Tax Benefits of Homeownership – Three Reasons Its Over-rated

One of the most compelling reasons for owning a home is the heavily touted tax benefits of homeownership owing to deductions for mortgage interest and property taxes. Real estate agents will play this benefit for all it’s worth in extolling the idea of homeownership for all.

However for three reasons, this benefit is not what it used to be: a generous standard deduction, low mortgage rates and low marginal tax rates.

The tax benefit of homeownership became an entrenched concept back in the 1970s and early 1980s and at that time it had overwhelming merit. Mortgage rates were in double digits most of the time, marginal tax rates ran as high as 70% and standard deductions were down in the low thousands. Owning a home made major sense even for moderate income earners and was an article of faith in the higher income brackets.

Tax Benefits of Homeownership – Three Reasons Its Over-rated
Tax Benefits of Homeownership – Three Reasons Its Over-rated

None of that is true today, yet the tax savings pitch remains. Standard deductions can exceed $12,000, interest rates are down below 5% and marginal tax rates cap out at 39.6% (but are substantially lower for the vast majority of households). Yet the notion of major tax savings remains almost unchallenged.

The rules have changed

The tax code as it stands in 2013 is far more taxpayer friendly than it was back when tax benefits had become one of the holy grails of homeownership.

For 2013 the standard deduction is $12,200 for married filing jointly and $6,100 for single filers.

Marginal tax rates for 2013 are as follows:

Married filing jointly:
0 – 17,850 10%
17,851 – 72,500 15%
72,501 – 146,400 25%
146,401 – 223,050 28%
223,051 – 398,350 33%
398,351 – 450,000 35%
450,001 and up 39.6%

Single:
0 – 8,925 10%
8,926 – 36,250 15%
36,251 – 87,850 25%
87,851 – 183,250 28%
183,251 – 398,350 33%
398,351 – 400,000 35%
400,001 and up 39.6%

The personal exemption is $3,900 per person.

Note also, that the deductibility of tax sheltered retirement plans, health insurance premiums, qualified child care expenses and cafeteria benefit plans reduce pre-tax income and can keep a taxpayer in even lower marginal tax brackets. Every situation must be considered based on the facts of one’s own situation and never generalized!

A working example of the diminished tax benefit

A couple with two dependent children, earning $85,000 per year, is considering purchasing a home for $250,000. They have $50,000 for the down payment and plan to take a $200,000 fixed rate mortgage loan at 5% for the balance. First year interest on the loan will be $10,000 and real estate taxes will be $3,000, both of which are deductible for tax purposes. So far, so good.

But when they go to file their free tax filing of their income taxes after their first full year in the home, the tax benefit windfall they were expecting yields a stark disappointment.

Mortgage interest……………….$10,000
Real estate taxes…………………..3,000
State income taxes………………..5,000
Charitable deductions…………….2,000
Total itemized deductions……$20,000

Deducting $20,000 in itemized deductions and $15,600 in personal exemptions (4 X $3,900) yields a taxable gross income of $49,400, which puts the couple in the 15% marginal tax bracket.

$20,000 in itemized deductions looks pretty appealing at tax filing time, but remember, the IRS was giving this couple $12,200 without itemizing. The benefit of owning the home and itemizing will only apply to $7,800 in income (20,000 minus 12,200)!

At the 15% marginal tax rate, this translates into a net tax benefit of only $1,170 per year! That’s the equivalent of a $97.50 effective reduction in their monthly house payment.

A $200,000 30 year fixed rate loan at 5% interest will have a payment of $1074 per month. Adding $250 for real estate taxes ($3,000 divided by 12 months) and a $75 per month estimate for homeowners insurance gives a monthly payment on the home of $1,399. If we deduct the $97.50 per month tax benefit, that produces a net payment of $1,301.50.

Certainly this couple will appreciate the tax savings, but the following questions emerge:

  1. Will this tax benefit represent a major reason in favor of purchasing this home?
  2. Will the benefit outweigh the higher cost of maintenance that comes with owning a home versus renting?
  3. Will it offset the opportunity cost of having $50,000 tied up in a down payment rather than earning interest or investment income?

It gets even worse

If the size of that tax benefit seems surprisingly small, consider that as the loan balance declines, the amount of interest paid will decline in step, further eroding the tax advantage of the mortgage interest deduction.

In addition, since the federal tax code adjusts to ever-present inflation, standard deductions are increased over time, while tax bracket thresholds are increased, gradually reducing the tax benefit even more.

Even if there is a modest tax benefit to owning home in the first few years, it will gradually disappear the longer you’re in the home.

None of this is meant to minimize the potential tax savings from homeownership—a single person with a six figure income for example may realize a substantial advantage. However, the benefit of income tax reduction should be carefully examined by anyone wanting to purchase a home to determine if it’s even relevant in their specific circumstances. For many, many households—perhaps even for the majority—it won’t be.

Photo by Brad Montgomery

12 Responses to Tax Benefits of Homeownership – Three Reasons Its Over-rated

  1. I did the same calculations and came to the same conclusions. It’s a shame that people don’t go through the calculations to find out how much they are “saving”.

    But in our case, buying the 200k house in your calculation is comparable to renting in our area, the DC metro area, so excluding all the $$$ spent on repairs, remodeling, and other maintenance for homeownership, it’s about even to rent.

    Our plan is to pay down the mortgage faster in order to reduce interest (since there is minimal tax benefits) and own the house outright… which hopefully beats renting.

