Leveraging owner-occupied homeownership

Homeownership has long been considered one of the best paths to building long-term wealth. Beyond providing you and your family a place to build memories, it is also an accessible source of income, providing value that can impact the lives of many future generations. Prudent homeowners can take advantage of a number of tax-minimizing strategies.

• The amount of mortgage interest you can deduct varies before and after the TCJA and by state.
• Home office space must be used for just that purpose to qualify
• Consider combining exclusions at the sale of your home

Mortgage Interest

With the average mortgage interest rate at 6.79% in 2023, remembering to claim your mortgage interest matters. If you are filing as Single (S) or Married Filing Jointly (MFJ), ensure you are deducting the right amount of your mortgage interest. This varies based on 2 core factors.

1. Loans taken before or after 12/16/17
2. The state the property is located in

For your Federal return, The Tax Cuts and Jobs Act (TCJA) came into effect on 12/16/17. Under the grandfather rule, for loans taken out prior to this date, you can deduct up to the 1st $1M in loans. For loans taken out after this date (far in the majority of cases), the maximum you can deduct is up to the 1st $750k. Your loan must have been used to buy, build, or improve a home and be secured by the home asset.

Some states deviate from the above amounts when filing at the state level. California, for example, allows for a mortgage interest deduction on up to $1.1M in mortgage debt.

Do you own more than one home? You can deduct interest on up to 2 homes. The interest on these can be combined if you’re below the relevant amount above. Otherwise, costs will need to be prorated.

The TCJA is set to expire in 2025. There is currently no future decision on how allowable amounts may change.

How it breaks down:

On a 7% interest rate on a $1.5M mortgage loan taken out in 2018, and an effective tax rate of 37% (for the top tax bracket).

1. Know your interest expense will be interest rate times your mortgage (listed on your 1098), in this case $105K
2. How much of your mortgage is then actually deductible? $750K / 1.5M = 50%
3. 50% of $105K interest expense = $52.5K total allowable deduction
4. $52.5K x tax rate of 37% is a tax savings of $19.4K

Reducing your effective annual mortgage payment to $85.6K and giving you an effective mortgage interest rate of 5.7%. Deducting mortgage interest on your state returns, as allowed, can further decrease your effective mortgage interest rate through tax savings.

Accessing equity ‍

With the increase in home values over the past few years, homeowners have been able to build substantial equity. All of which can make the idea of a Home Equity Line of Credit (HELOC) to unlock that value, an attractive option. Interest is deductible for a HELOC or a cash-out refinance if the funds are used for home-related expenditures like on a remodel, rental property or investments. However, if funds are diverted for investments, limitations on investment interest expense apply.

How it breaks down:

That home we purchased above has now increased in value by $500K. You take out a HELOC at a 10% interest rate.

If those proceeds are used to remodel your home, the additional interest is not deductible as you’ve already met the cap on the interest deduction.

If you took those funds to invest in a rental property the interest is fully deductible.

1. $500K at 10% = $50K
2. $50K  x tax rate of 37% is a tax savings of $18.5K

Reducing your effective annual HELOC payment to $31.5K, and giving you an effective HELOC interest rate of 6.3%. Deducting HELOC interest on your state returns, as allowed, can further decrease your effective HELOC interest rate.

Your home, your business

Another way the TCJA has impacted deductions is by removing the ability to claim a home office as a W-2 employee as of 2018. If you are self-employed or a small business owner, you can still use the deduction. Still, your office must meet the test criteria of being the regular place of business and be used exclusively for the purpose of this trade or business.

Are you using an area of your home for a side gig? You’re eligible! As long as it is not the space where you regularly work as an employee.

There are 2 different ways to calculate the deduction for a home office:

1. Simplified Method

The simplified method offers a straightforward $5 per square foot deduction, with depreciation not required. However, it’s exclusive to one home if multiple offices are claimed.

2. Actual Expense Method

Detailed expense records are vital for the actual expense method, which allows deductions for direct and indirect expenses. Direct expenses that are used only for that area of your home, such as purchasing a desk or computer, are 100% deductible. Indirect expenses that apply to your whole home, such as utilities or insurance, are deductible relative to the square footage of the office vs. the home. Expenses attributed to the home office must be reduced from itemized deductions, e.g., mortgage interest and property taxes.

Depreciating the home under the actual expense method can lead to significant immediate deductions. Still, it may trigger recapture as income later upon the sale of the home and cannot be excluded under section 121 below.

When it’s time to sell up

Under Section 121 of the Internal Revenue Code (IRC), the primary residence exclusion allows for a gain exclusion of $250K for single or $500K for married filers, provided the residence was used as a principal residence for 2 out of 5 of the prior years. This exclusion can only be used every 2 years, but it is possible to buy a new principal residence every 2 years and exclude the sale of the prior one.

You can stack a Section 121 exclusion with a 1031 exchange by converting your principal residence to a rental property prior to its sale. It is suggested to rent the property for a minimum of 12-18 months before attempting to sell. Then upon the sale of the property, you can first utilize the Section 121 primary residence gain exclusion, and any remaining gain can be deferred upon the sale if utilizing a 1031 exchange. It is also possible to convert a rental property to primary residence and later claim 121 exclusion upon sale if used as a primary residence for at least 2 years; however, there are limitations on the exclusion.

How it breaks down:

If you were to sell a home for $3M that cost $2M after 5 years as it being your primary residence and you are Married Filing Jointly.

In a direct sale:

1. $3M – $2M = $1M gain
2. With the $1M gain, of this $500K is excluded under Section 121, leaving $500K in taxable gain
3. The $500K that was excluded results in the following tax savings
   1. $500K x 20% capital gains rate =$100K
   2. $500K x 3.8% net investment income tax =$19K
4. The remaining $500K is still taxable at the 20% and 3.8% rates = $119K

In a rent-to-sell scenario:  

Instead of selling it after living in it for 5 years, you convert it to a rental property for the next 2 years and then sell it at $3M. You now could have the option to do a 1031 exchange.

1. $3M – $2M = $1M gain
2. With the $1M gain, of this $500K is excluded under Section 121, leaving $500K in gain
3. The $500K that was excluded under Section 121 results in the following tax savings
   1. $500K x 20% capital gains rate =$100K
   2. $500K x 3.8% net investment income tax =$19K
4. The remaining $500K could now be deferred under the 1031 exchange rules, resulting in an additional tax savings of $119K. Note: there are multiple caveats to be taken into consideration with this process.

Don’t forget about Augusta! 

The Augusta Rule enables homeowners to rent out their property for up to 14 days a year without reporting the income, making it a valuable strategy for maximizing tax benefits. If you are a business owner, this means you could be renting your home to hold your monthly executive meeting.

Taking advantage of the Augusta rule requires ensuring you have the right documentation in place. Show the comparable rental rates for the area, create a rental agreement, and keep track of the relevant calendar dates and payment records.

Bottom line

Homeownership isn’t just about comfort—it’s about making strategic financial decisions that optimize tax benefits and wealth-building opportunities. By understanding the nuances of mortgage interest deductions, leveraging home office deductions, and maximizing gains on property sales, you can turn your home into a powerful asset in your financial portfolio.

Any tax advice herein is not intended or written to be used.