Tax Credit vs. Tax Deduction: What All Homeowners Should Know

Homeownership can offer big tax benefits, and taking advantage of those benefits is especially important now, as higher interest rates over the past few years have driven up the cost of mortgage loans, and homeowners are eager to offset these higher payments.

The good news is that you may be eligible for more credits and deductions than you might have guessed, especially if going green is on your agenda. The Inflation Reduction Act (IRA) of 2022 ushered in new tax benefits for energy-saving home improvements and enhanced some existing benefits. While there are some yearly maximums, there are no lifetime caps.

Both credits and deductions can reduce the amount of tax you ultimately pay, but to better understand their impact on your tax situation, you should first understand the differences between credits and deductions.

What is a tax credit?

A tax credit is a dollar-for-dollar reduction of the tax you owe. For example, a credit of $100 means you pay $100 less in income tax. The United States government uses tax credits to reward taxpayers for engaging in activities considered beneficial to the economy, the environment, or to other issues it deems important. Tax credits are subject to strict eligibility rules, so before claiming a credit, you must first make sure your situation fits within the restrictions.

Tax credits can be nonrefundable, refundable, or partially refundable. A nonrefundable tax credit can only reduce a taxpayer’s liability to zero. If the credit is greater than the amount of your tax liability, you won’t receive a check for that excess; you’re essentially forfeiting it. With a refundable tax credit, any amount exceeding your tax liability will be refunded to you. Partially refundable credits, as the name implies, allow taxpayers to receive a refund beyond the amount of their tax liability, but that refund may be just a percentage of the total credit.

There are many categories of tax credits for individuals, including:

• Family and dependent credits
• Income and savings credits
• Homeowner credits
• Clean vehicle credits
• Health care credits
• Education credit

While all of these tax credit categories could apply to people who own their own home, here are a few of the credits that are geared specifically toward homeowners:

• Mortgage tax credit: The Mortgage Tax Credit Certificate program helps low-income, first-time homeowners afford a home. Those who qualify can claim a nonrefundable tax credit that reduces their tax bill dollar-for-dollar up to $2,000.
• Owning and renovating a historic home: Federal and state tax credits are available for people who renovate a historic property, but note that these programs have stringent guidelines. For instance, the federal program requires that a building be used as an income-producing property for at least 5 years after rehab; owner-occupied residential properties do not qualify. In addition to the federal program, 39 states offer historic tax credits, with widely varying requirements and credit amounts. Research limitations and eligibility, and remember that renovations can increase the value of your home, resulting in higher property taxes.
• Energy-saving improvements: Homeowners can receive a nonrefundable tax credit of 30 percent (up to a maximum of $1,200) of the cost of eligible energy-efficient items in categories such as air conditioning, skylights, and water heaters. Included in the $1,200 yearly maximum are credits (up to $600) for purchases of qualified central air conditioners, water heaters, and boilers that meet or exceed the Consortium for Energy Efficiency (CEE) highest efficiency tier (not including any advanced tiers). There is also a $2,000 credit available for the installation of certain high-efficiency heat pumps and biomass stoves and boilers.
• Clean-energy improvements: Homeowners can receive a nonrefundable tax credit of up to 30 percent of the cost of installing eligible clean-energy systems, such as solar, wind turbines, and fuel cells as well as qualified battery storage technology.

If you didn’t complete any energy-saving improvements in 2023, it’s time to set things in motion for next year’s taxes. To maximize benefits and minimize costly revisions, it’s important to make a plan. For instance, if your water heater is about to give out, replace it with one that qualifies for tax breaks this year and then replace your furnace or air conditioner the following year. Having a plan will also ensure that the electrical work you do, such as additional circuits and panel upgrades, will enable your future improvements. Finally, make sure to work with reputable contractors.

What is a tax deduction?

A tax deduction allows taxpayers to deduct some expenses from their taxable income, reducing their overall tax bill. Taxpayers can claim the IRS-determined standard tax deduction amount or they can choose to itemize their deductions.

