Tax Credits for Homeowners and How Tax Credits Work

Highlights:

• When tax time rolls around, certain homeowners may be able to recover some of their investment by claiming a special benefit known as a tax credit.
• Tax credits offer a dollar-for-dollar reduction that a taxpayer can claim on their return to reduce what they owe.
• The mortgage interest credit, the residential clean energy credit and the energy efficient home improvement tax credit are all examples of tax credits that may be available to qualifying homeowners.

Buying a home is a huge financial commitment that often requires years of careful saving. Luckily, when tax time rolls around, certain homeowners may be able to recover some of their investment by claiming a special benefit known as a tax credit.

What are tax credits?

Tax credits offer a dollar-for-dollar reduction that a taxpayer may claim on their return to reduce what they owe. For example, if you owe $2,000 on your tax return but qualify for a $1,500 credit, then your total bill may be reduced to only $500.

To qualify for tax credits, taxpayers must meet certain criteria regarding their income, retirement contributions, number of dependents or number of purchases and investments they've made throughout the year. The different types and amounts of tax credits offered may vary by tax year. You can refer to the IRS website to find more information about available tax credits and eligibility requirements.

How do tax credits work?

There are three types of tax credits:

• Refundable credits allow eligible taxpayers to receive money back once their tax liability drops below zero. Say you owe $1,500 in taxes and qualify for a $2,000 refundable credit. Once the credit is applied to what you owe, you may receive a cash refund of $500.
• Nonrefundable credits lower your tax liability to as little as zero but do not trigger a cash refund. For example, if you owe $1,500 on your tax return and qualify for a $2,000 nonrefundable credit, your tax bill would be reduced to zero but you would not receive a cash refund.
• Partially refundable credits allow taxpayers to receive a limited cash refund — typically 40% — once their tax liability drops below zero. Say you owe $1,500 on your tax return and qualify for a $2,000 tax credit that is 40% refundable. In this instance, you would receive a refund totaling 40% of the remaining $500, or $200.

Tax credits for homeowners

Tax credits can make a significant impact on what you'll pay to the IRS, especially when tied to a high-price purchase like a home. Here are three credits homeowners can look out for during tax season.

Mortgage interest credit

If you're a first-time homebuyer with limited income, you may qualify to claim the mortgage interest credit through the mortgage credit certificate (MCC) program.

Some lenders offer low-income debtholders a mortgage credit certificate (MCC), typically in concert with state or local housing agencies. If you're approved for an MCC, you're eligible to convert a percentage of your annual mortgage interest into a nonrefundable tax credit. This is generally equal to between 20% and 40% of your total mortgage interest, up to $2,000.

You're generally eligible to claim the credit each tax year, so long as the home remains your primary residence.

Residential clean energy credit

Homeowners who installed new clean energy systems can claim 30% of these costs through this nonrefundable tax credit. The credit covers a wide range of equipment including solar electric panels and water heaters, wind turbines, fuel cells, geothermal heat pumps, energy-efficient heating and cooling equipment and more.

Energy efficient home improvement tax credit

This nonrefundable tax credit allows you to claim certain expenses related to upgrading your home's energy efficiency, including installing energy-efficient doors, windows and heating and cooling systems. It even covers the cost of conducting a home energy audit. You're eligible for a credit equal to 30% of your qualifying expenses, capped at $1,200.

Are tax credits different from tax deductions?

It's important for homeowners to distinguish tax credits from tax deductions. Although both offer important financial benefits, tax credits are applied dollar for dollar to reduce any taxes that you owe. Tax deductions, on the other hand, impact what you owe by reducing your taxable income. There are many different deductions available to eligible homeowners. These include deductions related to mortgage interest, mortgage discount points, property taxes and certain home improvements.

Why tax credits are important

Many tax credits are designed to incentivize or reward certain economic behaviors. For instance, an environmentally friendly government may create or increase tax credits for purchasing electric vehicles. Other types of credits may provide aid to low-income families or caregivers with children.

In the context of homeownership, tax credits can help pave the way to home ownership for low-income buyers who can't otherwise afford it, while tax credits for energy efficiency support the development of eco-friendly housing.

Of course, for individual homeowners, the benefits also come down to dollars and cents. Not only can tax credits allow you to recoup some of the costs associated with your mortgage or energy-efficient home updates, but they may also slash your tax bill — and could even put some cash back in your pocket.