Buying real estate is a large investment worth hundreds of thousands of dollars. This investment often yields promising capital gains and offers many tax advantages. You can even rent out properties for a steady stream of income. However, like with any large investment, there are many risks involved, so you should make sure that you’ve considered all the financial drawbacks attached to a home purchase before pulling the trigger. In 2020, 6.5 million homes were sold in the US alone and this number is expected to reach over 7 million in 2021. With so many large financial transactions happening and large profits being made, it’s no wonder the government charges home buyers taxes. Those who can afford homes pay taxes on home purchases to help the government fund essential services. These taxes can eat into real estate profits, so it’s important to be aware of these costs.
The most obvious tax home buyers pay is a transfer tax. This is a government fee charged with every real estate transaction or when a property owner “transfers” ownership of a property. Transfer taxes can be charged at any non-federal government level. Transfer taxes vary by state and county with many states charging a transfer tax at multiple levels of government. The transfer tax also varies by who pays it. In some states, the seller is held responsible for paying the transfer tax while in others, it is expected that the buyer pays it. However, in most states, you should expect to pay at least some portion of the transfer tax. Calculating the transfer tax ahead of time lets you be prepared for the true cost of the property.
Transfer Tax Exemptions
Depending on your home buyer status and state, you may be eligible for a transfer tax exemption. This is uncommon, so if you plan on actively transacting real estate, you should expect to pay a transfer tax.
- Some states exempt first-time home buyers or buyers who fulfill certain requirements. For example, Delaware exempts first-time home buyers from paying the state-level transfer tax, but they still have to pay a transfer tax at the county level.
- Some states will exempt certain types of property transfers from a transfer tax. For example, Michigan’s transfer tax exemptions include many property types and written instruments.
- If either the buyer or seller (but not both) is exempt from paying the transfer tax, the other party is held responsible. While the government holds a certain party responsible, the transfer tax can still be split by negotiating a different property sale price. This should be listed in your purchase agreement.
If you are eligible for a transfer tax exemption, you may still end up paying for a portion of it if it is specified in your purchase agreement. Make sure to have a real estate agent and lawyer review your purchase agreement for any similar fees.
Even after you close the sale and transfer ownership, you’ll still be responsible for paying taxes to the government on your home. Your local government will charge property taxes as a percentage of your assessed home value. It’s important to understand the distinction between your assessed home value and the home price. The home price is the actual amount transacted while your assessed home value is an amount that your local tax municipality calculates. Your assessed home value is updated about once per year and will be adjusted when you purchase the home. Every US state has a property tax because they are used to fund essential public services including emergency services, education, etc. Your mortgage payments will usually include property taxes and your lender will automatically forward your money to the local government.
Property Tax Exemptions
As with the transfer tax, there are exemptions made for homeowners that include some or all of your property tax. To take advantage of a property tax exemption, you are required to find out for yourself and report this to your local taxing authority. There are three main groups of homeowners that qualify for property tax exemptions.
- There is a class of exemptions called “homestead exemptions” that protect homeowners from paying property tax. The most common homestead exemptions include widows/widowers, elders, low-income earners, and people with eligible disabilities.
- Veterans using the home as their primary residence who have served during wartime and were honorably discharged may qualify for property tax exemptions.
- You may be exempt from paying property taxes on the added value to your home through home renovations or improvements. An example of an eligible improvement is installing solar panels or geothermal heating. However, you will be required to pay the full property tax on the original value of the home.
There are other exemptions as well, but since your local tax assessor will not volunteer this information, it is up to you to visit your local tax assessor’s office to see if you qualify.
If you are buying property to rent it out, you will have to consider paying income tax. In the US, profits made from rental properties are taxed as regular income, This is because you can use any rental property-related expenses to deduct your taxable income. Your total taxable income is the sum of your rental property profit (rental revenue – property expenses) and any employment income. Fortunately, there are many possible expenses that you can deduct. In addition to management, repair, utility, and maintenance expenses, you can also deduct mortgage interest payments to a certain extent. This means that with high enough monthly rent payments, you can use your tenant to pay off your mortgage and still benefit from the many tax deductions. If you decide to turn your property into a rental property, there will be many additional tax implications related to the management of the unit.
The Bottom Line
No matter where you live or where the home you want to purchase is located, you’ll have to pay taxes. Even if you don’t end up paying a transfer tax, you might be hit with a larger property tax. Either way, governments need tax revenue to fund public services, so the best you can do is find the right balance of taxes that benefits you most. You can find ways to leverage the unequal taxes between states to find the best deal. However, taxes should never be the sole reason for choosing a home. Instead, worry about the local real estate market, the intrinsic value of the home, and the location. Picking a profitable home will yield much better results than picking a home to avoid taxes. If you are still unsure about the many tax implications of buying a home, talk to a real estate agent or lawyer. They know tax laws related to real estate extensively and can help you make your decision. The most important thing is that you are well informed about how buying a home could benefit you and that you are confident in your decision.