Renting has been compared to throwing money away. Homeowners can build equity and in the United States, can deduct home mortgage interest off their income taxes.
The Internal Revenue Service allows taxpayers to deduct mortgage interest from adjusted gross income (AGI) on Schedule A. The deduction is limited by the actual amount paid and AGI.
The tax savings may be beneficial, but the way taxes are calculated can reduce the positive impacts.
The Standard Deduction versus Itemized Deductions
One of the key calculations relates to the Standard Deduction. The Standard Deduction is an amount that any taxpayer can subtract from AGI in order to arrive at Taxable Income, without itemizing deductions.
For instance, the Standard Deduction for 2008 returns was $5,450 for single taxpayers and those married filing separately. If Adjusted Gross Income was $56,450, a taxpayer taking the standard deduction would have Taxable Income of $51,000.
However, taxpayers are allowed to take the greater of itemized deductions or the standard Deduction. Itemized deductions are computed on Schedule A and include home mortgage interest, real estate taxes and medical expenses over 7.5% of AGI, as well as other deductions.
Example of Deductions from Taxable Income
For example, itemized deductions on Schedule A may be:
State Taxes - $2,000
Real Estate Taxes - $1,000
Home Mortgage Interest - $2,500
Charitable Contributions - $500
Total $6,000
The taxpayer above would be able to deduct the itemized amount of $6,000. This is an increase of only $550 over the amount they could deduct without the home deductions.
The tax savings are only $550, which is multiplied times the tax rate, which may be 28%. $3,500 in home taxes and interest result in a savings of income taxes of only $154.
For these set of circumstances, it can be seen that there is a very small amount of tax savings generated by the home mortgage interest and tax expense.
Positives of Home Ownership
Tax savings are likely to be greater in the first few years of a mortgage, because as the loan is amortized, interest is higher and principal payments are lower then. As more of the principal is paid off, interest, and the corresponding tax savings, are decreased.
There are other reasons for buying a home rather than renting, including the gain in equity from paying principal, and the possibility of appreciation. The mortgage payments can be fixed, as opposed to rent, which can be increased by the landlord (although real estate taxes are subject to increase).
People considering buying a home should take these factors in account and not just assume that buying will generate substantial tax savings. Each person’s situation will be different, and some may find that renting is a better financial choice.
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