Buying a home is one of the most exciting, albeit stressful experiences in your life. If you plan on taking out a loan to pay for your home, you will most likely be required to establish an escrow account. What is an escrow account, and how will it affect your tax return?

The Basics of Escrow

Most homebuyers do not pay cash for the full amount of their new home, choosing instead to finance a large portion of the cost through a lender. If you take this route, you are held accountable for any interest and the principal on the mortgage payment you make each month. On top of this, you must also pay a portion of your property taxes for that year as well as a portion of your homeowner’s insurance premiums. Standard practice is to divide the total amount owed into equal monthly payments. However, the amount may fluctuate by year. This is achieved by means of an escrow account.

Required Contributions to Escrow Accounts

It is possible that your lender may not require an escrow account as part of their agreement to finance the home purchase. However, the vast majority of lender do use this practice. Each lender will have their own unique terms, but they are limited in part by federal laws designed to protect homebuyers from prohibitive minimum escrow payments. It is legal for lenders to gradually increase the minimum contributions, as this offers a sort of guarantee that you, the homeowner, are able to cover your tax payments and insurance expenses as needed.

Even if your lender does not require you to set up an escrow account, Doing so can actually work in your favor. This is especially true if you are worried that you might forget to make a payment, or if you have concerns that you might not remember to keep sufficient money on hand to make these payments—late or skipped payments can carry a hefty fee.

Filing Taxes and Reporting Escrow Accounts

By putting funds in your escrow account, you are setting it aside to pay property taxes, among other things. You might remember that you can deduct property taxes when you file your return. However, you may deduct them only if they came directly from the escrow account. This is because your lender has paid the property taxes in accordance with the requirements of the regulatory agency. You cannot deduct funds that were placed in your escrow account. If you receive a surplus check, this will not affect the amount of property taxes that can be deducted.

When Excess Funds Are Available

Once the real estate tax expenses and mortgage insurance payments have been taken from your escrow account, it is possible that you will have some money left over. If so, you can expect a check from your lender in the amount of the surplus. This is not. It is money that has always been yours. Therefore, it is not accurate to say that this surplus amount is any form of income. As such, you need not include it on your income tax return. By the way, you might think about taking your surplus funds and putting them toward your principal. You could end up saving yourself quite a bit of interest expense in the long run.

About Your Bellingham Tax Accountant

Questions about property taxes and escrow in Bellingham, MA? To learn more about tax returns, escrow accounts, and accounting services, or to schedule a meeting with Ann Irons, CPA, LLC, contact us at (508) 966-0700. We welcome individuals, businesses, and foreign investors in Holliston, Bellingham, Woonsocket, Medway, Milford, Worcester, and the surrounding areas.