Tax Avoidance: Using Your Home to Reduce Taxable Income

For some people, talking tax is like talking a foreign language. And at one point, I was that person, too.

But after getting into real estate these past few years, I’ve realized that understanding just enough could be the difference between quitting my job at 60 and quitting my job at 40 (and I plan on quitting years before that).

Using your home to reduce taxable income is a great way to pocket more of your money come tax season. And if you pick the right location, when it comes time to sell the place, you can actually make a lot of money as well (and keep it, too) all by just living day-to-day life in your home.

With that being said, let's get into how we can keep Uncle Sam off your back.

Itemize Certain Recurring Expenses

If you’ve read Getting in the Game - A Guide for the First-time Homebuyer (and you should if you haven’t), then you already know a bit about the recurring expenses you can expect to pay after you’ve purchased a home. Although it may pain you to see that money leave your account each month, you may be able to recoup some of it come tax season.

As we mentioned in The Basics: What You Should Know as You Prepare to File Your Taxes, one of the most common methods in using your home to reduce taxable income is by itemizing certain recurring expenses (when greater than the standard deduction), such as mortgage interest and property taxes, on Schedule A of form 1040. However, there are limits to the amounts you can deduct:

Mortgage Interest: If you purchased a home prior to December 15, 2017, you can deduct interest on a mortgage of up to $1,000,000. For homes purchased after December 15, 2017, you can only deduct interest on a mortgage of up to $750,000 (some exceptions may apply to you).

The scenarios below show how the limit on a home purchased in 2018 generally works (assuming no principal balance is paid off during the year):

Property Taxes: In combination with state and local taxes, or with sales taxes, you can deduct up to $10,000.

You should receive a form 1098 from your lender every January showing how much mortgage interest and property taxes you paid during the previous year.

Additionally, if you were paying private mortgage insurance (PMI) during the 2017 through 2020 tax years, and itemized your deductions, you could have deducted that amount to reduce your taxable income as well (deductible amount decreases after a certain point). However, for the 2021 tax year, the deduction for PMI will not be available unless Congress approves an extension.

Generally speaking, homeowners insurance is not deductible when purchased on your primary residence. However, you may be able to deduct a portion of it when you use your home for business purposes (as you’ll see in the next section).

Take Advantage of the Home Office Deduction

Since the Covid-19 pandemic hit in 2020, working from home may have become routine for you. And if getting things done from your bed wasn't cutting it, then you probably created some space for what you might call your home office.

If so, you may be able to take advantage of the home office deduction. In order to do so, however, your home office has to be used for your own business. Unfortunately after 2018, you are no longer allowed to use the home office deduction if you work for an employer.

There are 2 options to choose from when using the home office deduction: the standard option or the simplified option.

The standard option allows you to deduct the actual expenses of your home office, and even a portion of your overall home expenses (based on the size of your home office compared to the overall size of your home). The simplified option limits you to a deduction of $5 for each square foot of your home office, up to 300 square feet (a maximum deduction of $1,500).

While the standard option can be much more difficult to calculate than the simplified option, in most cases it will grant you a larger deduction.

To give you an easy example of how this works, let’s say you bought a home that has 2,000 square feet of living space and you have a home office that is 200 square feet. If you were to choose the simplified option, you could only deduct $1,000 ($5 per square foot times 200 square feet)

Under the standard option, your deduction could look something like this:

*For the purpose of simplicity, depreciation was excluded as a deductible expense.

Because your home office makes up 10% of the total square footage (200 square feet divided by 2,000 square feet), you can deduct 10% of the home expenses not directly related to your home office. Your deduction is limited to the amount of income made from your business and is taken on form 8829.

If you’d like to learn more about how to calculate the standard option for your home office, please reach out!

Keep Track of Home Expenses for Airbnb, Too

If you have some extra space for travelers to come crash for a couple of nights, you may be considering going the Airbnb route. Similar to the standard option above, you can deduct 100% of the expenses directly related to your business (cleaning fees for example) and a portion of your home expenses that help you keep your guests comfortable (again, based on the size of the space used for your Airbnb rental).

Shared Economy Tax has some additional tidbits that may be helpful to you when using your home to reduce taxable income through Airbnb.

Take Advantage of the Tax-exempt Gain on the Sale of a Primary Residence

I’ve saved the best (and probably least known) tip for last when it comes to using your home to reduce taxable income. If you really want to know how the wealthy folk keep getting wealthier, it’s because of tax breaks like this.

Because of the Taxpayer Relief Act of 1997, you may be able to avoid paying taxes on the total profit you make from selling your home (yes, all of it). The catch? The property has to be your primary residence (basically where you call home) for 2 of the last 5 years. Those 2 years do not need to be consecutive.

Those who are single filers can avoid taxes on a profit of up to $250,000. If you are married filing jointly, that amount increases to $500,000 (see, there’s at least one perk to getting married).

For example, let’s assume you’re single and bought a house for $200,000 in 2021. You live in it for the next 3 years and decide you want to sell the place. The property gods heard your prayers and you get $400,000 for it. Congratulations - that $200,000 you made is yours to keep (minus any costs incurred to sell the home).

The IRS allows you to take advantage of this once every 2 years. This means if you have 2 properties that are eligible for the tax-exempt gain on a sale, you can only use it for one and will have to wait another 2 years to use it for the other.

Even if the profit made from selling your home exceeds the limits mentioned above, you will still catch a break on the surplus due to capital gains tax rates. Capital gains are made on investments sold for a profit, and have tax advantages if they were held for more than a year. We will get into this a bit more in due time.

Lastly - any upgrades made on your home will increase its tax basis (the amount used to determine if you have a profit or loss on a sale). Using the same example above on the home you purchased for $200,000, if you spent another $50,000 upgrading your kitchen, your tax basis in the home would then be $250,000. When you sell it for $400,000, your profit would be $150,000 instead of $200,000 (all of which is still tax-exempt).

So, What Can You Do Now?

While tax season may not be upon us just yet, that doesn't mean your efforts can't start now.

If you were planning on making larger-than-normal payments towards your mortgage each month, you may decide there are better uses for that money (for example, putting it in the stock market), while still being able to take advantage of a higher mortgage interest deduction.

Those home expenses you paid for and forgot about may be of use to you if you qualify for the home office deduction or have some extra space for Airbnb rentals. You can get a head start on estimating what you will owe in taxes next April and plan your budget accordingly.

The moral of the story here? Your home is not just one big expense until it's paid off. Having just a basic understanding of what the tax rules allow you to do can be a difference maker for years to come.