Why You Should Avoid the Mortgage Tax Deduction
Lin Ennis
January 10, 2008
The advice to buy a house and never pay it off because you need the tax deduction is financially deadly for most home buyers. The tax deduction might be worthwhile for 1-2%--the top earners in America and similarly income-tax-structured countries. But the average Jane and John Doe need cash far more than they need the tax deduction. Here’s why.
The Tax Savings Myth
The main problem with spending money in order to save money is that you always have to spend much more than you save. "Thank you for shopping at Safeway; you saved $22.14 today." Whenever you save double digit dollars shopping, you’ve spent triple digit dollars! You understand that, right?
Spending over $200 at the grocery store to save $30 is similar to deducting mortgage interest expense off your U.S. Federal Tax Return. You spend a dollar on your home to save 30 cents (or whatever tax bracket you’re in…28%, 30% 33%, 35%, 45%…) on the tax deduction.
It’s challenging for the average person to compute, because so many different taxes deducted from your payroll checks. The rate on the Internal Revenue Service charts is just federal tax, only a small part of overall taxation. All combined, as a general rule of thumb, most upwardly mobile or successful United States citizens are levied approximately 30 cents on the a dollar. In the case of tax deductions (an plan most savvy Americans pursue), for every tax-deductible dollar you spend, you can avoid approximately 30 cents in overall taxes.
Here’s an example. The Rodriguez family earns $100,000 a year. For federal tax alone, they’ll owe $18,330 (besides all the other taxes: state, county, etc.).
Let’s also say that their mortgage interest is $11,215. If they deduct the entire $11,215 interest from their $100,000 income, their taxable income is $81,670, not $100,000. Note, they deduct the interest off their taxable income, not off their owed taxes. That’s why the savings is not dollar-for-dollar.
The difference between the tax on $100,000 and the tax on $81,670 is about $3000. Therefore, the Rodriguezes will save $3000 on their taxes, not the entire $11,215 they paid in interest. Instead of paying $18,330 in federal income tax, they’ll pay $15,525.
To determine whether the Rodriguezes—or you—would be better off with a mortgage and mortgage interest tax deduction or no mortgage and no mortgage interest tax deduction, we have to look at a true measure of wealth: cashflow. Compare the results from the following tables.
Rodriguez -- Mortgage Holder Cashflow
Mortgage holders who earn $100,000.00
less mortgage payments of $12,069.36
less federal tax payment of $15,525.00
CASHFLOW $72,405.64
You – Smart Non-Mortgage Holders Cashflow
Cash homebuyers earn $100,000.00
less mortgage payments of -0-
less federal tax payment of $18,330.00
CASHFLOW $81,670.00
The family without a mortgage is $9,264.36 cash ahead of the Rodriguezes--people holding a mortgage in order to claim a tax deduction.
According to these numbers off the 2005 U.S. Internal Revenue Service Tax Rate Schedules, folks with the mortgage interest tax deduction reduce their tax bill by only 2.8% of their gross income ($2805) via deducting their home mortgage interest. (Other deductions and dependents could change their tax liability, but this is an analysis only of how a mortgage affects savings).
Conversely, the principle of “it’s better to pay cash for your home” does not always apply. If you have a very low interest rate on your home, and a high yield on some stable investments, it could be better to carry a home loan. It depends upon your yield—income minus outgo.
However, buying a home on long-term monthly payments just so you can get a tax deduction is, 98% of the time, the wrong reason to go into debt.
And if you’d like to know how to get yourself into the positive cashflow position of owning your home free and clear years sooner, try one or more of the early mortgage payoff strategies available today, such as the numerous ones outlined and compared in Let Your Mortgage Make You Rich.
The Tax Savings Myth
The main problem with spending money in order to save money is that you always have to spend much more than you save. "Thank you for shopping at Safeway; you saved $22.14 today." Whenever you save double digit dollars shopping, you’ve spent triple digit dollars! You understand that, right?
Spending over $200 at the grocery store to save $30 is similar to deducting mortgage interest expense off your U.S. Federal Tax Return. You spend a dollar on your home to save 30 cents (or whatever tax bracket you’re in…28%, 30% 33%, 35%, 45%…) on the tax deduction.
It’s challenging for the average person to compute, because so many different taxes deducted from your payroll checks. The rate on the Internal Revenue Service charts is just federal tax, only a small part of overall taxation. All combined, as a general rule of thumb, most upwardly mobile or successful United States citizens are levied approximately 30 cents on the a dollar. In the case of tax deductions (an plan most savvy Americans pursue), for every tax-deductible dollar you spend, you can avoid approximately 30 cents in overall taxes.
Here’s an example. The Rodriguez family earns $100,000 a year. For federal tax alone, they’ll owe $18,330 (besides all the other taxes: state, county, etc.).
Let’s also say that their mortgage interest is $11,215. If they deduct the entire $11,215 interest from their $100,000 income, their taxable income is $81,670, not $100,000. Note, they deduct the interest off their taxable income, not off their owed taxes. That’s why the savings is not dollar-for-dollar.
The difference between the tax on $100,000 and the tax on $81,670 is about $3000. Therefore, the Rodriguezes will save $3000 on their taxes, not the entire $11,215 they paid in interest. Instead of paying $18,330 in federal income tax, they’ll pay $15,525.
To determine whether the Rodriguezes—or you—would be better off with a mortgage and mortgage interest tax deduction or no mortgage and no mortgage interest tax deduction, we have to look at a true measure of wealth: cashflow. Compare the results from the following tables.
Rodriguez -- Mortgage Holder Cashflow
Mortgage holders who earn $100,000.00
less mortgage payments of $12,069.36
less federal tax payment of $15,525.00
CASHFLOW $72,405.64
You – Smart Non-Mortgage Holders Cashflow
Cash homebuyers earn $100,000.00
less mortgage payments of -0-
less federal tax payment of $18,330.00
CASHFLOW $81,670.00
The family without a mortgage is $9,264.36 cash ahead of the Rodriguezes--people holding a mortgage in order to claim a tax deduction.
According to these numbers off the 2005 U.S. Internal Revenue Service Tax Rate Schedules, folks with the mortgage interest tax deduction reduce their tax bill by only 2.8% of their gross income ($2805) via deducting their home mortgage interest. (Other deductions and dependents could change their tax liability, but this is an analysis only of how a mortgage affects savings).
Conversely, the principle of “it’s better to pay cash for your home” does not always apply. If you have a very low interest rate on your home, and a high yield on some stable investments, it could be better to carry a home loan. It depends upon your yield—income minus outgo.
However, buying a home on long-term monthly payments just so you can get a tax deduction is, 98% of the time, the wrong reason to go into debt.
And if you’d like to know how to get yourself into the positive cashflow position of owning your home free and clear years sooner, try one or more of the early mortgage payoff strategies available today, such as the numerous ones outlined and compared in Let Your Mortgage Make You Rich.
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