively as your principal place of business; or
regularly and exclusively as a place to meet or deal with your patients, clients, or customers in the normal course of your trade or business, or
in the case of a separate structure not attached to your home, in connection with your business;
on a regular basis for certain storage use; or
for rental use; or
as a daycare facility.
If you are an employee you must also meet the following two requirements: (1) your business use must be for the convenience of your employer (just helpful is not enough); and (2) you must not rent any part or your home to your employer and use the rented potion to perform services as an employee for that employer.
These rules are not as easy to follow as they sound. To qualify for exclusive use you must use a specific area of your home only for your trade or business. You do not meet this test if you use the area for both business and personal purposes. For example, a consultant using his spare bedroom to check emails and write reports does not cut it if the bedroom is also frequently used by visiting guests and family. The consultant cannot claim a deduction for the business use of the spare bedroom because it is not used exclusively for his consultancy work.
To meet the regular use test, the taxpayer must use the specific area for business on a regular basis. Incidental or occasional use is not regular use. Checking email is unlikely regular use.
Also, remember that this deduction is limited to trade or business use. Reading financial reports and conducting online research for your investment portfolio is likely a profit-seeking activity but not a trade or business.
If you are claiming that you use part of your home as a principal place of business then you must show you use your home office or work area:
exclusively and regularly for administrative or management activities of your trade or business; and
have no other fixed location where you conduct substantial administrative or management activities of your trade or business.
It may be easier to show that you use an area of your home exclusively to meet with patients, clients or customers in the normal course of your business. For example, a self-employed consultant working 3 days a week in her city office and 2 days a week in her home office may qualify if she regularly meets with clients at her home office.
If you do use part of your home regularly and exclusively for a trade or business, you can be eligible to take some valuable deductions. First, you will need to divide qualifying homes expense between personal use and business use. This division can be based on area or time-usage or any other reasonable method. Expenses that may be divided include: real estate taxes, deductible mortgage interest, utilities and services, insurance, and repairs. In addition to these expenses, you may depreciate the part of your home used for business as nonresidential real property using the straight-line method over 39 years.
Principal Residence Exclusion: If you sell your home, gain on the part of your house used for business and depreciated will not be covered by the principal residence exclusion and could result in taxable gain and depreciation recapture.
Attributing part of your home mortgage interest, property taxes and other home expenses to business expenses may be particularly beneficial for those with higher incomes who cannot claim itemized deductions on Schedule A. Remember from the discussion of mortgage interest and points that in order to claim the deduction you must file Form 1040 and itemize deductions on Schedule A. The home office deduction allows you to deduct a portion of the mortgage interest, property taxes and other home expenses on a separate business schedule.
Home Improvements and Repairs
Even though home repairs are necessary, they are not beneficial from a tax standpoint. Home repairs are considered personal expenses; they are not deductible and cannot be added to the home’s basis. An improvement, however, adds to the value of the home and its basis. Therefore, it is best to make improvements, not repairs, to your home. The opposite is true for rental properties, which are discussed below.
How does an improvement differ from a repair? An improvement adds to the value of your home, prolongs its useful life, or adapts it to new uses. Repairs, on the other hand, maintain your home in good condition. For example, putting up a new roof is an improvement whereas replacing a few damaged shingles is a repair.
Improvements can be big and small. Adding a room to your house is an obvious improvement. However, built-in appliances and fixtures can also be considered improvements. Other improvements include constructing built-in bookcases and adding new light fixtures. Landscaping, such as planting trees and shrubs, may also qualify as an improvement.
Rental Property Expenses and Deductions
As we mentioned at the beginning of this blog the Code also provides some great tax advantages to rental property investors. One primary goal of most rental property investors is to create rent income. Generally rent income is included in your gross income. Rental income includes the actual rent payments plus: (1) any expenses of the investor paid by a tenant; (2) the fair market value of services provided in lieu or rent; (3) payments by tenant for cancelling a lease; and (4) payments by tenant for an option to purchase the property. One of the few times rent is not included in income is when you rent property that you also use as your home or second home and you rent it for 14 days of less during the year. In this situation you are also, however, not permitted to deduct rental expenses.
In this section we discuss expenses and deductions that can reduce taxable rental income. Most of the ordinary and necessary expenses of renting a property can be deducted from its rental income. Generally, rental expenses are deducted in the year you pay them. And they can be deducted even if the property is vacant as long as it is held out for rent.
