Updated for Tax Year 2014

OVERVIEW

Buying your first home is a huge step, but tax deductions available to you as a homeowner can reduce your tax bill.

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Tax breaks ease the cost of mortgage

Buying a home is when you begin building equity in an investment instead of paying rent. And Uncle Sam is there to help ease the pain of high mortgage payments. The tax deductions now available to you as a homeowner will reduce your tax bill substantially.

If you have been claiming the standard deduction up until now, the extra write-offs from owning a home almost certainly will make you an itemizer. Suddenly, the state taxes you pay and your charitable donations will earn you tax-saving deductions, too. So make sure you know about all these breaks that may now be available to you:

Mortgage interest

Points

Real estate taxes

You can deduct the local property taxes you pay each year, too. The amount may be shown on a form you receive from your lender, if you pay your taxes through an escrow account. If you pay them directly to the municipality, though, check your records or your checkbook registry. In the year you purchased your residence, you probably reimbursed the seller for real estate taxes he or she had prepaid for time you actually owned the home.

Private Mortgage Insurance Premiums (PMI)

Buyers who make a down payment of less than 20 percent of a home’s cost usually get stuck paying premiums for Private Mortgage Insurance, which is an extra fee that protects the lender if the borrower fails to repay the loan. For mortgages issued in 2007 or after, home buyers can deduct PMI premiums.

Penalty-free IRA payouts for first-time buyers

As a further incentive to homebuyers, the normal 10 percent penalty for pre-age 59 withdrawals from traditional IRAs does not apply to first-time home buyers who break into their IRAs to come up with the down payment. This exception to the 10 percent penalty does not apply to withdrawals from 401(k) plans.

At any age you can withdraw up to $10,000 penalty-free from your IRA to help buy or build a first home for yourself, your spouse, your kids, your grandchildren or even your parents. However, the $10,000 limit is a lifetime cap, not an annual one. (If you are married, you and your spouse each have access to $10,000 of IRA money penalty-free.) To qualify, the money must be used to buy or build a first home within 120 days of the time it’s withdrawn.

But get this: You don’t really have to be a first-time homebuyer to qualify. You’re considered a first-timer as long as you haven’t owned a home for two years. Sounds great, but there’s a serious downside. Although the 10 percent penalty is waived, the money would still be taxed in your top bracket (except to the extent it was attributable to nondeductible contributions). That means as much as 40 percent or more of the $10,000 could go to federal and state tax collectors rather than toward a down payment. So you should tap your IRA for a down payment only if it is absolutely necessary.

There’s a Roth IRA corollary to this rule, too. The way the rules work make the Roth IRA a great way to save for a first home. First of all, you can always withdraw your contributions to a Roth IRA tax-free (and usually penalty-free) at any time for any purpose. And once the account has been open for at least five years, you can also withdraw up to $10,000 of earnings for a qualifying first home purchase without any tax or penalty.

Home improvements

Energy credits

Some energy-saving home improvements to your principal residence can earn you an additional tax break in the form of an energy tax credit worth up to $500. A tax credit is more valuable than a tax deduction because a credit reduces your tax bill dollar-for-dollar.

There is a completely separate credit equal to 30 percent of the cost of more expensive and exotic energy-efficient equipment, including qualifying solar-powered generators and water heaters. In most cases there is no dollar cap on this credit.

Tax-free profit on sale

Another major benefit of owning a home is that the tax law allows you to shelter a large amount of profit from tax if certain conditions are met. If you are single and you owned and lived in the house for at least two of the five years before the sale, then up to $250,000 of profit is tax-free. If you’re married and file a joint return, up to $500,000 of the profit is tax-free if one spouse (or both) owned the house as a primary home for two of the five years before the sale, and both spouses lived there for two of the five years before the sale.

Thus, in most cases, taxpayers don’t owe any tax on the home-sale profit. (If you sell for a loss, you cannot take a deduction for the loss.)

You can use this exclusion more than once. In fact, you can use it every time you sell a primary home, as long as you owned and lived in it for two of the five years leading up to the sale and have not used the exclusion for another home in the last two years. If your profit exceeds the $250,000/$500,000 limit, the excess is reported as a capital gain on Schedule D.

In certain cases, you can treat part or all of your profit as tax-free even if you don’t pass the two-out-of-five-year tests. A partial exclusion is available if you sell your home early because of a change of employment, a change of health, or because of other unforeseen circumstances, such as a divorce or multiple births from a single pregnancy.

A partial exclusion means you get part of the $250,000/$500,000 exclusion. If you qualify under one of the exceptions and have lived in the house for one of the five years before the sale, for example, you can exclude up to $125,000 of profit if you’re single or $250,000 if you’re married50 percent of the exclusion of those who meet the two-out-of-five-year test.

Adjusting your withholding