A new tax-deduction for homebuyers.
Today’s topic is a new tax-deduction for homebuyers.
A nifty new tax deduction is available to homebuyers this year. In late December, the President signed a tax relief act into law that makes mortgage insurance for homes purchased in 2007 tax deductible.
OK, so what exactly is mortgage insurance and under what circumstances can you deduct it?
Private Mortgage Insurance (PMI)
Private Mortgage Insurance (also known as PMI) is insurance that protects the lender, not you. If you buy a home, the lender typically requires that you pay PMI if the amount of your loan is 80% or greater than the value of the house. The idea is that a loan that’s more than 80% of the value of the house is a riskier loan for the lender to make. In the eyes of the lender, you might be more likely to walk away from the loan or be stretching more financially to buy the house since you put less than 20% down. (In reality, these assumptions may or may not be the case – for example, many homebuyers and investors can put 20% or more down, but choose not to so that they can keep more of their money working for them through their other investments.)
If the borrower defaults, PMI insures the lender in the event that they need to foreclose on the house. Even though this insurance protects the lender, unfortunately, the borrower pays for it.
How Does PMI Work?
PMI is a charge that’s typically added to your monthly mortgage payment. The cost of PMI increases as your down payment decreases. The annual cost of PMI varies but is generally around 0.5% of the loan amount. And, getting rid of PMI isn’t always straightforward, but it’s usually possible after you have at least 20% equity in the house (more on this topic in a future episode).
One of the drawbacks of PMI is that, until this year, it hasn’t been tax deductible. As a result, creative solutions have been invented to either avoid PMI or make it tax deductible.
How to Avoid PMI
One creative solution that’s frequently used to avoid paying PMI is getting two loans instead of one. Let’s say, for example, that you want to purchase a house and put 5% down. You can avoid PMI by getting a first loan for 80% of the home value and a second loan for the remaining 15%.
Using two loans together in this way to avoid paying PMI is called a piggy-back loan. The second loan “piggy backs” on the first loan. The second loan can be a home-equity line of credit or a fixed-rate second mortgage.
Homebuyers putting less than 20% down have typically used a piggy-back loan to avoid PMI. Before this year, it was almost always a better deal than paying PMI because the mortgage interest for both the first and second loans is deductible if you itemize deductions.
A creative solution for those who have wanted to put less than 20% down and don’t mind taking PMI so long as they can deduct it has been to go with a lender who will roll the cost of PMI into your interest rate. By charging a slightly higher mortgage interest rate, the lender can pay the PMI for you and you get to deduct the cost. One drawback of this strategy, however, is that you can’t get rid of the PMI without refinancing the loan.
But with the new tax relief act, you can now deduct PMI for a home or a second home that you purchase in 2007 if you are eligible. The new law applies for new purchase loans originated in 2007. It doesn’t apply to refinanced loans.
Who Can Deduct PMI?
OK, so who is eligible to deduct PMI? You can deduct PMI if your adjusted gross income is $100,000 or less (or $50,000 if you are married and filing separately). For adjusted gross incomes between $100,000 and $110,000, the PMI deduction phases out: it’s reduced by 10% for each $1000 that your adjusted gross income exceeds $100,000. If your adjusted gross income is $110,000 or more, the deduction is not available to you.
Remember that your adjusted gross income or AGI is your income minus most deductions, including mortgage interest. So keep in mind that if you buy a house this year, your AGI may be lower if you itemize deductions and deduct your new mortgage interest. Consult a tax advisor if you need help estimating your AGI and eligibility for deducting PMI.
The new law that makes PMI deductible is in effect only for 2007. However, it’s likely to be renewed by Congress beyond 2007.
The goal of this tax law change is to bring homeownership within reach of more people and make saving up a big down payment less of a barrier to homeownership. Remember, though, that the new deduction applies to loans on homes purchased in 2007. It doesn’t apply to loans taken out before this year.
So, if you’re planning on buying a home or second home this year and are eligible to deduct PMI, ask your mortgage broker or lender to show you the cost of paying PMI versus the cost of having a second loan. Compare the two costs and go with the deal that’s better for you. For a link to a calculator that compares the cost of a second loan versus PMI, go to the bottom of this page.
Today, I’m giving away two copies of Ric Edelman’s Ordinary People, Extraordinary Wealth. This book tells the secrets of how 5,000 ordinary Americans became extraordinary investors. This week’s winners are Richard B. and Jody in Manchester, Michigan. Congratulations, Richard and Jody! Check your email for instructions.
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- Calculator: Which is better? Taking a second loan or paying PMI?
- The Tax Relief and Health Care Act of 2006
- The White House’s Fact Sheet on the Act