Purchasing a Home in the Post-TCJA Era

Before the Tax Cuts and Jobs Act of 2017 bill was passed, buying a home was a big incentive to taxpayers looking to reduce their annual taxes.  While some states do have a benefit calculation on rental costs, and home office users can add rental costs to their expenses, for most taxpayers the tax breaks received on the real estate taxes and mortgage interest you pay through homeownership were far more beneficial than renting.  In addition, building equity in your home for possible use later was a nice added bonus.  With the changes put in place by the TCJA, taxpayers are starting to wonder if homeownership is as valuable as it once was.

For many taxpayers, the first thing they think of when looking at the “rent versus buy” scenario is that renting means that each dollar you spend in rent goes to someone else, while buying a house is a great investment.  This is the old “why pay a landlord when you could be building your own equity” adage.  While this is a common thought, there are quite a few costs associated with homeownership that do not increase equity.  Nor are they deductible.  Funds spent towards mortgage interest, real estate taxes, and in some cases homeowner’s and other insurances are items that can potentially have additional benefit in annual tax breaks.  But they aren’t helping you build equity.  Additionally, the fees paid through the mortgage, Association dues or fees, landscaping, repairs and maintenance items, some utilities, and the like are expenses that your landlord would incur on your behalf as a renter and are not of added advantage to you.  So, while at first blush, the mortgage payment may be lower than your monthly rent, it’s just the beginning of the costs of homeownership.  The associated costs of homeownership can run up to an additional fifty percent of your mortgage payment per month.

Home equity is built when the home’s market value outweighs its mortgage value.  In other words, the equity is the amount of the home that you “own.”  If you borrowed money to purchase your home, your lender also has an interest in your home.  While the lender doesn’t “own” your home, the home is securing the loan and can be subject to a lien.  That value cannot be added to your equity.  One way to build equity in your home is to continue to pay down the mortgage, thereby increasing the amount of the home that you own free and clear.  In addition, you may be the beneficiary of increased equity if the housing market in your area takes an up-swing.  And if you add any large improvements to your home that increase the sales value, this will also create added equity.  Capital improvements made to the property will also help you reduce the potential capital gains at the time of sale.

Equity in your home can be used for a variety of things.  Most people look at it as a way of having a savings they can draw on in times of need.  And while a home equity line of credit (HELOC) or a home equity loan can be used to payoff current expenses, it is money better spent if put towards long-term investments.  The equity in your home can also be used to pass on wealth to your heirs, fund your retirement, or purchase your next home.

But how did TCJA change the conversation?  The first tax break that people think of is the deductible interest associated with the mortgage payments.  This is because, in most cases, your interest is the largest of the deductible portions of your homeownership annual costs.  Interest of this nature is deductible as part of your Itemized Deductions.  According to 2016 filing data, roughly thirty percent of taxpayers itemized, and only three out of every four taxpayers who itemized took this deduction.  That means that approximately twenty-one percent of tax filers claimed this deduction.  With the near doubling of the standard deduction by TCJA, the incentive to itemized is greatly reduced.  The Tax Policy Center estimates that a mere four percent of taxpayers will itemize in 2018 and beyond.

Traditionally, taxpayers with larger mortgages received bigger tax breaks.  Under TCJA, those with a new home purchase made between December 14, 2017 and 2026, can deduct the interest on up to $750,000 in mortgage debt used to purchase or improve the home.  This is down from the previous amount of up to $1 million.  Additionally, you can no longer deduct the interest on a home equity loan.  Prior to TCJA, you could deduct the interest on these types of loans up to $100,000.  Also gone with TCJA is the ability to deduct mortgage interest from a second home.  Previously, taxpayers could deduct interest on both their primary residence as well as a secondary residence or vacation home, as long as the combined mortgages were under the $1 million cap.  Again, this applies to new purchases made.

The second tax benefit that homeownership brought was the deductibility of real estate taxes.  Historically, taxpayers were allowed to take the full value of the cost of their property taxes on their federal return.  Again, however, these are deductible using itemized deductions.  As mentioned previously, the number of taxpayers who will be claiming the itemized deduction will greatly decrease in the coming years.  For those that will be claiming real estate taxes, the TCJA reform capped the state and local tax deduction at $10,000.  For many taxpayers, $10,000 does not come close to covering the costs of their combined property and income tax bills. 

There is some good news in the mix.  The capital gains rules are staying the same.  Initially, there was talk of changing the rules to increase the ownership and use requirements from two out of the last five years to five of the last eight, but it did not make the final version of the bill.  This means that taxpayers are still eligible for the $250,000 exclusion for single filers and $500,000 for joint, provided you meet the residency qualifications.  And while the tax deductions may have been reduced, an unintentional benefit may be that housing prices may begin to reduce, and buyers may come out ahead.