Tax Credits on Mortgage Loan - A Fairy Tale

We are hooked on to CNBC and read extensively on how to make a better return on the hard earned money. We know a company matched 401k is a no brainer and also tried our hands at stocks and options trading.   You get the picture. Most of us consider ourselves as savvy when it comes to finance and savings. However, when it comes to home ownership as a way to increase the net worth, our opinions are divided.

Some do extensive spreadsheet analysis on renting vs owning a home and almost always come out with a decision that renting is better. There are a lot of details spread throughout the sheet with cost side outweighing the numerical benefits.  Interest expenses, property taxes, maintenance, furnishing and even the added cost of transportation from the new location to office and opportunity cost of down payment are all neatly figured out.  Others are skeptical about this number juggling as it understates the appreciation potential,  tax benefits and the sheer happiness of owning a home.  Also, they are inclined to believe the gurus who recommended for decades that home buying is the way to create wealth. It’s not clear the recent mortgage meltdown proved the opinion wrong as we still hear them from our blaring TV shows. My intention here is to call out just one situation that’s often missed out in this analysis paralysis.

The idea of deducting a huge sum from taxes is, without doubt, the most appealing proposition to the new home investors. Almost 70% of your mortgage payments in the first full year are interest payments and property taxes and they are tax deductible. This is a fact and I will explain in a bit why it is deceiving a statement to many.

Let us do some simple math for a $500,000, 30 yr, 4% mortgage with a 20% down payment. Assuming you are living in California, you could deduct approximately $15,000 in interest payments and about $6,000 in property taxes. A total of $21,000 is qualified as a tax deductible in the first year. Say you have earned $150,000 and that means your taxable income is now drops to 129,000 when you itemize your expenses.   Typically someone in this tax bracket would end-up paying 15% taxes so a quick estimate is that you saved at least $3,150 (15% of 21K) with your decision of buying a home. When you do the tax preperations, soon you realize that you did not save $3,150 because when you itemize, the standard deduction that was applicable to you earlier was lost.  Let us assume that you are eligible for a standard deduction of $12,000 (married filing jointly), your benefit from itemization is only $9,000 not $21,000. So this means you get a tax credit of only $1,350 not $3,150. Further, you could now itemize state tax and vehicle registration fees, say another $6000.  So that will jack up your tax credits by another $900 or a total $2250. So question is for a $190 per month benefit, will you sign-up to be a homeowner in these uncertain times?

Adds to the grievance is that size of an average  mortgage is less than $500,000 and interest rates are at historic lows making the tax credits to drop even more. So the argument “You get a tax benefit close to the property tax you pay” is simply wrong when you take in to account the standard deduction you enjoyed in the past.   Personal situation can vary as a million dollar jumbo home loan or 5% down payment or a 35% tax bracket could produce a different number but that’s not common.

Let me call this tax break a fairy tale but at the same time, let us pursue the American dream. A place of our own brings a lot into our life that a spreadsheet seldom captures.