Tax Return: Home Mortgage Interest Tax Deduction

How homeowners can get the maximum tax refund.

Owning a home. Ask any landlord what’s so great about owning versus renting, and most will say “the tax breaks!” That’s right, because all homeowners who itemize their taxes can deduct 100% of their mortgage interest and property taxes from their tax returns. But how do you get the maximum tax refund for homeowners? If you don’t already own a home, there may be good reasons, but the advantages of owning a home far outweigh the rent. There are really only two reasons not to own a home: you can live rent-free with your parents or friends, or maybe you plan to move in 3 years or less. Even if you are single, but plan to stay in the area for more than 3 years, consider buying a home.

The main tax incentive to owning a home is that it allows you to deduct the interest you pay on your mortgage. This is usually the biggest tax break for most people, because a significant amount of your house payment goes toward interest during the first few years of a mortgage. What are the main advantages of owning a home come tax season?

Deductible mortgage interest including “points” when buying your home.

Deductible property taxes on your return.

Deductions for improvements made to your home when you sell.

Up to $500,000 in tax-free capital gains when you sell your home.

To get the maximum homeowners tax refund, you’ll need to use Form 1040 and itemize your deductions. If you’re in a 28% tax bracket, the government effectively subsidizes about a third of your borrowing costs, making your home more affordable. Plus, your closing costs and points are tax deductible, and millions upon thousands of dollars of any capital gains you realize when you sell your home are exempt from income tax.

At tax time, it is essential to know what you are entitled to, in order to claim it. So here are five essential tax tips to get the maximum tax refund for homeowners.

1. Fill out the long form at least once and learn how to itemize your deductions.

Nearly 40% of homeowners miss out on the number one tax break every year when they don’t itemize their income taxes. If you own a home and have a fairly simple tax return, it might be tempting to take the standard deduction or file Form 1040A. In some cases where your mortgage, property taxes, and income are low enough, the standard deduction may be a larger deduction than your itemized deductions. But you’ll never know unless you fill out both forms at least once.

So before you start filling out Form 1040A or 1040EZ, gather your documentation and answer the questions about tax software like TurboTax, which will automatically calculate whether itemizing or taking the standard deduction will result in the lowest tax bill.

Why the extra work? You can only pay less tax, never more, by filing the longer Form 1040.

2. Home office deduction.

The average home office deduction is over $3,000. Of course, there are special IRS rules about what you can claim as a home office. The space you claim as your home office may not be exempt from capital gains tax when you sell your home. Visit the IRS.gov website for complete details.

3. Tax relief for loan modifications, foreclosures and short sales.

The Making Home Affordable® (MHA)® Program is an important part of the Obama Administration’s comprehensive plan to stabilize the US housing market by helping homeowners obtain mortgage assistance and avoid foreclosures. To meet the diverse needs of homeowners across the country, Making Home Affordable ® programs offer a variety of solutions that can help you take action before it’s too late. You may be able to refinance and take advantage of today’s low mortgage interest rates and reduce your monthly mortgage payments.

While the long-term housing outlook began to improve in 2011, loan modifications are expected to peak this year. Distressed homeowners who are on the verge of a short sale, loan modification, or foreclosure should note that any mortgage balance that is wiped out by one of these outcomes is typically taxed at what the IRS calls Cancellation of Debt Proceeds, or CODI.

Under the Mortgage Forgiveness Relief Act of 2007, the IRS is currently not collecting income tax on CODI incurred through a loan modification, short sale, or foreclosure on most residences through 2012. But banks are taking many months, or even years, to settle new mortgages. If you see any of this happening in your future, don’t procrastinate. Get free advice from a housing expert at MakingHomeAffordable.Gov. or call 888-995-HOPE (4673) to speak with an expert.

4. The tax consequences of a refinance or property tax appeal.

Homeowners around the world are working to request a lower property tax bill based on the decline in value of their homes in recent years. Those who have equity have tried to refinance their existing home loans at rates of 4% to 5% for the past several years. These strategies offer some of the biggest savings today. But here’s a little warning for homeowners who can cut these costs. Property taxes and mortgage interest, the very costs you’re minimizing, are also the foundation of the major tax benefits of homeownership. So plan ahead so your tax deductions go down along with your taxes and interest.

5. Don’t forget closing costs.

If you’ve purchased or refinanced your home, you may be able to focus on your mortgage interest and property tax deductions and forget about closing costs altogether. Remember that any origination fees or discount points paid to your mortgage lender at closing are tax deductible on your return. When you finance a home, you can pay what are called “points.” Points reduce the interest rate on your mortgage by effectively prepaying a portion of the interest at closing. Points are paid by the borrower to the lender as part of the loan deal, and are a percentage of the loan. Points may also be called loan origination fees, maximum loan charges, loan discount, or discount points. If you can’t figure out exactly what you paid, look up your HUD-1 Settlement Statement. It is filled with line item credits and debits that you should have received from your escrow provider or title attorney at closing.

helpful tip:There are two things you can count on when you become a homeowner: you get more tax breaks and your taxes get more complicated. Whether you’ve purchased a single-family home, townhome, or condo, there are tax breaks available to you. It’s time to get familiar with the tax forms because that’s where you’ll need to provide all the details about your new tax-deductible expenses.

Don’t forget PMI premiums on your tax return. PMI is the private mortgage insurance premiums on certain mortgages. If you make a down payment of less than 20%, you are generally required to have private mortgage insurance. This type of insurance is paid for by the buyer but protects the lender in case the borrower defaults on the loan. PMI premiums may be deducted if the mortgage was issued after 2006. This deduction may be changed in 2012, so check the IRS website for updated information.

Final thought: There are also huge tax savings on the gain when you sell. If you are going to live in your house for at least 5 years considering buying a house for this reason alone. When you sell your home, the amount of your gain from the sale is tax free if you meet the criteria. If you are married, you can gain up to $500,000 on the sale and you will not have to pay taxes on the gain. If you are single, you can earn up to $250,000 without paying any federal taxes. There’s only one catch: You must own and occupy your home for at least two of the last five years. Visit IRS.gov for more information.