Sunday, September 30, 2007

Home Mortgage Tax Deduction Snake Oil: Housing Myths Part 7

Previous: Hidden Burden of Overbuying: Housing Myths Part 6

The Home Mortgage Income Tax Deduction NEVER Saved ANYone ANY Money

Taking the Mortgage Deduction Always LOSES You Money

Mortgage Tax "Savings" Are Always Losses

Taxes are losses. "Tax savings" are NOT real savings. Tax reductions reduce tax losses of your initial "pile" of income from, say, negative 10% to negative 9%--but still negative (still a loss). In most tax cases, the best you can do is break even by keeping what you started with (0% loss). There is almost never a chance of real gain or real savings.

The mortgage-interest tax deduction is worse than many tax deductions.

Mortgage-interest "tax savings" are NOT savings. Mortgage-interest "tax savings" are losses because you pay more to qualify for the "benefit" than you get in return. The economic illogic is stark. Would you start a business to make a widget that costs you $10 to make and sell it at $1? Would you borrow money at 10% interest to put it in a bank account that earns 1%? The simplest example of the mortgage-interest tax deduction is that you must pay $10 to "earn" $1 (at a 10% marginal tax rate) for a net loss of $9.

That is a return on investment (ROI) of negative 90%, a 90% loss. A 25% tax rate would return a loss of negative 75% ROI. Does working to "get" or "keep my mortgage deduction" sound like the road to wealth?

Even the "net loss of $9"/"90% loss" way of thinking is too optimistic (for the following reasons):

The standard deduction makes a mortgage an even worse deal.

Tax Deduction Cancellations: The government giveth with one hand and taketh with another.

Assuming for a moment that mortgage interest is the only itemized deduction:

  • A 2006 single person could pay $5,150 in mortgage interest and not save a single penny in income tax.
  • A 2006 married couple could pay $10,300 in mortgage interest and not save a single penny in income tax.

Everyone gets these $5k-$10k tax-deduction amounts regardless of housing situation.

  • A couple who paid $10,300 rent gets a $10,300 tax deduction (standard deduction) without having to pay a penny of interest.
  • A couple who paid cash for a house gets a $10,300 tax deduction (standard deduction) without having to pay a penny of interest.
Update 5/6/09: The new 2008 IRS property tax deduction without itemizing means that a couple under 65 years old gets a $12k standard deduction and a senior-citizen couple age 65 or older gets a $14k standard deduction.
"Estimates suggest that approximately 40% of homeowners do not itemize" (Congressman Baron Hill D-IN).
The mortgage holder can deduct mortgage interest instead of taking the standard deduction. A mortgage holder only gets an extra discount on the extra marginal amount of itemizations that exceed the standard deduction.

(The total itemized amount can include other items such as property tax but I will refer only to mortgage interest for simplicity. If a couple already has $10k of itemizable spending even without a mortgage, that level of spending might explain the lack of savings--and perhaps a reduction of spending would help more than the addition of debt.)

The mortgage-interest tax-deduction effective rate is NOT your top marginal tax rate.

The effective rate accounts for the trade-off of losing the standard deduction to take the itemized mortgage deduction instead.

If a couple with a 10% top tax-bracket paid $20,300 in interest, the relative income-tax reduction (compared to not taking a mortgage) would be only the marginal rate of the marginal amount, 10% of the $10,000 ($20,300 paid - $10,300 standard deduction), a relative tax reduction of $1,000.

The so-called "tax saving" is:
  • NOT at the full, top, marginal rate. It is less than half of the top rate, not a 10% discount but a 4.9% discount ($20,300/$1,000).
  • NOT a net saving. The couple has saved nothing and in fact lost at least net $19,300 ($1,000 - $20,300).
  • NOT a real gain. It is only a tax-drain shift from negative $1k to $0 (vis-a-vis the IRS) so the real loss of wealth is the full $20,300 ($0 - $20,3000).

Households at the highest marginal rates, who might think that they would merit the biggest tax reduction, might find their deductions canceled by the Alternative Minimum Tax (AMT) at $42,500 income levels for singles and $62,550 for married couples in 2006.

Any way you slice it, the borrowing cost always overwhelms the tax reduction.

Net Loss: Mortgages Harm Net Worth

Consider 2 couples facing the earlier scenario who start the year with $20k cash:

  • The one who denied $1k to the IRS by paying $20k interest to the bank lost all $20k and has $0.
  • The one who paid the extra $1k taxes to avoid paying $20k interest lost $1k and still has $19k.

What a difference a year can make.

Would you rather be negative 5% (lose 1k of 20k) or negative 100% (lose 20k of 20k)?

The mortgage tax deduction is 20 times worse than borrowing from Peter to pay Paul.

