Calculation of mortgage interest tax deduction

Calculation of the mortgage interest tax deduction

The mortgage interest tax deduction is one of the most valued U.S. tax breaks. Land brokers, homeowners, would-be homeowners and even tax accountants would market their value. In truth, the myth is often better than the reality.

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Many homeowners get nothing

According to data compiled by the President's Advisory Committee on Tax Reform 2005, only 54% of taxpayers who pay interest on their mortgages receive a tax benefit. This leaves a hefty 46% of homeowners paying interest but receiving no benefit at all. Even those who receive a benefit are likely to receive far less than they expect.

Mortgage interest deduction is perhaps the most misunderstood aspect of homeownership. It has almost mythical status to the point where many would-be homeowners are sold on the benefits before even considering the underlying math to determine their eligibility. Underlying the myth are two primary misconceptions. The first is the misguided idea that every homeowner gets a tax break. The second is that every dollar paid in mortgage interest results in a dollar-for-dollar reduction in income tax liability. (If you are a homeowner, this is a point you will want to understand and use on your return. See tax deductions for mortgage interest .)

Misconception 1

Despite the pre-sale hype, there are a significant number of homeowners who receive no tax benefit at all from the mortgage interest tax deduction. Remember, to even qualify for the deduction, homeowners must itemize their deductions when determining their income tax liability. Itemization provides an opportunity to account for specific expenses, including mortgage interest, property taxes and medical expenses. Since mortgage interest is often a taxpayer's largest expense, deducting it is often cited as a financial incentive to buy a home.

Although it is an attractive theoretical idea, the fact is that itemizing does not make sense for everyone. First, the standard deduction amount is based on your tax filing status. Using 2011 data as an example, taxpayers who are single or married but filing separately, the standard deduction is $5.800. For heads of households, it is $8.500, and for married couples filing joint returns, the standard deduction is $ 11. , 600.

Taxpayers who do not have deductions that exceed the standard deduction amounts cannot itemize their deductions. Taxpayers who do not have enough deductions to qualify for itemization receive no benefit from paying interest on their mortgages. Don't forget – nearly half of all homeowners with mortgages fall into this category.

Misconception 2

Even for homeowners who itemize their taxes and qualify for the mortgage interest tax deduction, the amount of the deduction is only a fraction of the amount of interest paid on the mortgage. Once again, a little number crunching is required to fully understand the situation because the deduction is not a tax credit – you don't get a $1 tax benefit for every dollar spent; you get pennies on the dollar. Unlike a credit, which provides a dollar-for-dollar reduction for the actual taxes owed, the mortgage interest deduction reduces the amount of taxable income based on the taxpayer's tax bracket. (From community-based services to free software, there are many free resources to help you with your taxes. Read 6 sources of free tax help .) A taxpayer pays 12.000 dollars for mortgages. Interest and taxes paid at an individual income tax rate of 35% would be allowed, 12.To exclude $ 000 from income tax liability, resulting in a savings of $ 4, 200. For example, the homeowner paid $12.000 to the bank in interest to get one-third of this amount excluded from taxation.

Mathematically, it does not make sense to spend $12, 000 to reduce the amount by which you pay taxes by $4, 200. Even worse, an honest assessment of actual savings should rule out the value of the standard deduction. The following table provides a comparison.

Mortgage deduction at $12.000 in interest

Between standard deduction and mortgage deduction

Using our $12 example.000 mortgage interest, A married couple in the 35% tax bracket would receive a standard deduction of $11, 600, which is worth $4, 060 in reduced tax payments. If the couple itemized their deductions on Schedule A, the mortgage deduction would be $4,200. Even without a mortgage interest deduction, taxpayers would receive the standard deduction amount. The difference between the two – the added value from paying $12, 000 real dollars to the bank in mortgage interest – is $140. (If you don't take the standard deduction this year, you could save hundreds of dollars. For more information, see An overview of itemized deductions .)

Taxpayers in lower tax brackets receive an even smaller benefit. A taxpayer who spends $12, 000 on mortgage interest and pays taxes at an individual income tax rate of 25% would only receive a tax deduction of $3, 000. The "benefit" of the mortgage interest deduction is shown in the table below.

Mortgage deduction at $12.000 in interest

Between standard deduction and mortgage deduction

Putting the numbers in a broader context, The Tax Policy Centre reports, "The average value of the MID (mortgage interest deduction) rises steadily with incomes of $91, for those with annual incomes of less than 40.000 $ to $ 459, for those who owe more than 250.Make $ 000."The data show that a tax deduction ostensibly used to encourage home purchases does not encourage individuals to switch between renting and owning. Instead, it will be used most by taxpayers, who tend to be higher-income households. Read more about the differences in tax ideology between political parties and how they can affect your paycheck. Parties on taxes: Republicans vs. Democrats .

A Better Way

Instead of spending large sums of money on interest for little money back, you will be much better off paying cash for your new home.A cash purchase will save you tens of thousands of dollars because you won't be paying interest. (This can be the biggest debt you I'll ever explain to you why you should pull it back sooner rather than later, in Paying your mortgage .

Of course, there's always the argument that you could make more money paying interest and investing. The rest of your money in the stock market. It seems like a great strategy when the market is going up, but forecasters who give this advice are nowhere to be seen when the stock market is down 40%, home values are down 40%, and their investment advice owes homeowners more through their mortgages than the home is worth.

As there are no investments that guarantee better returns than the amount you would save by avoiding interest payments, the conservative choice is clear. Avoid paying interest if you can. Pay for the house quickly if you can't.