Calculating The Mortgage Tax Break

Mortgage Interest Deduction Calculation For Itemized Tax Returns

The newest tax break is a $8,000 credit for first time home buyers, passed in 2009, to replace the $7,500 credit from 2008. The credit in 2008 was in the form of a no interest loan that was paid back by the taxpayer on their tax filing at $500 a year for the next 15 years. According to what I've read in the paper new $8,000 credit (originally a $15,000 tax credit was proposed) is literally a gift, does not have to be paid back, and anybody can get it. The only limitations seem to be that it has to be for your primary residence, and the tax credit may be limited to 10% of the purchase price, so that you can't buy a $20,000 house in a depressed area and get a $8,000 credit, but it remain fuzzy. I think they have proposed a pahse out with income, started around $80,000, but wasn't set in stone. Also, starting in 2011, taxpayers who currently pay at the 33% or 35% rate will now have the value of their mortgage deduction capped at 28%, but all of this is pending the passing of the 2009 budget just released by President Obama. See also my new article about determining how much house you can afford.

One of the most abused arguments in discussions over whether to rent or buy a home is the mortgage tax break. Realtors like throwing it out there like an assumed, parents tell their children that it made the country great, but there are a number of catches. As with all tax deductions, as opposed to credits, the "savings" are a percentage of money you are spending. No spending, no savings. In the case of the tax break for home buyers, the deduction amount is equal to the interest you are paying on your mortgage, up to a certain amount. Since most of us don't have the cash to buy a house outright and will end up with a mortgage, being able to deduct the interest sounds almost like free money. But there are two very big reasons it's not as simple as it sounds. The first is that you're forced to itemize rather than taking the standard deduction, and the second is that ultimate savings are dependent on your tax bracket, so if you aren't earning a lot of money, you can't save a lot of money. The IRS does allow a special mortgage interest deduction for a home office, and that deduction is worth much more since it comes off your Schedule C gross business income.

The standard deduction in 2007 is $5,350 for single filers, $7,850 for head of household, and $10,700 for married filers. The standard deduction is the "freebie" that all taxpayers can take without itemizing deductions. If you choose to itemize, as you must if you want to get the mortgage interest deduction, you can't take the standard deduction. Itemized deductions, including mortgage interest, are taken on Schedule A. The total amount of deductions allowed can be limited by your income if you earned more than $150,500, or $75,250 (if married and filing separately). The details are all explained in IRS Publication 936, but the catch is a simple one. If your mortgage interest deduction and all your other Schedule A deductions (primarily state income tax, local taxes, auto excise tax and charity for most filers) is less than your standard deduction, you'd lose money if you itemized. Medical and dental expenses can't be taken unless they exceed 7.5% of your AGI (Adjusted Gross Income). The mortgage interest and any fees you can deduct (such as closing points) should be sent to you by the lender on a Form 1098 every year.

In most cases, at least during the early years of your mortgage when most of your payment is being applied to the interest, it probably will pay to itemize. But the question we're trying to determine here is how the mortgage tax break changes your cost of ownership. I went over how to calculate mortgage payments and interest already, so lets pull some arbitrary numbers out of the hat (and make sure you see the lower example for a 4% mortgage). Let's say you're in the early years of paying down a $150,000 mortgage, 30 year term, 6.5% interest. The monthly payment is $948.10, so in the first few years of the mortgage, you're paying about $10,000 a year in interest. Lets also say your property tax is $2,000 a year, you gave $1000 to charity and paid another $2000 in other deductible taxes. How much have you increased your tax deduction by buying a house rather than renting? Well, there's the $10,000 in interest, plus the $1000 you gave to charity and the $2000 you spent on excise tax, state tax, whatever tax. I'm also giving you credit for the $2,000 you're paying in property tax, but keep in mind that if you were renting, you wouldn't be paying property tax. That's a unique privilege of ownership. So you have $15,000 in Schedule A deductions, versus the $5,350 you could have taken as the standard deduction for a single filer or the $10,7000 if filing as a married couple. In the single case, itemizing and taking the mortgage interest deduction has allowed you to reduce your taxable income by about $10,000, in the married case, you've been able to reduce your taxable income by about $5,000. In any case, you need to calculate how much mortgage interest you're paying each year or create an amortization table.

Now for the bad news. You haven't saved $5,000 or $10,000, you've only reduced your taxable income by that amount. This is where I mentioned you have to be paying a lot of taxes already in order to save a lot of money. It's the same issue that comes up with buying tax free municipal bonds. If you are earning less than $30,650 as a single filer after deductions or less than $61,300 as a married couple after deductions, the most those deductions are saving you on your taxes is 15%. Our single filer who grosses up to around $40,000 a year and took out a $150,000 mortgage is seeing a tax benefit of about $1,500/year, and our married couple who grosses up to about $70,000/year with the deductions above is saving just $750/year on taxes - 15% of the $5000 of additional deduction. In both cases, the $2000 of property tax more than cancels out the "savings." All things being equal, it would be cheaper AND more tax efficient to rent the same house for around $1,000 a month.

Note, if the government succeeds in pushing mortgage interest rates down to 4%, that greatly reduces the amount of interest you pay and means the mortgage tax deduction will only come into play for the most expensive houses purchased by high earners. For the $150,000 mortgage example above, if the mortgage rate was 4%, the monthly payment would be $716.12, and the interest portion in the early years would be around $6,000. A married couple would be better off taking the standard deduction unless they could find around another $5,000 in Schedule A deduction, a combination of state and local taxes and charity.For tithers (people paying a 10% tithe to their religious institutions) you might get there, or people in high property tax states like New Hampshire, but I'm guessing the majority of married folks with a mortgage on the median home value in the US will be better off taking the standard deduction. A single person would probably itemize for the first few years of home ownership and save a couple hundred dollars.

So who are the big winners in the mortgage deduction game, other than the realtors who talk buyers off the fence by painting a glowing picture of tax savings? High income individuals who give a lot of money to charity or pay a lot of local taxes are the main beneficiaries, especially if they have large mortgages on expensive properties. There are limits, but in the end, about half of home owning Americans don't itemize and take the mortgage deduction, either because they are in the later years of their mortgage where the interest portion is much smaller, or because the standard deduction proves to be larger than their itemized deductions. For most of those who do, the "savings" are relatively small. I wouldn't be a bit surprised if the average savings is less than the average property tax bill, which means no savings at all.

The government is now talking about a new sort of standard deduction for mortgage holders who don't itemize. The number I saw was $500. Talk about a way to lose a little tax revenue without actually helping anybody, it's the stupidest idea I've heard yet. What the government might do that would be useful and not hurt anybody is change penalty free IRA deduction for first time home buyers from $10,000, where it's languished forever, to $25,000. But the government isn't really interested in helping savers.