Imagine this all too familiar scenario. A young couple just a few years out of college are living in a small apartment. It’s not the fanciest place, but it’s nice enough to have guests over and they’re comfortable living there. It’s in a nice and clean building with front door security. And if anything goes wrong maintenance wise, they can call on their trusted landlord to fix it up in a day or two. But after a few years they start to get the “itch”. They visit a couple of friends who recently got a nice house and it seems that more and more of their peers are buying houses or hunting for them. It hasn’t really crossed their minds but the latest advice from a well meaning (but uninformed) friend puts them in the hunt: “You need to buy a house because you get a great deduction on your taxes.”
The couple discuss this and decide it is time to buy. It’s just the “right” American thing to do. And besides, they’ll be saving so much money on taxes right? The hunt begins, and they soon find a nice house not too far from where they both work. They put in an offer and it’s accepted! Because they’ve been working for a few years they were able to save up a 20% down payment on their home. The monthly mortgage payment isn’t much more than their rent was, but with the awesome tax savings that they’ll receive, they will be so far ahead! They move in, figure out how they want to decorate and they both live happily ever after.
Right? That is, until they do their taxes and find out the awesome tax deduction isn’t as awesome as they’d thought. If only they did a little research into the tax implications of the mortgage interest deduction, maybe they would need a more compelling reason to buy a home. This happens all too often, and many well intentioned people are singing the praises of the home interest deduction without even knowing if it applies. The issue at heart here is the misunderstanding (or ignorance) between taking the standard deduction or deciding to itemize deductions.
When you prepare your taxes, you have a choice to either take the standard deduction or to itemize your deductions (or neither if you’re a dummy). When you take the standard deduction, you have your taxable income lowered by a predetermined value set by the almighty IRS. This is a deduction that everyone gets just for being a US citizen. See, the IRS ain’t all that bad. For tax year 2013, the standard deduction for a married couple filing their taxes jointly was $12,200. That means even if this couple didn’t have any specific deductions to make that year, they would get a $12,200 deduction on their taxable income just for filing their taxes. Not bad.
If you decide to itemize your deductions, you have to calculate how much those eligible deductions add up to. If it is more than the standard deduction amount, then you should go ahead and itemize. Eligible deductions include state taxes, real estate taxes, charitable contributions and, the holy grail, mortgage interest deduction (Here’s a more official list). If the combination of all of these deductions is more than the standard deduction amount, then you should go ahead and itemize.
So what happened to our happy home buying couple? When they were living in their cozy apartment, they didn’t even get close to being able to itemize so they got the standard deduction every year. Now that they own a home and can add the mortgage interest and real estate taxes to the mix, their itemized deductions amounted to $13,000. They definitely should itemize their deductions but the difference in their deduction is only $800 more than if they took the standard deduction. So their taxes aren’t reduced by much at all.
Another thing to remember which most people surprisingly don’t get is that a deduction doesn’t reduce your taxes directly but only your taxable income. If you’re in the 15% tax bracket, that means a $10,000 mortgage interest deduction will save you $1,500 (10,000 x 15%) on your taxes and not reduce it by $10,000 directly. So in the case of our couple, that $800 extra they could deduct because of mortgage interest only saved them $120 (800 x 15%) on their taxes as opposed to taking the standard deduction. You could save more by going to Starbucks four days a week instead of five. So if our couple knew these facts beforehand, they might not have gotten a house so soon. Or they still might have because there are a lot of reasons to buy a house. But doing it solely because of the mortgage interest deduction shouldn’t be one of them.
The US tax code is very complex but it pays (literally) to know some of its intricacies. That’s because it is a tax code that rewards certain behaviors and punishes others. For example, if you withdraw money too early from your 401k, you’re going to be hit with a penalty. This is presumably to prevent people from raiding their retirement accounts and putting their future at risk. If you pay student loan interest, you are rewarded by being able to deduct some of it from your income. This is presumably because the government likes when citizens get educated (not so sure about this one).
What about itemizing your deductions and, specifically, the mortgage interest deduction? It seems to favor those in higher tax brackets who have bigger mortgages, unlike our couple who was in a lower tax bracket and had a modest amount of mortgage interest. So is the government promoting high rollers to buy big houses? Maybe. But it is important to know what rules favor what type of behavior so you can pay the least taxes (legally) possible. This deserves a whole series of posts in itself, so look for that sometime in the future.
Has the mortgage interest deduction been a big help for you or not so much? Comment below and join the discussion.