Know the tax rules when buying, selling, or refinancing your home

Owning a home in Massachusetts provides a lot of tax advantages. Sometimes, though, the rules can be tricky.

Here’s a brief introduction to some of the many tax rules involved in buying, selling, or refinancing a home. But remember, the rules are complicated, and there are always exceptions. You’ll want to consult a Massachusetts real estate attorney or tax advisor to see how the general rules apply to your specific situation.

  • If I own a home, can I deduct my mortgage interest payments?

Yes, home mortgage interest is generally deductible on your federal income tax return on loan amounts up to $1 million. To get the deduction, you’ll need to itemize your deductions on Schedule A. For most people, this is the primary tax advantage of owning a home.

Your lender will typically send you a notice at the end of the year telling you how much of your payments were for interest as opposed to principal.

  • Can I deduct my property taxes?

Yes, in most cases you can deduct your local property taxes on your federal income tax return – again, if you itemize deductions.

Homeowners often pay some money each month as part of their mortgage payment that goes into an escrow account, which the lender then uses to pay property taxes. Note that the amount you can deduct is the amount that’s actually paid in taxes – not the amount you pay into this account, which might be slightly different.

Some types of property taxes – such as special one-time assessments for sidewalks or sewer lines – might not be deductible. Also, condo fees and homeowners’ association fees are not deductible.

  • When I buy a home, can I deduct my closing costs?

There are a number of different types of closing costs, some of which are deductible and some of which are not. For instance, you can generally deduct “points” you pay on a mortgage on your primary residence. Interestingly, you can usually deduct points even if the seller pays them for you – a nice arrangement for a buyer!

On the other hand, there’s typically no deduction for other types of closing costs such as appraisals, title insurance, recording fees, or private mortgage insurance.

You might be entitled to a deduction if you pre-pay mortgage interest or a pro-rated amount of property taxes at closing. Buyers who close in the middle of a month often pay these amounts through the end of the current month.

  • If I take out a home equity loan, can I deduct the interest?

It depends on what you use the money for.

If you use the money for a car, a vacation, college tuition, etc., then you can deduct your interest on loan amounts up to $100,000. If you borrow more than $100,000, the interest on the excess is not deductible.

However, if you use the money to make improvements on your home, then the money is treated for tax purposes as though it’s part of your home mortgage … so you can deduct all the interest, along with your mortgage interest, as long as the total amount you’ve borrowed doesn’t exceed $1 million plus $100,000.

There are a few exceptions, however. One is that if you’re subject to the alternative minimum tax, then home equity interest can’t be deducted when calculating the AMT. Another is that if you’re married and you file separately, the relevant amounts are $500,000 and $50,000, not $1 million and $100,000.

Also, if you don’t use your home equity loan to improve your home, and at some point you become “upside-down” such that you owe more on your home than its fair market value, then you can no longer deduct interest on the part of the home equity loan that causes your total indebtedness to exceed the value of the home.

  • What happens if I refinance?

If you refinance, and the amount of your new mortgage is equal to (or less than) the amount you owe on your old mortgage, then the new mortgage is treated the same as the old mortgage – meaning that, generally, the interest is deductible on loan amounts up to $1 million.

If you do a “cash-out” refinancing and you borrow more than you owe on your existing mortgage, then the excess amount is treated the same as a home equity loan.

This is a tax issue that sometimes trips people up. Many people think they can refinance and simply deduct all the interest on the new loan. But if you “cash out” more than $100,000 and you don’t use the excess for home improvement, then interest on the excess is not deductible.

Another issue arises if you pay points at refinancing. While points can usually be deducted immediately if you pay them when you first buy a home, the same is not true if you pay points when refinancing. Generally, you have to deduct them over time. So for instance, if you pay $4,000 in points on a 10-year refinancing loan, you can deduct $400/year for each of the next 10 years.

However, there’s an exception if part of the loan is used for home improvement. Suppose you do a cash-out refinancing and you use 15% of the loan proceeds for roof repairs. In that case, you could deduct 15% of the points right away, and deduct the remaining 85% over the life of the loan.

(By the way, if you buy a home that’s not your principal residence – such as a vacation home – and you pay points at closing, you generally have to deduct those points over the life of the loan as well.)

  • Do I have to pay taxes when I sell my home?

In theory, if you sell your home for more than you paid for it, you have a capital gain, and you have to pay capital gains tax.

However, in most cases, you don’t have to pay taxes on the first $500,000 of capital gain on a home (or $250,000 if you’re married and filing separately).

To get this special treatment, you have to have owned the home and lived in it as your primary residence for two years out of the last five years prior to the sale.

Even if you didn’t own and live in the home for two full years, you might still be able to exclude some or all of your capital gain; you just won’t be eligible for the full $500,000 exception.