Federal income tax treatment of a home: deductions and the principal residence exclusion

Two different tax benefits

Federal income tax rules apply to homes in New York as elsewhere. A deduction reduces taxable income; an exclusion keeps qualifying gain out of gross income. Neither is a dollar-for-dollar tax credit. A homeowner generally must itemize to deduct qualifying home mortgage interest and deductible real property taxes, subject to applicable limits. Mortgage principal, homeowners insurance, and ordinary personal maintenance are not personal-residence income tax deductions.

While owning the home

For mortgage interest, distinguish interest from principal and examine the debt's purpose, security, and applicable limitations. Borrowing to buy, build, or substantially improve the home securing the loan can qualify as acquisition debt. Calling a loan a home equity loan does not decide its tax treatment. A qualified residence can include a principal residence and one selected other residence meeting the requirements. Under Section 163, debt secured by qualifying cooperative shares can be treated as secured by the apartment.

When selling

Start with amount realized, generally sale price less selling expenses. Subtract adjusted basis to determine gain. Basis generally starts with cost and increases for capital improvements; ordinary maintenance is different. A mortgage payoff reduces cash received but does not itself reduce gain. A loss on a personal residence generally is not deductible.

Section 121 generally allows exclusion of up to $250,000 of gain if the taxpayer owned and used the property as a principal residence for periods aggregating at least two years during the five years ending on the sale date. These are ownership and use tests, not a requirement for five years of ownership. The exclusion generally cannot apply if it applied to another sale during the two-year period ending on this sale.

For a qualifying joint return, the limit is $500,000: either spouse must satisfy ownership, both must satisfy use, and neither may be disqualified by the prior-sale restriction. Joint filing alone is insufficient. Buying a replacement home is not required. Special circumstances can permit a reduced exclusion when ordinary requirements are not met.

For example, $600,000 realized minus $300,000 adjusted basis produces $300,000 gain. A fully eligible single seller with no special gain restrictions excludes $250,000, leaving $50,000 unexcluded. The exclusion applies to gain, not the selling price or mortgage balance.

Limits on the benefit

Gain attributable to depreciation adjustments for periods after May 6, 1997, cannot be excluded under Section 121. Gain allocated to nonqualified use can also be ineligible, with statutory exceptions; not every rental interval has the same result. For a cooperative, ownership concerns the stock and use concerns the apartment. A real estate salesperson should explain these concepts and refer individual tax calculations to a qualified tax adviser.