Repairs and Improvements
Rental properties require maintenance. Sometimes this means repairing broken windows or fixing leaks. Sometimes it means improving the property by installing a new water heater or modernizing the kitchen. Whether you make a repair or an improvement impacts how much you can deduct. Repairs are preferred with rental properties because the entire expense is deductable in the year it is paid. Improvements, on the other hand, are considered capital assets and must be depreciated over time.
Repairs differ from improvements in that repairs keep the property in good operating condition but do not materially add to the value of the property or substantially extend the life of the property. If a repair is part of an extensive remodeling or restoration of the property, then it must be included in the whole job and treated as an improvement instead of a repair. Here are a few things to keep in mind to maximize your deductions for repairs:
Schedule and track repairs and improvements separately;
Use comparable materials when making repairs since using better materials may seem more like an improvement;
Limit repairs to damaged areas only; and
Make repairs following a triggering event, such as a broken water pipe.
Also, be sure to keep accurate records. For improvements, you will need to know the cost of improvements when you sell or depreciate your rental property.
There are many other expenses that can be deducted from rental income as well as the cost of repairs. Some of these expenses include: advertising, cleaning and maintenance, utilities, insurance, taxes, mortgage interest, points, commissions, tax return preparation fees, certain travel and transportation expenses, and rental payments for equipment or leasehold interests.
If you rent a condominium or cooperative apartment, you may also deduct dues or assessments for care of the common areas as long as the funds are used for maintenance and not improvements or capital assets.
If you rent part of your property and use another part for personal use, then you must divide certain expenses between the two parts as though they were separate properties. For example, painting the exterior of a home would normally be a non-deductible personal expense but if you rent a room in the home you may use a reasonable method of dividing the expense and deduct a part of the cost as a rental expense. You do not have to divide expenses that belong only to the rental part of the property. For example, the entire cost of painting a room that you rent is a rental expense.
Similarly if you have a vacation home that you rent, you must divide your expenses between rental use and personal use. If you used your vacation home as a home you cannot deduct rental expenses that are more than your rental income for the property. Whether the IRS will consider the property used as a home is discussed in detail in Chapter 4. If the property is not used as a home, you can deduct rental expenses that are more than your rental income, subject to certain limitations we discuss in the next chapter.
The Internal Revenue Code provides strategies to save taxes for homeowners and rental property investors. Homeowners can deduct qualifying home mortgage interest on their principal home and a second home. The deductable mortgage interest must be related to acquisition indebtedness and is limited to $1,000,000 of debt ($500,000 for a married individual filing separate tax returns).
Interest paid on qualifying home equity loans can also be deducted up to a limit of the lesser of $100,000 ($50,000 for a married person filing separate tax returns) and the difference between the fair market value of the property and the total acquisition debt
Points paid to obtain a home mortgage loan on a primary home may also be deductable.
Homeowners can also deduct qualifying business expenses associated with the business use of part of their home. But use caution here. Home office deductions have been known to trigger IRS audits and the requirements to take this deduction are strict. To qualify, part of your home must be used exclusively and regularly as your principal place of business or to meet with clients, patients, or customers.
If you are an employee (as opposed to self-employed) your use must be necessary for the employer’s business. A potential down side can result when you sell your home because gain from the part of your home depreciated for business use could be taxable.
Rental property owners also have big opportunities to reduce taxable income.
Make repairs rather than improvements when possible. Repairs are deducted in the year made while improvements must be depreciated over many years. To keep repair work separate from improvement work keep good records and even have them done at different times and by different contractors if possible.
A few more notes from this blog:
Interest from personal debt like credit cards and automobile loans is not deductable. Consider refinancing such debt into a home equity loan.
Unlike a rental property, repairs to a principal residence are personal expenses and not deductable but improvements are added to your basis and can therefore help your tax position when you sell.
Maximize your rental deductions for repairs (as opposed to improvements which are capitalized) by scheduling and tracking repairs and improvements separately. And remember always keep good records.
The deductions in this chapter can be valuable however you will need to read the next chapter to learn about the ultimate rental property deduction – depreciation. In the next chapter we also outline the passive activity loss limitations which apply when your rental expenses exceed your rental income.
Don't forget this is general information only and is not legal or tax advise. Laws, especially the tax code, are subject to change. For specific advice talk with your lawyer and/or CPA.