As you know by now, owning a home has many advantages—you can decorate it the way you want, and it provides stability for you and your family.

You also have one more substantial benefit to being a homeowner—your home becomes your own little tax shelter. From the moment you sign the documents and close on your home, it provides you with a number of income tax savings. It’s just a matter of knowing where to look for them.

For example, did you know that there was an $8,000 tax credit for first-time home buyers in 2009? If it’s not extended into 2010, don’t worry—there are more tax savings when you buy a home. Some of these apply to every homeowner, and some vary depending on your individual circumstances.

Of course, owning a home costs money—mortgages, taxes, maintenance, and upgrades—but there are financial advantages to owning versus renting. Unfortunately, your tax return may become a little more complicated, but you won’t mind once you see the savings and tax breaks you’ll get (if it gets too complicated, be sure to talk with a financial or tax professional for guidance). This chapter focuses on exactly what those tax breaks are and how you can take advantage of them.

When you purchase a home, you pay interest on the mortgage loan, just like you would pay interest on a personal or car loan. The difference is that you are permitted to deduct all of the interest that you pay on the first mortgage of any amount—up to a $1 million mortgage—on your income tax return. It’s not unusual for those in higher tax brackets to deliberately maintain a mortgage on their home so they can claim the interest paid on their taxes. Remember, though, this savings is a deduction from your taxable income, not a credit against your taxes.

Here’s how it works: you deduct the mortgage interest from your income. You are then taxed on what is left after any other deductions you may have. For example, if you are in the 15 percent income tax bracket and pay $13,000 in deductible interest on your mortgage, you’ll deduct that amount of interest from your income and have a tax savings of 15 percent of that, or $1,950. Not too shabby!

What’s just as good is that you don’t have to be in any particular tax bracket to be eligible for this tax deduction. Obviously, it is probably more valuable to you if you are in a higher tax bracket because you have more income to try to shelter from taxation, but the rule applies to every taxpaying homeowner who has a mortgage.

Points, discussed in Chapter 5, are a form of fee income that the lender can make on the mortgage loan at the time it is given to the homeowner. Each point is equal to 1 percent of the principal amount of the loan.

The amount you pay the lender in points is deductible on your income taxes. You can claim points on your tax return in two ways. You can either deduct the entire amount you paid for points in the year you paid for them, or you can deduct the amount over the life of the loan. The choice is yours, but there are limits to both choices as established by regulations published by the Internal Revenue Service. To be sure of which way is best for you, discuss this with your tax advisor.

To claim the entire deduction in the year the points were paid, you must meet the following criteria:

On the other hand, if you want to deduct the points over the life of the loan, you must conform to a different set of rules. You must meet the following criteria:

You’ll love this one! You actually save on taxes by paying your taxes! It may sound confusing when you first hear it, but it’s really quite simple. Your local or county government makes you pay taxes on any real property you own in its jurisdiction—known as property, real property, or real estate taxes. Each jurisdiction has its own method of calculating the tax and when it is due. For example, in California, real estate taxes are due twice a year, on April 10 and December 10, with each payment being half of your annual property tax bill. Once they are paid, you can deduct them from your federal income tax.

In some cases, the state where you live also allows you the same type of property tax deduction from any state income tax you pay. This varies from state to state, so your tax advisor can give you more detail on your exact savings. Some states, such as New Hampshire, have no income tax, so this doesn’t apply in those states.

Just as with mortgage interest, real estate taxes are a deduction on your taxes, not a credit. As a deduction, you get to deduct the amount you paid in property taxes from your gross taxable income. Again, this reduces the amount of income you pay taxes on. For example, if you are in the 28 percent tax bracket and pay $5,000 annually in real estate taxes, you have just reduced your federally taxable income by $5,000 and in doing so have saved 28 percent of that figure, or $1,400, in income taxes come April 15.

Separately, some of the citizen-based tax “revolts” of the late 1970s and 1980s have resulted in special real estate tax savings opportunities in certain states. A good example is a law passed in California that requires that property tax be assessed based on 1 percent of the purchase price, with additional local bond issues added in based on voter approval. Due to likely inflation increases, the law also allows minor adjustments in the tax obligation annually.

It makes no difference how long you’ve owned your home. The tax on your home cannot increase by any more than 1 percent of the tax amount you had assessed on purchasing it. Because of this, it’s fairly common for two homes that exist side-by-side to have dramatically different tax bills, based entirely on their respective dates of purchase.

Although California was the leader in this tax revolt, other states took a cue from this and restructured their laws. Massachusetts is one. In that state, the law was changed by Proposition 2½. Also, in the state of Washington, tax rates are limited to 1 percent of assessed value, while property tax levies are limited by Initiative-747.

Does the state where you live or are planning to buy have real estate tax savings? For example, in California, Proposition 90 is a law that allows a homeowner to take his tax basis to the next home where he lives. It’s a godsend to those nearing retirement who would be most disadvantaged by drastic increases in their property tax bills. However, it does have some limitations, including a once-in-a-lifetime use. The other major limitation to this privilege is that it is usable only if the county where you plan to buy your next home accepts it. In other words, if you move from one county to another and the new location is in a county that rejects this benefit, your tax on the new home will be based on its new purchase price. However, if the county you move to accepts this benefit, then your real estate tax on your new home will be based on your tax basis from your former home—very likely a huge savings for you.

