Whenever Washington creates a new bill that becomes law, we need to take some time to interpret what are the benefits of that new law. The National Association of REALTORS® has put together a useful summary to help you understand how the new law affects homeowners..
Here are some excerpts directly from that summary about a few of the major provisions affecting current and prospective homeowners.
Exclusion of Gain on Sale of a Principal Residence
“The final bill retains current law – a significant victory that NAR achieved.” This is great! If you have a capital gain (ie equity) when you sell your home, you can qualify to exclude up to $250,000 of that gain from that year’s income, or up to $500,000 of that gain if you file a joint return with a spouse. You of course have to wait at least 5 years after you’ve bought a property to sell it.
To quote from irs.gov “In general, to qualify for the Section 121 exclusion, you must meet both the ownership test and the use test. You’re eligible for the exclusion if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its date of sale. You can meet the ownership and use tests during different 2-year periods. However, you must meet both tests during the 5-year period ending on the date of the sale.”
Mortgage Interest Deduction
The final bill reduces the limit on deductible mortgage debt to $750,000 for new loans taken out after December 14, 2017. Current loans of up to $1 million are grandfathered and are not subject to the new $750,000 cap. Neither limit is indexed for inflation. So in essence, if you need a mortgage to purchase a home after Dec.14, 2017 you will be able to deduct the interest paid on that mortgage from your stated income.
The final bill repeals the deduction for interest paid on home equity debt through December 31, 2025. Interest is still deductible on home equity loans (second mortgages) if the proceeds are used to substantially improve the residence.
Interest remains deductible on second homes, but subject to the $1 million/$750,000 limits.
So, if your mortgage is under $750,000, you are still able to deduct the interest you paid in a tax year from your tax bill. Let’s say you make $100,000. per year and you purchase a home and make a mortgage payment every month (in the beginning years of a mortgage loan, you are mostly paying interest to the bank or to the lender). If that interest added up to $8,000 you could deduct that $8,000 from your stated income, making it $92,000. You will of course add other deductions to further lessen the stated income, but for our purposes we are focusing on the benefits of home ownership.
Here are some examples from the National Association of Realtors® (NAR) website (https://www.nar.realtor). While the mortgage interest can still be deducted, the overall benefits of home ownership appear to be less attractive, according to NAR.
Example 1 – First-Time Homebuyer. To illustrate how the changes to the standard deduction, repeal of personal exemptions, mortgage interest and state and local taxes might affect a first-time homebuyer, consider the example of Barbara Buyer. Barbara, an accountant making $58,000 per year, is single and currently rents an apartment. She also pays state income tax of $2,900 and makes charitable contributions of $2,088, but the total of these is lower than the standard deduction, so she claims the standard.
Barbara’s tax liability for 2018 under the prior law is as follows:
Salary income | $58,000 |
Standard deduction | ($ 6,500) |
Personal exemption | ($ 4,150) |
Taxable income | $47,350 |
Tax | $ 7,491 |
Under the new law, Barbara would get a tax cut, computed as follows:
Salary income | $58,000 |
Standard deduction | ($12,000) |
Personal exemption | ($ – 0 -) |
Taxable income | $46,000 |
Tax | $ 6,060 |
Tax Difference Under New Law. Even though Barbara would not get the benefit of the personal exemption under the new law, her higher standard deduction would more than make up for the loss. In addition, the lower tax rates of the new law would help deliver the total tax cut of $1,431 ($7,491 – $6,060) as compared with the prior law.
However, let’s take a look at what happens to Barbara if she were to purchase the condo that she likes costing $205,000. She takes out a 30-year fixed rate mortgage at 4% interest, putting down 3.5%. Assuming she buys early in 2018, her first-year mortgage interest would total $7,856 and she would pay real property taxes of $2,050.
As a first-time homeowner, her tax liability under the prior law would be computed as follows:
Salary income | $58,000 | |
Mortgage interest | $ 7,856 | |
Real property tax (1%) | $ 2,050 | |
State income tax (5%) | $ 2,900 | |
Charitable contributions (3.6% of income) | $ 2,088 | |
Total itemized deductions | ($14,894) | |
Personal exemption | ($ 4,150) | |
Taxable income | $38,956 | |
Tax | $ 5,393 |
Note. Under the prior law, Barbara would lower her tax liability for 2018 by $2,098 ($7,491 – $5,393) by purchasing the condo. This is the financial effect of the prior law’s tax benefits of buying a home. This amount effectively lowers her monthly mortgage payment by $175 per month.
Now, let’s take a look at what her tax situation would be under the new law as a first-time homebuyer:
Salary income | $58,000 | |
Mortgage interest | $ 7,856 | |
Real property tax (1%) | $ 2,050 | |
State income tax (5%) | $ 2,900 | |
Charitable contributions (3.6% of income) | $ 2,088 | |
Total itemized deductions | ($14,894) | |
Personal exemption | ($ – 0 -) | |
Taxable income | $43,106 | |
Tax | $ 5,423 |
Tax Difference Under New Law. Even though Barbara would still be able to claim all of her itemized deductions under the new law, she would lose the benefit of her personal exemption. This would mean that her taxes would actually go up under the new law by $30 ($5,393 – $5,423). But far worse, look at the tax differential between renting and owning a home. This difference, which was $2,098 under the prior law, has now shrunk to just $637 ($6,060 – $5,423), or $53 per month. In other words, under the prior law, Barbara was given a strong incentive to move into the ranks of those who own their home. The new law still offers her an incentive, but it is a shadow of what it was, and is unlikely to be very compelling.
