Property Taxes and Mortgage Deductions: Owning a Home in Tax Season

by Amy Lillard

(2/27/2013) Tax season has come again, and consumers are frantically examining their financial records from the previous year to come out on top.

For homeowners, taxes are both a bane and a boon. While those with homes and mortgages must face the potentially painful and confusing prospect of property taxes, they can also look forward to the significant benefit of tax deductions afforded to homeowners.

Let’s take a look at what it means to own a home in tax season.

Property taxes

Taxes are a sneaky addition to most purchases. Most consumers have felt seduced by a great deal, only to find the added tax may sour it. The same applies to home purchases. New home buyers in particular often just look at the price of the home, and for condo buyers, the cost of monthly assessments. Property taxes are often forgotten in the judgment to buy or not to buy.

For every purchased property, taxes are levied by local governments, who can use the funding for schools, local services, and a wide array of other projects. The rules and amounts will vary widely from state to state and even region to region. Depending on the home and the location, buyers may find they are subject to taxes from multiple organizations, including state, county, and city governments, and local water, sewer or school authorities.

Just as with income tax or taxes on other purchases small and large, property taxes are an unavoidable fact of life. However, property taxes are set up and billed differently than most other taxes, which can result in a lot of confusion and mistakes.

Property taxes are calculated based on the value of the home, but each state or locality will use its own formula to calculate specific tax rates. Most will consider the home’s value, the value of comparable homes in the area, any improvements that added value, and the applicable tax rates of all levying parties. Because of all the elements that go into calculation, property taxes may change from year to year. Typically, a new property will have an assessed tax rate for the first year of existence and ownership, and experience a rate hike in the second and subsequent years. Existing properties may face reassessments of taxes with new ownership, or every few years. Finally, remodeled homes may face reassessment of taxes that will raise the rate.

Before considering a property, then, it’s important to understand from the local assessor’s office how tax is calculated, and when and if reassessments may occur. Also understand any potential tax breaks, rebates, or deferrals that may be offered by specific properties and lenders.

The complexity of how taxes are calculated makes lenders as uneasy as borrowers. Mortgage companies and other lending institutions want their borrowers to pay property taxes in full and on time. Why? In the case of foreclosure, lenders are often saddled with unpaid property taxes. To ensure that their borrowers pay property taxes then, most loans count missed tax payments as an “event of default” This could be the cause for serious action, up to and including foreclosure.

Since taxes are so complicated, and lenders require their payment, many set up “escrow” accounts. In these cases, monthly mortgage payments include a portion of the principal and interest, and also an amount set aside in escrow that goes towards your taxes. This amount is 1/12 of the estimated yearly property taxes. When taxes are due, the lender withdraws money from the escrow account and pays on your behalf.

When opening a home loan, refinancing, or setting up a home equity loan, ensure you understand how the escrow account works for that lender. And then check to ensure that funds are indeed dispersed when taxes become due. Ultimately you are responsible for paying taxes in full and on time.

Tax deductions

There’s a significant financial burden associated with taxes when owning a property. But at the same time, owning a home or other property represents significant tax benefits when it comes time to file your annual returns.

As homeowners and property owners know, folded into your monthly loan payment is interest. For qualified owners, all of this mortgage interest paid over a year’s time can be deducted from your U.S. federal taxes. It’s a significant boon for many, but it’s also an increasing target of regulators looking to change tax laws — it narrowly avoided being changed or eliminated as part of the oft-discussed “fiscal cliff” negotiations late last year.

The deduction survived for the foreseeable future, meaning homeowners will generally be able to take advantage if they meet these requirements:

• File Form 1040 and itemize deductions on Schedule A
• Are legally liable for the loan (either the borrower or co-borrower)
• Made payments on a primary home (house, condominium, cooperative, mobile home, boat, recreational vehicle or similar property that has sleeping, cooking and toilet facilities) or, in some cases, a second home

The deduction can apply to interest paid on a mortgage, second mortgage, home equity line of credit, or home equity loan. The deduction is limited for mortgages totaling more than $1 million, and deductions for home equity loans will only apply to values of up to $100,000.

In addition to a tax deduction for mortgage interest, new home buyers can take advantage of another tax deduction from their purchase: the money paid for mortgage points.

In many cases of new home loans, lenders will charge “points” (each point being 1 percent of the total loan amount) as a method of making their profit. Often, these points are paid in exchange for borrowers receiving lower mortgage rates. In a typical homebuying transaction, the buyer and/or seller may split the points as part of closing. But the buyer will always get the tax deduction afforded from the points.

Of course, there are requirements in order to take advantage of this tax deduction:

• Loan is for main home of residence
• Points are used in accordance with regional practices
• Points are not paid in place of appraisal fees, inspection fees, title fees, property taxes, or other amounts state separately on the settlement sheet
• Funds provided at closing (down payment, earnest money, etc) must be equal to or greater than the amount of points paid
• Points are calculated as a percentage of your mortgage’s principal amount

In most cases, this tax deduction also applies to points paid for refinanced loans or home equity loans as well.

For both of the tax deductions associated with your home, you’ll need to provide documentation to support your case. These include:

• Form 1098, provided by your lender detailing how much mortgage interest you paid during the year. It will also detail any deductible points you paid
• Closing statement on a refinanced loan documenting points paid
• Federal tax return from the previous year if you refinanced and/or if you’re deducting mortgage interest over the life of the loan