  2. Family Finance – Unfortunately, with all that’s written about the financial aspects of the home buying decision, for most people it’s ultimately an emotion driven decision. That being the case, there’s a tendancy to use financial “facts” as support for a decision that will be favorable anyway. Maybe this is the reason few people look too closely at common conventions without looking first to see if it even applies to them.

    Outstanding idea paying down the mortgage faster. If there’s little or no tax benefit to keeping the loan open, it becomes an ordinary debt, to be handled in the way you would any debt, which is to pay it off as soon as possible.

  3. Great analysis, Kevin. I wrote about the same thing a while back. Too many people think of owning a home as a great tax deduction, but they don’t net out the standard deduction. I think a lot of realtors use that fact to exaggerate the tax benefits of owning a home. If people did the math, they’d see that it’s usually not that great.

  4. Paul, like I wrote in the comment above, buying a home is mostly emotional. A “fact” will be used, often blindly, in support of that decision. It won’t be examined closely if it doesn’t support the desired outcome.

    We all have our “blinder places” in life, this one maybe one of the more obvious.

  5. I definitely concur with this article. My husband and I had our home built in 1993, and at the time we were told by our real estate agent that we would be able to deduct the interest and property taxes on our new home. At the time, that sounded like a nice added benifit of owning a home. Granted the excitment and thrill of having a new home built just the way you want it was what we were so focused on. Very emotional like the previous post says.
    As it turned out, never once were we able to deduct the interest and property taxes. Each and every year the standard deduction was always higher than our interest and property taxes. This was something that I always understood, because I personally do our taxes every year, but my husband had a hard time grasping the fact that we couldn’t deduct this from our taxes. I’d like to also mention that I’ve always completed our taxes honestly which is what is expected, however I know too many people that do not uphold to that. It’s a shame!
    Moving forward, this year, much to my surprise, in addition to the standard deduction for 2009, we can now deduct our property taxes as well (up to $800 for married filing jointly). So it’s been a long time coming, but finally some good changes for what it’s worth. I totally agree that making payments on your mortgage is truly the way to go, ours we’ll be paid off in 4 years, which will save us $1000’s of dollars.

    “An honest person ought not go down with a dishonest ship. But the responsibility of building and maintaining the lifeboat rests with the individual who expects to occupy it later”. Author Unknown

  6. Shari, the fact that your house will be paid off in four years is worth many years of tax deductions. You’ll no longer have a house payment, and you won’t need to be concerned about property values the way the indebted do.

    Too bad the author of that quote is unknown, it’s truly brilliant. Even if the ship does go down for reasons beyond our control, we’re still reponsible for us!

    Thanks for reading and thanks for sharing your thoughts.

  7. I have a rough draft on this topic as well.
    You really nailed it, I like when authors run the numbers instead of talking in vague generalities.
    For better or worse, my property tax exceeds my standard deduction. So I think of my 5% mortgage as costing 3.6%. Nonetheless, I plan to pay it in full before the kids goes to college in 7 years.
    At that point, I’ll likely use to maximize the deductions over time.

    Note to Shari’s Realtor – CFPs don’t sell real estate, you should not be offering tax advice. (Not that you’d ever be reading this.)

  8. Joe – The mortgage interest and property tax deductions were put in place for people like you! Since your property taxes exceed the standard deduction, everything else you have is deductible, which is not a bad deal. In high cost areas like the Northeast and the West Coast, there’s far greater incentive to own. The tax code makes it almost the choice by default.

  9. In your example above it seems like your saying owning a house is only marginally ($107/ month in your ex.) better than renting? What i didn’t see you mention was how much of that $1399 in mortgage is different in a $1399 rent… difference being how much went to equity. In 20 years of owning vs renting you are actually building equity, and yes your tax deductions will get less as your interest piece is lower but you are still paying the same $1399 which means a bigger percentage of your pmt is going towards equity rather than a bank. I think there are definite ways to rationalize renting, no maintenance, no down payment, marginal benefit in taxes and ussually the ppl who are rationalize / beleive you are not in a financial position to own a house anyways but real estate will continue to be one of the most fiscally rewarding investments you can make and important in building true net worth….You don’t see too many rich ppl renting, instead they own and rent to the poor / debt ridden ppl who believe renting is better

  10. J–You’re taking the discussion beyond the topic of the post, which is centered on the tax benefit of homeownership. And it is overrated for all of the reasons presented in the post, at least for the majority of people. Tax benefits are hyped as a central reason for buying a house, but with the reduction in both tax rates and interest rates, that advantage has declined substantially over the years. A home buyer needs to know that there may be no tax windfall and buy accordingly. A lot of them are banking on that windfall as it’s promoted by the real estate community and many “experts” who over generalize.

    As to the increasing equity situation, you’re correct. But as the loan balance reduces and the principal portion of the house payment increases, the tax benefit will decline even more.

    As to rich people owning and not renting, that’s categorically true. But because they’re in higher tax brackets and buying more expensive homes they’re the ones who ARE getting the tax benefit and it makes perfect sense. When ever you write a post, you write to a general audience, but there will always be exceptions. I hope this all makes sense…

  11. “gives a monthly payment on the home of $1,399. If we deduct the $97.50 per month tax benefit, that produces a net payment of $1,201.50.”

    Shouldn’t the final number there be $1,301.50?

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