Owning a home is the first step to building equity. Tenants build equity but not for themselves; they build it for the owners.
Equity is the difference in the value of the home and what is owed on the home. There are two dynamics that cause this to grow: appreciation and principal reduction.
As the home increases in value, it is said to appreciate. Various authorities will annualize an appreciation rate based on average sales prices from one year to the next. Since appreciation is based on supply and demand as well as economic conditions, it will not be the same year after year.
If you looked at a ten to twelve-year period, some would be higher than others and there may even be some individual years that it is flat or even declined. For the most part, values tend to appreciate over time.
Most mortgages are amortized which means that a portion of the payment each month is applied to the principal in order to pay off the loan by the end of the term. A $300,000 mortgage at 4.5% for 30 years has $395.06 applied to the principal with the first payment. A slightly larger amount is applied to the principal each following month until the loan is paid with the 360th payment.
If additional principal payments are made, it will save interest, build equity faster and shorten the term of the mortgage. Using the previous example, if an additional $250.00 principal contribution was made with each payment, it would only take 270 payments to retire the loan instead of 360. It would save $69,305 in interest and shorten the mortgage by 7.5 years.
To see the dynamics of equity due to appreciation and principal reduction, look at the Rent vs. Own. To see the effect of making additional principal contributions on your equity, look at the Equity Accelerator.
Whether you’re an owner now or expect to be one in the future, it is important to be familiar with the federal tax laws that affect homeownership. Since personal income tax was enacted in 1913 with the 16th amendment, homes have had preferential treatment.
The mortgage interest deduction is based on up to $750,000 of acquisition debt used to buy, build or improve a principal residence. In addition to the interest, the property taxes are deductible, limited to the new $10,000 limit on the aggregate of state and local taxes (SALT). The taxpayer may also deduct interest and property taxes subject to limits on a second home.
Homeowners can decide each year whether to take itemized personal deductions or the allowable standard deduction which was significantly increased under the Tax Cuts and Jobs Act of 2017.
Single taxpayers may exclude up to $250,000 of capital gain on the sale of their home and up to $500,000 if married filing jointly. They must have owned and lived in the home for at least two of the last five years. For gains more than these amounts, a lower, long-term capital gains rate is paid rather than one’s ordinary income tax rate.
Capital improvements made to a home will increase the basis and lower the gain. Homeowners are probably familiar that large dollar expenses like roofs, appliances or major remodeling are capital improvements. However, many lower dollar items may also be considered improvements if they materially add value or extend the life of the property or adapts a portion of the home to a new use.
Homeowners are urged to keep records of money they spend on the home that they own over the years so that their tax professional can decide at the time of sale what they must report to IRS.
You can download a helpful Homeowners Tax Guide that explains in more detail and includes a worksheet to keep track of the basis of your home and capital improvements.
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