Standard Deduction

A standard tax deduction is a set number that typically rises each year to adjust for inflation. All taxpayers are eligible for some standard income deductions.

Your filing status determines the amount of your standard tax deduction. In 2023, single and married taxpayers filing separately can claim a $13,850 standard deduction, while married couples filing jointly can claim double that number: $27,700.

Taxpayers who file as a “head of household” (unmarried individuals with dependents) can claim a standard deduction of $20,800.

2023 Marginal Income Tax Brackets

Your taxable income determines which federal tax bracket you fall into. There are seven brackets in total, each with its own marginal tax rate (the amount of additional tax paid for every additional dollar earned as income). Often these federal tax rates change year to year for inflation, and the beginning and ending dollar amounts can change as well.

Itemized Deductions

Itemized deductions are specific, tax-deductible expenses incurred by the taxpayer. Taxpayers typically itemize their deductions when their expenses exceed the amount of their standard deduction. Common itemized deductions include business expenses, charitable donations, state or local income taxes, medical or dental expenses above adjusted gross income limits, mortgage interest, and property taxes. Self-employment expenses and student loan interest payments can also be itemized. Itemized deductions are subtracted from your income, and what remains is then taxable.

Taxpayers who itemize their tax-deductible expenses can lower their tax bill by a greater amount than they would with the standard deduction. But after the 2017 Tax Cuts and Jobs Act increased standard deductions, fewer taxpayers found a benefit in itemizing. In 2017, roughly 30 percent of taxpayers itemized their deductions; in 2019, that figure fell to about 11 percent. That said, with the recent rise in mortgage rates, those who recently purchased a home may find it worthwhile to itemize. Here are some of the most common tax deductions that homeowners should be aware of:

• Discount points: With rising interest rates, you may have chosen to pay discount points to bring down the interest rate on a new or refinanced mortgage. These points are generally tax deductible, although the deduction may need to be spread out over the life of the loan. In some situations, though, these points can be deducted in the year they were paid. When in doubt, consult a tax professional.
• Property taxes: Property taxes vary from state to state. These state and local taxes are deductible, as are state income taxes and state and local sales tax. You can deduct only up to $10,000, though, for state and local taxes combined.
• Interest on home equity loans and lines of credit: The interest on HELOANS and HELOCS is tax deductible if you use that money to improve your home substantially. Home furnishings do not qualify.
• Medically necessary improvements: Capital improvements that are undertaken to accommodate a medical condition—for instance, the installation of ramps, stair lifts, and grab bars—are tax deductible. The IRS website offers a list of typical improvements.
• Home office expenses: If you are self-employed, you can deduct home office expenses as long as you use a dedicated office as your principal place of business.

Do you need a receipt for every itemized deduction?

In general, even if you don’t have a receipt, you should always have definitive proof of payment or other documentation.

For example, if you have a mortgage and you paid more than $600 in deductible interest during the year, your lender should send you Form 1098. But if there are delays getting the form from the lender, you can pull the info from your mortgage statement, which can serve as backup documentation.

Similarly, if you are funding a renovation, a contractor might not give you a receipt for each payment you give them, but your records of payment (either through an electronic transfer or cashed check record) can serve as receipts.

Tax credit vs. deduction: Which is more valuable?

Tax credits are generally more valuable than deductions because they reduce your tax liability on a dollar-for-dollar basis. For example, if you’re eligible for a $1,000 tax credit, you will pay $1,000 less in taxes. A tax deduction, on the other hand, simply reduces the amount of your taxable income. The amount of the tax reduction you receive will depend on your tax bracket. For example, if you fall into the 35 percent tax bracket, a $1,000 deduction will save you just $350 in taxes.

Do not, however, underestimate the power of tax deductions. They can be sizable, and they can add up. Especially with skyrocketing mortgage rates, being able to deduct the interest paid on a mortgage can amount to thousands of dollars in savings.