6 Home Tax Deduction Traps to Avoid: Do You Know What They Are?
The tax benefits of owning a home abound—but with all of these rewards come great risks. Even the smartest of homeowners can have the best of intentions when itemizing real-estate-related deductions … only to end up in a pickle when they deduct the wrong things, or the right things for the wrong amount. To make sure you don’t end up with errors that can trigger headaches down the road, keep your eye peeled for these common home tax deduction traps and steer clear.
Trap No. 1: Deducting energy-efficient appliances that don’t qualify
Tax credits are available for installing certain energy-efficient systems in your home: up to $500 for items like biomass stoves, central AC units, roofs, and insulation, and a credit for 30% of the cost of installing energy-generating systems like solar panels, geothermal heat pumps, and wind turbines. But the regulations for what systems qualify are strict and can change year to year, warns Patrick O’Connor of O’Connor & Associates.
Some taxpayers think if they buy a stove with an Energy Star label, they can deduct the cost of the stove, but it doesn’t quite work that way.
“If you’re not sure whether you qualify for a credit, talk to the vendor,” says O’Connor. “The rules are complicated.”
Another trap people fall into is not realizing that some of these credits have a lifetime—not annual—cap of $500, and can’t be used for new construction or second homes. The IRS regulations and deduction instructions can be found on Form 5695.
Trap No. 2: Deducting PMI above the income limit
Private mortgage insurance, or PMI, is the extra fee you pay if you did not put 20% down on your home. It’s tax-deductible only if you make an adjusted gross income of under $100,000 a year. If your AGI is between $100,000 and $109,000, you can deduct some of your PMI; if it reaches $110,000, it’s not deductible at all.
This deduction is not insignificant, according to O’Connor. It usually runs $50 a month for every $100,000 of loan amount, so it’s worth taking if you qualify.
Just make sure you don’t make too much in yearly salary. Interesting problem to have, eh?
Trap No. 3: Bungling the home office deduction
As more people work from home, the home office tax deduction has become more common, and was recently simplified to be a straight deduction of $5 a square foot up to 300 square feet. Furthermore, experts say it’s no longer a red flag for an audit! Still, the rules are strict about what qualifies. It has to be a space that is only used for an office, and it must be your primary place of business, not a secondary office you use sometimes.
“You have to wonder how many people can set aside a part of their house to be only used as a home office,” says O’Connor. “If you’re going to be uncomfortable, don’t claim it and sleep better at night.”
It maxes out at $1,500, so it’s not an enormous deduction anyway.
Trap No. 4: Deducting the wrong amount of property tax
If your lender pays your property taxes from an escrow account you put money into every month, you might assume you can simply deduct that total amount from your taxable income. Don’t! The amount in your account is just a ballpark, and it may be a bit higher or lower than your actual property taxes.
For example, while your tax bill might be $1,600, your lender may have collected $1,700 or $1,400 in escrow over the year. Your lender will adjust for the discrepancy later.
So what’s the right way to deduct property taxes? Check the 1098 Form your bank should have sent you. In addition to the amount of interest you paid this year (which you should be deducting, by the way!), it will tell you exactly how much you’ve paid in property tax.
Trap No. 5. Deducting too much interest on a HELOC or home equity loan
If you take out a HELOC or home equity loan, the amount of deductible interest depends on what you use the loan for.
“It’s kind of counterintuitive,” says O’Connor. If you use your loan money for a vacation, college funds, or anything other than a home improvement, the interest is deductible on only up to $100,000 of principal. So if you took out $250,000 to send your kid to Harvard, deduct the interest from only the first $100,000. However, if you’re using the loan to renovate your home with a new roof or half-bath, the interest is deductible up to $500,000 for a single person or $1 million for a married couple.
Trap No. 6: Deducting the wrong amount for mortgage points
If you have a new loan or a newly refinanced loan, you can usually deduct any points you paid to lower your interest rate. To qualify as a deduction, points must be: a) paid by the buyer, not the lender, and b) calculated as a percentage of the mortgage and appear on the closing sheet as points. Also, while you can deduct all of the points you paid on a new loan, a refinance works differently.
“It’s not nearly as beneficial,” says O’Connor, because you have to spread the deduction out over the life of the loan. For example, if you paid $3,000 in points on a 15-year refinance, instead of deducting the entire amount, you would deduct $200 a year for 15 years. If you sell the house before your loan is paid, you can deduct what you’ve paid so far, but no more.