Buy a House for the Mortgage Tax Deduction? Not so Fast
At some point every single one of us has heard the advice, “Buy a home, so you can get the tax deduction.”
The reality is that this piece of advice being a financially smart move is not a universal truth. It’s anything but that.
Before I get into number crunching, I want to clarify the basics of what the mortgage tax deduction is and when you could claim it.
What is a Mortgage Tax Deduction?
When you get a mortgage, you are often paying insane amounts of interest in that mortgage, particularly in the beginning. Banks front load the mortgage with higher interest amounts in the beginning of the mortgage which taper off over the years. They do this so they can get more money out of each mortgage in the event the debtor were to pay off the loan early.
On the mortgages I’ve held, almost two-thirds of the total payment in the first 5 or more years of the loan were interest payments. The other third actually went to paying down the principal (what you actually owe) on the house. It’s highway robbery (but that’s a different story for a different day). Ask your bank for an amortization schedule if you want to see what you’d be paying in interest vs. principal.
There is also the difference between a tax credit and a tax deduction. A credit is getting the full dollar amount of taxes owed returned to you. A deduction is subtraction from your taxable income (what you actually end up being taxed on based on your tax bracket). Mortgage interest is tax deductible, not a tax credit.
To sum it up, a mortgage tax deduction is the amount of interest you pay on your mortgage, which you then can deduct from your taxable income total.
The Standard Deduction
It’s important to note that you can only claim the mortgage tax deduction if you itemize your taxes (in reality, only about 35% of taxpayers do). If you’re like the other 65% of the population that claims the standard deduction, you cannot additionally claim the mortgage tax deduction. In some cases, you’ll actually be able to pay less in taxes if you opt for the standard deduction.
The 2012 standard deductions are as follows:
- $5,950 for single filers & married filing separately (up from $5,800)
- $11,900 for married filers (up from $11,600)
- $8,700 for head of household (up from $8,500)
- $950 for dependents (same as 2011)
The standard tax deduction changes annually usually and is based on inflation. So while it will generally go up over the years, your itemized tax deduction will decline as your interest payments on your mortgage do too.
Running the Numbers on the Mortgage Tax Deduction Benefit
Let’s take a hypothetical situation to crunch some numbers. We’ll assume:
- You take out a $200K mortgage @ 4.5% interest over 30 years.
- In your first full year, you’d be paying about $8,873 in interest and $3,287 in principal.
- You have property taxes of $3,000 per year.
- You’re married.
Your two biggest itemized deductions would likely be your mortgage interest and your property taxes. This would equate to a total deduction of $11,873. If you had no other deductions, you’d only gain a total of $273 in tax deductions. If you were in the 15% tax bracket, this would equate to a whopping annual tax savings equal to $41 (15% x $273).
In the process, you’ve paid $11,873 (mortgage interest + property taxes) that you’ll never get back to get that $41 in tax deductions.
Still think your buddy’s advice is so great?
This is just one scenario – your benefit may vary dramatically. It does highlight the importance of running the numbers for your own situation before buying a home. You may find that unless you buy a very pricey home, the tax benefit for you is going to be minimal, potentially even negative compared to the standard deduction.
There has even been discussion of the mortgage tax deduction being eliminated. Imagine buying a home under the guise of huge tax savings only to the deduction be wiped out by legislators in desperate need of generating new revenue.
What Should you Consider When Buying a Home?
There are some other things that I would recommend considering above any tax deduction benefit possibilities. They include:
- How long do you plan on staying in the home? If less than 5 years, it probably doesn’t make sense. Don’t forget that there are closing costs and realtor fees involved in buying and selling a home. And houses are not easy to sell in this market, so it may just sit there as a burden.
- Are you ready to make that kind of expense commitment? It will create a lack of freedom to invest that money elsewhere.
- What does the mortage-rent ratio look like in the area you are living or moving to? Some places offering a compelling reason to buy. Others are very risky.
- Do you need a home to live the lifestyle you feel like you need to live?
I’m a happy homeowner myself, but buying a home is not a decision that should be based off of generalized advice that might actually be wrong.
Mortgage Deduction Discussion:
- Have you heard the advice of buying a home for the mortgage tax deduction?
- Have you bought a home based on this advice?
- What factors would you recommend when considering whether to buy a home?