Last year, my sister bought her first house. It was very exciting for her and she had been saving her money for a long time. For most new home buyers, one of the many attractions of home ownership is the tax deduction for the mortgage interest paid. My sister was looking forward to saving a little taxes while enjoying her own home.
When I did her taxes in April, she was very surprised to discover that her new home wasn’t going to save her much in the tax department. How can that be? I actually had to think for a moment before explained the answer because even though the answer is very simple, it flies in the face of the home interest deduction hype and that makes it seem confusing even when it is not. The tax savings from the mortgage interest is only based upon the additional amount that the itemized deductions exceed the standard deduction.
Looking at taxes on the simplest level, there are just a few steps. First, you figure your income, then subtract the deductions (either standard or itemized), subtract the exemptions, and calculate your taxable income. From your taxable income, you calculate your tax liability. After adding and subtracting all sorts of credits, withholding, and other stuff, you determine whether you withheld too much or too little during the year. Any tax refund or taxes owed represents the amount of your tax liability versus your contributions toward that tax liability.
The home mortgage interest deduction falls into the category of an itemized deduction. Itemized deductions are used when you calculate that the value of all your itemized deductions is more than the standard deduction for your filing status. The home mortgage interest deduction is only of value if it pushes your itemized deductions to be higher than you would receive using the standard deduction.
For 2009, the standard deductions were:
- Single or married filing separately: $5,700
- Married or qualifying widow/widower: $11,400
- Head of Household: $8,350
There aren’t many things that go into the itemized deduction, so it can be hard to rack up enough total deduction to beat the standard deduction unless you live in an area where housing prices are high and you have a large mortgage. The itemized deduction includes:
- Medical and dental expenses that exceed 7.5% of your income.
- Taxes, including state and local income taxes OR general sales tax deduction, real estate taxes, and a few other specific taxes.
- Interest paid for homeownership purposes, including mortgage interest, points paid, and qualifying mortgage insurance premiums.
- Gifts to charity.
- Losses due to casualty or theft.
- Job expenses that exceed 2% of your income.
It might seem like it is pretty easy to exceed the standard deduction. Sometimes it is (we live outside of DC, we pay a TON of mortgage interest) but often times it is not. My sister, for example, lives in Texas and houses are pretty inexpensive there. Her mortgage is small and as a result, she doesn’t pay much mortgage interest.
For most people with anywhere near an average mortgage, their total itemized deductions will exceed the standard deduction. For example, if you have $12,000 worth of mortgage interest, plus other itemized deductions adding up to a total of $15,400, and you are married, then the mortgage interest bonus is really only the $4,000 amount that your itemized deductions exceed the regular standard deduction of $11,400. If you are in the 25% tax bracket, you will save $1,000 on your taxes. The confusion comes in when people are quickly calculating the tax savings of buying a house and erroneously think that they are going to save the taxes on the entire amount of their itemized deduction, and calculate 25% of the entire $15,400, coming up with $3,850 in tax savings. That is a difference of $2,850!
None of this is to say that you should or should not buy a house, and certain the home mortgage interest deduction is a bonus if you do decide to buy. However, don’t do your budget based on erroneous math. I know when we bought our first house, a difference of $2,850 per year would have made a huge difference in our budget. If you are counting on the home mortgage interest deduction to make your budget balance, make sure you are figuring it correctly!