The real estate and housing market is on FIRE, and people are buying homes at an unprecedented rate despite the economy and the coronavirus pandemic. If you’re considering buying or selling a property, you NEED to know about closing costs and which ones are tax-deductible.
Closing costs are an unfortunately pricey but necessary part of a transaction whenever you buy, sell, or refinance a house. For most taxpayers, opting for the standard deduction over itemizing is the way to go to maximize savings. However, the year you purchase or refinance a house may be the exception to this rule. Therefore, it’s important to analyze this carefully.
Closing costs can result in tax-deductible expenses that might not be present in a regular year of home ownership. These extra expenses can help you cross the threshold to where it might be a better decision to itemize, instead.
Are All Closing Costs Tax-Deductible?
No. Costs that can be classified as taxes or interest are deductible. The IRS may have a broader definition of which expenses can be considered interest than you do, however. As a result, you may actually be able to deduct more closing costs than you think.
What Closing Costs Can You Deduct On a Home Purchase?
Let’s take a look at current standard deduction amounts first. For 2020 tax returns being filed this year, the standard deduction is $12,400 for individuals, $18,650 for heads of household, and $24,800 for married couples filing jointly and surviving spouses.
To benefit from closing cost tax deductions, your itemized deductions need to exceed these amounts. All itemized deductions go on Schedule A of your federal tax return.
1. Property Taxes
Both state and local real estate taxes are deductible in the year that you pay them. You can only deduct property taxes that are levied at a similar rate on all the real estate in your area, in order to benefit the general welfare.
Additionally, you cannot deduct more than $10,000 or $5,000 if married filing separately annually — for properly, sales, and state and local income taxes, combined.
2. Prepaid Interest
Unless you close at the start of the month i.e. the 1st, you will have to pay interest for a partial month once you close on your mortgage. This partial interest is called prepaid interest, and it’s deductible, like other mortgage interest.
The mortgage must be secured by your home and the proceeds must be used to either build or buy or significantly improve your primary residence or second home for mortgage interest to be deductible. If you’re taking out a large mortgage, you should know that you can only deduct interest paid on the first $750,000 of mortgage debt (and half of that if married filing separately).
Your lender reports all the interest you’ve paid annually on IRS Form 1087. If you pay less than $600 total, your lender doesn’t have to report it. However, you can still deduct that amount. In addition, you can deduct the mortgage interest you pay with your monthly payments, as well as any late fees you incur.
Loan points can be paid to reduce your interest rate. The IRS considers these to be prepaid interest, which then makes then tax deductible in the year you pay them if you meet the following conditions:
- The mortgage is secured by your main home
- The mortgage is being used to buy, build, or substantially improve your main home
- Paying points is an established business practice in your area
- You didn’t pay more points than is customary in your area
- You use the cash method of accounting
- The lender didn’t charge you more for points in exchange for charging less for something else other than interest
- The cash you brought to closing was at least as much as the amount of points the lender charged
- The points are calculated as a percentage of your loan amount
- Your mortgage settlement clearly shows what you paid in points
You can deduct points if the seller pays them too, as long as you meet the aforementioned conditions. However, when you do sell your home, don’t forget to reduce the value of the purchase price by any points the seller paid.
If you’re eligible to do so, you will probably be able to achieve the greatest tax savings by deducting all your points in the same year you pay them. Alternatively, you can deduct points over the life of your mortgage.
4. Origination Fees
This is classified by the IRS as points. You can deduct your loan origination fees even if the seller pays them.
5. Mortgage Insurance Premiums
The IRS considers four different types of expenses to be mortgage insurance premiums: private mortgage insurance (PMI), VA funding fees for VA loans, USDA loan guarantee fees and FHA loan up-front mortgage insurance premiums. This is one deduction that is constantly phasing out and getting renewed though, so make sure you check current laws before claiming it!
Mortgage insurance can be paid in different ways: monthly, in a lump sum at closing, or in a lump sum that you finance along with your mortgage. The IRS says that for a lump-sum fee, you can deduct the entire amount in the year you close on your mortgage, whether you pay the fee in cash or finance it.
This is another deduction that depends on income limits. The mortgage insurance premium deduction phases out if your adjusted gross income (AGI) is more than $100,000 (and half of that if you’re married filing separately). If your AGI exceeds $109,000 ($54,500 if you’re married filing separately), you can’t claim this deduction at all.
Which Closing Costs Aren’t Tax Deductible on a Home Purchase?
Only mortgage interest and property taxes are potential deductions for a home purchase. This means that the following fees are not tax deductible:
Homeowners association fees
Flood determination fee
Flood monitoring fee
Home warranty fee
Credit report fee
Which Closing Costs Can You Deduct on a Home Sale?
Home sellers also pay closing costs. However, there are ways to keep more money in your pocket — legally — if you’re selling.
If you’ve lived in your home for 2 of the last 5 years, you don’t have to pay taxes on the first $250,000 of profit from selling your home if you’re single or $500,000 if you’re married. These are exemptions, and the tax savings are greater than if these had been deductions.
If you sell your home for more than $250,000 (double that if you’re married) more than what you purchased it for initially, anything you can do to increase your home’s cost basis will lower your capital gains tax on the profits.
Some of the closing costs you can’t deduct as a buyer or seller can be added to your home’s cost basis instead, including:
Title search and abstract of title fees
Utility service installation fees
Transfer or stamp tax fees
Owner’s title insurance
Additionally, you can add these selling expenses to your basis:
Real estate agent commissions
Loan charges you paid on the buyer’s behalf
Any other fees or costs you incurred to sell your home, such as staging fees
Credit report, appraisal and homeowners insurance fees cannot be added to your home’s cost basis, nor are they deductible.
We hope this in-depth look at which closing costs you can deduct help you keep more of your money. The US real estate market is booming, despite the pandemic. If you’re buying or selling, use the strategies outlined above to deduct closing costs.
At Evolution Tax Center, we are always looking for ways to help you keep your money where it belongs — in your pocket. Whether it’s advice on maximizing tax deductions, how to deal with a mortgage, how to eliminate debt, or saving more when it comes to filing taxes — we do it all, and we help you save your hard-earned money.
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