Example 2 – Middle-Income Family of Five:
To illustrate how the changes to the standard deduction, repeal of personal exemptions, mortgage interest and state and local tax deductions, and increase in the child credit might affect middle-income family of five, consider the example of Steve and Melinda. Steve is a store manager making $55,000 per year, while Melinda is a school principal, earning $65,000. They have three children, ages 17, 14, and 9. Steve and Melinda recently relocated from another city, and while they are getting to know their new community, they are leasing a home. But they would like to purchase as soon as they identify which area is the best fit for their family. As renters, they pay state income tax on their salaries, totaling $6,000, and also make some charitable contributions equaling $3,120. Since these itemized deductions do not reach the level of the standard deduction, they do not itemize, but they expect to do so when they purchase their home.
Here is a look at Steve and Melinda’s tax liability for 2018, computed under the prior law:
Salary income | $120,000 |
Standard deduction | ($ 13,000) |
Personal exemptions (5 x $4,150) | ($ 20,750) |
Taxable income | $ 86,250 |
Tax before credits | $ 12,870 |
Child tax credits (2 x $1,000 less $500 phase-out) | ($ 1,500) |
Net Tax | $ 11,370 |
Under the new law, Steve and Melinda, as renters, would get a tax cut, computed as follows:
Salary income | $120,000 |
Standard deduction | ($ 24,000) |
Personal exemption | ($ – 0 -) |
Taxable income | $ 96,000 |
Tax before credits | $ 12,999 |
Child tax credits (2 x $2,000) | ($ 4,000) |
Net Tax | $ 8,999 |
Tax Difference Under New Law As Renters.
Steve and Melinda lose the big benefit of the personal and dependency exemptions for the two adults and three children. And the increase in the standard deduction is not enough to make up for this loss. However, the big increase in the child credit for the two younger children and the lower tax rate are enough to deliver them a tax cut of $2,371 ($11,370 – $8,999) as compared with the prior law.
Let’s now consider how Steve and Melinda’s tax situation changes if they were homeowners, rather than renters. Assume they find an ideal home in a nice neighborhood that costs $425,000, and after offering a 10% down payment, Steve and Melinda take out a 30-year fixed mortgage at a 4% rate. Let’s say that their real property tax for the year totals $4,250, which is just 1% of the home’s value.
Here is how their 2018 tax liability would be computed as homeowners, under the prior law:
Salary income | $120,000 |
Mortgage interest | $ 15,189 |
Real property tax (1%) | $ 4,250 |
State income tax (5%) | $ 6,000 |
Charitable contributions (2.6% of income) | $ 3,120 |
Total itemized deductions | ($ 28,559) |
Personal exemptions (5 x $4,150) | ($ 20,750) |
Taxable income | $ 70,691 |
Tax before credits | $ 9,651 |
Child tax credits (2 x $1,000 less $500 phase-out) | ($ 1,500) |
Net Tax | $ 8,151 |
Note. Under the prior law, Steve and Melinda would lower their tax liability for 2018 by $3,219 ($11,370 – $8,151) by purchasing their home instead of renting. This is the financial effect of the prior law’s tax benefits of buying a home. This amount effectively lowers their monthly mortgage payment by over $268 per month.
Now, let’s take a look at what her tax situation would be under the new law as a home-owning family instead of renters:
Salary income | $120,000 |
Mortgage interest | $ 15,189 |
Real property tax (1%) | $ 4,250 |
State income tax (5%) (limited by $10,000 cap) | $ 5,750 |
Charitable contributions (2.6% of income) | $ 3,120 |
Total itemized deductions | ($ 28,309) |
Personal exemptions | ($ – 0 -) |
Taxable income | $ 91,691 |
Tax before credits | $ 12,051 |
Child tax credits (2 x $2,000) | ($ 4,000) |
Net Tax | $ 8,051 |
Tax Difference Under New Law As Homeowners.
For Steve and Melinda, most of their itemized deductions from the prior law are preserved by the new law. They are limited slightly ($250) by the $10,000 limit on the deduction of state and local taxes. However, they lose big by the repeal of the personal and dependency exemptions, which equal $20,750 for this family. Even so, Steve and Melinda receive a small tax cut of $100 ($8,151 – $8,050) under the new law, thanks to the much larger child credit and lower tax rate. But as renters, they received a tax cut of almost $2,400. Thus, buying a home becomes a net tax change of almost $2,300.
What happened? What happened is that the new law is taking away most of the tax benefits of owning a home. Under the prior law, this benefit was $3,219 for Steve and Melinda. But under the new law, they enjoy only a benefit of $948 ($8,999 – $8,051). This gives them a benefit of just $79 per month, which is obviously a far weaker incentive to own.
It’s important to understand the basic implications of the new tax law, hopefully this interpretation makes a very complicated law easier to understand. Home ownership will continue to offer a safe, long term investment for people despite the tax implications may not be as favorable as in the prior law. Non of this information is intended to be taken as tax advice, please consult your tax advisor for guidance.