At some point every single one of us has heard the advice, “Buy a home, so you can get the tax deduction”. The popularity of this advice ranks right up there with the “Buy a home, it’s a good investment” meme. In fact, many people argue that a home is a good investment precisely because of the mortgage tax deduction possibilities.
But as we discovered, your home is not an investment (at least not a good one).
Will the mortgage tax deduction advice hold up under closer inspection?
Before I give you some examples, I want to first clarify the basics on 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. 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 goes 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). If you ever want to self induce vomiting, look at a mortgage amortization schedule, which will show you how much of your monthly payment is interest vs principal for each month of the loan.
You must also understand 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.
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 absolutely essential 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 taxpaying population that claims the standard deduction, you cannot also add on the mortgage tax deduction. So right there, 65% of the population will not (or is not benefiting) from mortgage tax deductions.
How much is the standard deduction you will have to surpass to make it worth it?
The 2016 standard deductions are as follows:
- $6,300 for single filers
- $6,300 for married, filing separately
- $12,600 for married filing jointly
- $9,300 for head of household
- $1,050 for dependents
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 actually decline (all else being equal) 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, and eligible for a $12,600 standard deduction.
Your two big deductions are your mortgage interest and your property taxes. We’ll assume these are your only two, but individual situation may vary. In this example, this would equate to a total itemized deduction of $11,873. If you had no other deductions, you’d actually lose $727 in tax deduction benefits vs. a standard deduction.
Even if you took out a larger loan that cranked up your mortgage interest payments to $10,000 in the first year and you were in the 15% tax bracket, this would equate to a whopping annual tax savings equal to $60 (15% x $400).
In the process, you will have paid $13,000 (mortgage interest + property taxes) that you’ll never get back in order to get that $60 in extra tax savings!
And what if you have a smaller mortgage, lower property taxes, or a mortgage with lower interest rates than this? Your “benefit” is even less impressive – and might actually be far less than the standard deduction.
And the longer you pay off your mortgage, the less of your mortgage payment goes to interest – and the less you can deduct from your taxes. In other words, every passing year equates to a lower tax benefit.
This highlights 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.
The reality is that the tax advantages that come from a mortgage interest tax deduction are over-rated at best and can actually be non-existent for some home buyers.
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?