Homeowner tax breaks not as great as you think

Bill Biscoff for MarketWatch writes:   Homeownership Tax Write-Offs. As far as the IRS is concerned, the cost of renting a personal residence is generally a nondeductible personal expense (an exception is when you use part of a rented home for business purposes, such as a deductible home office). In contrast, our beloved Internal Revenue Code allows you to write off some homeownership expenses as itemized deductions.

* You can generally write off the interest on up to $1 million of mortgage debt used to acquire or improve your first residence (and a second residence if you have one).

* You can also generally deduct the interest on up to $100,000 of home equity debt secured by your first (or second) residence.

* You can write off real estate property taxes on as many personal residences as you own.

This is all good, but there's more to the story.

The Standard Deduction Factor

If you've been claiming the standard deduction, buying a home may not generate all the extra write-offs you were expecting. That's because the standard deduction is a freebie. You don't need any deductible expenses to claim it. For 2013, the standard deduction amounts are:

* $12,200 for married joint-filing couples.

* $8,925 if you use head of household filing status.

* $6,100 for singles.

If your itemized write-offs for the year add up to less than the standard deduction, you simply forgo itemizing and claim the standard deduction. Most individuals find themselves in the standard deduction mode until they buy a home. Then they finally have enough itemized deductions (mainly due to mortgage interest and property taxes) to exceed the standard deduction. However, only the incremental amount of itemized write-offs (excess of total itemized deductions over the standard deduction) actually does you any tax-saving good. So how much in tax savings will you actually reap from homeownership? Here's an example on how to figure it out.

Example: Say you're married and will claim the joint-filer standard deduction amount of $12,200 (for 2013) if you don't buy a home. On the other hand, if you do buy, you'll claim itemized deductions for $15,000 of mortgage interest and $3,000 of property taxes. You might initially think that buying a home will simply lower your taxable income by $18,000. Not so fast! You may be forgetting about some other itemized deductions that you could also claim if you bought a home. Say you pay $5,000 of state income tax and donate $1,000 to charity. Since homeownership would put you in the itemizing mode, you could write off those amounts too. When all is said and done, your itemized write-offs would total $24,000 ($15,000 + $3,000 + $5,000 + $1,000).

So, if you're in the 25% federal income tax bracket, you might think buying a home would cut your IRS bill by a healthy $6,000 ($24,000 x 25%). Sorry, but that overstates the case. In fact, homeownership would only reduce your taxable income by $11,800. That's the difference between the $24,000 of itemized write-offs you could claim if you buy and the $12,200 standard deduction you could claim without buying. So your actual federal income tax savings would only be $2,950 ($11,800 x 25%). While that's a meaningful tax reduction, it's likely to be offset by the higher cost of homeownership. It's good to understand this up front.

Important Point: If you're already itemizing--or close--before buying a home, the additional write-offs from mortgage interest and property taxes will reduce your taxable income dollar for dollar or nearly so. In this scenario, you'll collect about the amount of tax savings you hoped for.

The Alternative Minimum Tax Factor

A further cause for concern is a provision that disallows any alternative minimum tax (AMT) deduction for home-equity loan interest unless the loan proceeds are used to acquire or improve your residence. Another provision disallows any AMT deduction for property taxes.

Example: Say you take out a $50,000 home-equity loan and use the money to pay off a car loan and some credit card balances. For regular tax purposes, you can generally deduct the home-equity loan interest, along with the interest on your first mortgage. But if you're in the AMT mode, you can't deduct any of the home-equity loan interest in calculating your AMT bill. On the other hand, if you spend your $50,000 of home-equity loan proceeds on a pool and landscaping, you can generally deduct the interest for both regular tax and AMT purposes.

To add insult to injury, you can't deduct your property taxes on your home for AMT purposes either.

The Bottom Line

Now you know some homeownership tax angles that your friendly neighborhood realtor may not have mentioned. Still, buying a home usually works out to be a pretty reasonable proposition tax-wise. And if you eventually sell for a nice gain down the road, the tax results can be excellent if you qualify for the principal residence gain exclusion break. It allows a married couple to avoid paying any federal income tax on up to $500,000 of home-sale profit. For unmarried individuals, the maximum tax-free profit is $250,000.