Borrowing $1k from Peter to pay $1k to Paul is a classic example of going nowhere fast.

However, the mortgage deduction is much worse and actually puts your finances in reverse because you are avoiding paying $1k to Peter only by paying $20k to Paul.

"Hey, what happened to my $1k tax-deduction money that I wanted to keep in my pocket?"

Sorry, your mortgage-interest deduction goes in the bank's pocket, not yours.

IRS "Teaser" Rates:
The evaporating tax discount races to zero.

The effective tax discount, if it existed at all at first, diminishes each year as the amount of mortgage interest paid decreases each year (the "mortgage payment" is mostly interest at the beginning and mostly principal at the end of the loan--and the principal is not deductible).

Therefore, not only might you not get an advantage on the full amount of interest paid in each year that you do itemize, the diminishing interest payments mean that you might not itemize for the full 30 years (not in later years).

If you itemize only for the first 20 of 30 years (because the diminishing interest eliminates the itemization advantage in later years), and during the 20 years your average itemizations exceed the standard deduction only slightly, you get very little tax advantage.

You can pay tens of thousands of dollars of mortgage interest with no itemized deduction for the costs.

Deduct half a million dollars without paying a penny of interest.

The biggest mistake that a person can make is to multiply his/her lifetime total of mortgage interest by his/her top tax bracket, which can grossly overestimate the tax advantage and underestimate the costs (as explained above). Do not make the mistake of assuming that you get a tax advantage on 100% of all mortgage-interest paid when you might get a relative advantage on, say, only 20% of all the interest you paid.

Compare the dollar amount from itemized deductions to $300k of a couple's standard deduction over 30 years or $500k over 50 years.

Why not take the $500k of deductions without paying interest?

Next: The "Debt-Free" Deception: Housing Myths Part 8


greencat856 said...

J at IHB
I saw your link at The Happy Rock's blog and came over to see what you had to say. You have invited comment on this post.

I read your post and am confused. Do you believe that couples or single folks should rent instead of buying a home with a mortgage? It would take most of us a lifetime to save up enough to pay cash for a home while we are also paying rent for a place to live.

In your example of a married couple in the 10% tax bracket paying $20,300 in mortgage interest would not save anything. I don't see how this example can work out mathematically. The 10% tax bracket for 2007 is up to taxable income (assumed wages) of 15,100. Our example couple is at the top of the 10% bracket. Add to this 2 personal exemptions of $3,400 each for 2007 plus the 2007 standard deduction for MFJ of $10,700 and you have a gross income (W-2)of $32,600. How can a couple making this kind of income afford the kind of mortgage in your example? However, if they did have a deduction of $20,300 instead of $10,700 against the taxable income of $15,100 they would pay $550 (15,100 - (20,300 - 10,700) x 10%)of federal income taxes instead of $1,510. It seems to me that is a savings of $960 in the couple's pocket. I am very confused as to how you consider this a "loss?"

Even if a couple or single person does not get an additional tax deduction for mortgage interest over the years, they are building equity in a property for the time they live there. When they sell that residence, as long as it was their personal residence for 2 of the 5 years prior to the sale, they can exclude MFJ $500,000 or single $250,000 of any gain on the property. This seems like a good investment to me.

I think your premise that couples buy homes to save immediate tax dollars and with the standard deduction a mortgage is a worse deal is not a valid hypothesis. Your "return on investment" analysis also does not make sense to me. Couples buy homes because it makes more sense to have a deed to real estate with equity at the end of 30 years instead of a box of rent receipts worth nothing.

J at IHB and HFF said...



You are correct that the hypothetical couple would have a tight budget (probably would have no other debt and very low local taxes so their biggest expense is a few thousand for food) but I used 10% and $20,300 just to keep the math simple for the examples.

The couple did not save/gain $1k ($960) in their pockets because that paper victory cost them $20k to accomplish (imagine if a telemarketer told you that he could save you $1k in taxes for a "small" $20k fee). They did not save $1k. They lost $20k. They did not save anything and instead magnified their losses 20-fold.

This article addressed only the US federal mortgage-interest income-tax deduction because of the many times I have read or heard people explain how they organize their finances to not "lose" the deduction, as if it were an investment in itself with a positive ROI (it is not) or provides extra cash (it does not).

Property tax can be worse than capital gains tax. Other articles in the Housing Myths series address other aspects of real estate investment.

Recent news teems with examples of how the mortgage cost is what turns a real estate investment into a loss (and the same principle applies less dramatically in normal times too). Renting while saving can be a good option in some situations. Some working people pay (or could pay) cash for houses while reasonably young.

Thank you for comment.

J at IHB and HFF said...

I added explanation to the article. Thank you.