As your accountant can tell you, your tax basis is the original amount you paid plus any expenses you have had in improving the property. Also, if you paid the commission to your Realtor, that is included. For example, if you paid $500,000 for a home five years ago and have since redone the kitchen at a cost of $25,000 and the master bath for $15,000, your basis is $540,000.

Check with the state tax authorities in the state where you are considering purchasing your next home. Additionally, ask your tax advisor.

In Chapter 5, you read how IRAs can be used to fund your down payment and that there are typically tax penalties for early withdrawals. Just as a reminder, you are exempt from these penalties if you use the money to purchase your home.

So far, everything sounds pretty simple, doesn’t it? Well, nothing is ever that simple! Things can get complicated when you refinance your home after having partially paid down the mortgage. Let’s say you take out a $200,000 mortgage when you buy your home. Fifteen years later, you’ve paid it down to $100,000. You decide to refinance and take out a larger loan at the same time so you can borrow cash for a vacation, your daughter’s college education, or your home improvement projects. As a result, you increase your debt to $225,000.

When you paid down the original loan, the remaining balance of $100,000 became your acquisition indebtedness amount when refinancing, which allows you to deduct interest on only $100,000 over that new amount of $100,000. Thus, having refinanced to a new total of $225,000, you are over the excess of $100,000 principal over purchase money debt allowed for interest deductions. All you’ll be able to do is deduct the interest on the first $200,000 of the refinanced loan, not the interest on the entire new principal. Put another way, the interest on the last $25,000 of your new principal will not be deductible.

The reason for the difference is that your original first and second mortgages were borrowed to purchase and physically improve your home. The refinance of the mortgage has the limitation cited because the Congress recognized that it may very well be used to pay for things other than the physical acquisition or improvement of the home.

This rule does have exceptions, however. If your refinance was done to remodel, that money is looked at as if it were spent on an acquisition of your personal residence; thus, the interest you pay for this loan will be fully deductible. However, you must be able to trace the funds you borrowed directly to the remodeling projects so you can claim these funds as acquisition money and receive the interest deduction. Again, if this sounds confusing, and it can be, consult with your tax advisor.

Although this book is about buying a home, a chapter on the tax advantages of home ownership wouldn’t be complete without mentioning the tax savings you may receive when you sell your home. In terms of federal income taxes, there are at least two of them.

The first of these is the capital gains exclusion rule. Under the federal tax code, if you sell your home, you may be able to exclude up to $500,000 in increased value from being subject to capital gains tax on the home if you meet certain conditions. You must have lived in the home at least two out of the previous five years, and it must have been your primary residence. It’s just that easy.

For example, let’s say that three years ago you bought your home for $125,000, and it is now worth $200,000. That’s a gain of $75,000. Without this rule, you’d expect to pay what’s called capital gains tax on that $75,000. Currently, the capital gains tax rate is 15 percent, so you’d have to fork over $11,250 to the federal government, along with whatever capital gains tax your state may require.

But under the capital gains exclusion rule, you may be able to exclude from taxation the first $500,000 of any gain. Thus, you would have no taxable capital gain at all. It’s as if the gain never existed! The $500,000 is for married couples only; if you’re single, your exclusion can max out at $250,000. Still, it’s a nice deal!

When you put money into your home for remodeling and upgrades, you often get that money back when you sell. Improving your home adds to the value of your home. For example, let’s say you bought a home five years ago for $200,000. Two years ago, you added a master bath ($20,000) and attached a small addition for a home office/studio ($45,000). The total cost of your work so far is $65,000. Therefore, your current basis of your home is $265,000, not $200,000. Any potential capital gain on the home has been reduced by that increased $65,000 in basis. Along with it, your tax liability has also been reduced. You’ve improved the value of your home.

Let’s say you buy your home for $600,000 and live in it for 12 years. Over that period of time, it increases in value to $1,200,000. That would be a hefty capital gain to pay taxes on, even at only 15 percent. But hold on a minute—part of that increase in value comes from the in-ground Olympic-sized swimming pool you added five years ago and the second-story master suite that was added seven years ago. The cost of those two items is $125,000 combined.

So now your basis has grown to $725,000 ($600,000 + $125,000). But now you have a gain of $475,000 to pay capital gains tax on. Not yet. Remember the $500,000 exclusion? When you deduct the $500,000 gain from the $475,000, you have suddenly wiped out any possible capital gains tax because you no longer have any taxable gain.

If you’re single, your exclusion would be $250,000, so you’d have a taxable gain of $225,000. In this case, you would have to pay capital gains tax, but only on that remaining $225,000, not on the whole increased value of $475,000. With capital gains rates of 15 percent, the difference in tax liability is $37,500 less than you’d otherwise have to pay. That’s still fairly impressive.

While your tax breaks are generally limited to what we’ve already discussed, one potential additional break is available in certain cases: the duplex. In this case, you, the owner, would live in one of the two units and lease out the second. This second unit becomes an investment property and comes with additional tax advantages.

One of these is depreciation, an accounting fiction by which the value of an asset—the second duplex unit, in this case—is reduced by a regular amount each year. This on-paper reduction in value helps create a paper loss for your investment for the year, and you can deduct that loss from your taxable income. Because of this, your income is lower and so are your taxes.

In addition to depreciation, you also deduct your maintenance and repair costs from the unit’s operating income. This further reduces your own income, and thus again lowers your income tax. Check with your tax advisor for details in each specific case.

As you can see, you have many possible ways to use your purchase to reduce the amount you will pay in income tax every year. This varies based on the specifics of income and mortgage, but you definitely gain valuable tax benefits from owning a home.