New IRS Tax Deductions Worsen Mortgage Debt Deal

The new IRS property tax deductions make mortgage debt an even worse deal than it already was.

2008 and 2009 tax years allow you to take the standard deduction but also deduct $1,000 in property taxes (if married filing jointly, or $500 if single) simply by checking box 39c on Form 1040.

IRS Standard Tax Deductions for 2008 Tax Return
(ie, no "itemized" Schedule A needed)

$ 5,450 (single)
$ 5,950 (single, property tax deduction)
$10,900 (couple, married filing jointly)
$11,900 (couple, married filing jointly, property tax deduction)
$14,000 (senior couple, age 65 or older, married filing jointly, property tax deduction)

Non-senior singles can deduct almost $6k without itemizing and without paying a penny in mortgage interest.

Non-senior couples can deduct almost $12k without itemizing and without paying a penny in mortgage interest.

Senior-citizen couples can deduct $14k without itemizing and without paying a penny in mortgage interest.

These deductions are in addition to the $3.5k per person deductions ("personal exemption") for yourself and dependents.

The IRS tax changes are another reason on top of recent market declines as to why debt does not pay.

I warned about such issues before the market crash:

Prepay Mortgage V. Invest in Stock Market
Myth of Mortgage-Interest Income-Tax Deduction
Myth of the Stock Market (Leveraged Borrow-To-Invest Dangers)

Ron Paul Sets Financial Record for Presidential Candidate

Amusing Theme Yields Impressive Funds for Presidential Candidate Ron Paul

Air Force veteran, Congressman, and obstetrician Dr. Ron Paul is one of the most interesting presidential candidates for the 2008 election. Ron Paul inspires energetic loyalty and outperforms other alleged "frontrunners" in some respects. Paul's supporters ("Paulites") spontaneously organized an earnest if humorously named "Guy Fawkes Day" "money bomb" of 1-day fundraising yesterday which apparently set a record:

From Baltimore Sun:

It is people voting for someone other than the establishment, odds be damned.

Paul already had raised a stunning $5 million in the last quarter, and he has set a goal of $12 million for this final quarter of the year. And, according to his campaign Web-site, Paul raised more than $3.1 million in 19 hours on Monday, marking the single largest fundraising effort of the 2008 election cycle.

As of 4 pm, the campaign maintained, it had raised $2.7 million, surpassing the record for the largest online presidential primary fundraising effort in a single day, and by 6:30 pm, the campaign said it had surpassed Republican Mitt Romney’s $3.1 million record for single-day fundraising this year. This morning, the Web-haul was reported at $3.8 million-plus.

Commenters asserted that the final tally was $4.2 million.

(Update 11/13/07: CNN reported Ron Paul's 1-day total as $4.38 million.)

Homeownership Cost Cliches: Housing Myths Part 10

Previous: House Depreciation-Maintenance: Housing Myths Part 9

Housing Clichés Can Cost You Dearly

The last article mentioned that counting just 2 factors (inflation and maintenance/repairs) can cancel any supposed real-estate “investment” appreciation but there are many more costs that can turn home ownership into a loss: mortgage interest, taxes/insurance/fees, and opportunity costs of missed investments.

Your mortgage costs DO increase every year and these increases disprove the "payments never go up," "payback with cheaper money," and "good debt" cliches.

“Your rent goes up but my mortgage payment does not” is just another way of saying that the "fixed" mortgage payment starts too high, in real (inflation-adjusted) terms (plus, rents DO NOT always go up). The mortgage-holder tends to assume that the first mortgage payment is the “just right” size and everything later is discounted (by inflation) but rarely considers that the last payment might be the “just right” size and everything earlier is at a penalty rate.

“I get to pay back my mortgage later in cheaper money” is another common cliché that undermines the first cliche: If postponing repayment is so lucrative, then you would want to pay little at first and more later, so mortgage payments that do not increase over time would be bad. The “cheaper money” slogan argues for the ultimate balloon-payment plan of paying $0 for 29 years and paying everything (several times the purchase price) in the last year.

Both of these common quotes misread the mortgage situation:

All mortgages have annual cost increases built-in but people overlook the increases by looking at the nominal payment rather than the accrued cost. If your mortgage rate is 5%, each year your new, extra cost is an additional 5% of the year’s debt. The mistaken belief of no payment increases is an illusion simply because the bank has pre-calculated your 30 years of cost increases and front-loaded your money-up-in-smoke interest costs.

You are repaying your mortgage with more expensive money (not cheaper money) because the interest rate is almost certain to increase the debt cost at a rate faster than the official inflation rate. The repayment would be "cheaper" only if the mortgage had no interest rate (or one less than inflation), but I have not seen any mortgages like that, so I think the banks have figured out that loophole. Unless you find a bank that is so stupid that it lends for less than its costs decade after decade, you are losing more money each year that you keep a mortgage.

A $225k 5% fixed-rate mortgage is about the same as taking 30 years to pay off a $225k 5% credit card debt. Debt is debt. Compound interest compounds.

Pre-paying principal is so powerful at lowering your costs because it reduces the compound-interest increases.

The only escape from annual mortgage-cost increases is to end the mortgage.

Non-debt home-ownership costs increase too and these costs disprove the "but eventually I'll have free housing" cliche.

Owning has many costs such as taxes and insurance that can increase faster than the inflation rate and faster than rent increases. Experiences vary from person to person but consider these real-life examples: One person rented for 7 years without a penny increase in rent while another person during the same period bought a house and saw property taxes skyrocket 50% in 5 years. Even with no mortgage, a homeowner’s costs can increase faster than a renter’s costs.

Opportunity costs of missed investments disprove the "renters end up with nothing," "at least I have home equity," and "mortgages are forced savings" cliches.

Neither borrowing 100% nor paying 100% cash to buy a house necessarily beats renting:

Borrowing $225k at 5% costs $11,250 in interest in the first year ($937.50/mo), not counting loan origination “points,” closing costs, taxes, repairs, and other fees/costs--none of which creates a penny of equity.

Anyone who likes to pay principal on top of the consumption costs can just as well save/invest on top of paying rent, so "owning" and renting offer similar equity opportunities.

Building equity depends primarily on the individual. Spendthrifts can find a way to stay in debt whether they rent or "own."

0% downpayments, interest-only loans, HELOCs, reverse mortgages, and other house-as-ATM "equity harvesting" all prove that home-"owning" is no guarantee of "forced" savings. An automatic payroll deduction into a money-market account might be a cheaper "forced" savings plan. A renter's security deposit has more equity than some no-money-down homebuyers do.

Renters might beat homeowners in the equity-building race because renters are more likely to have lower early payments and therefore benefit from the renown compounding magic of saving early (contrary to "mortgage payments do not increase" and its backward logic of high costs/low equity-building now and low costs/high equity-building late in the game).

Paying $225k cash for a house will avoid paying interest but then you have nearly a quarter-million dollars tied up in an illiquid asset that might appreciate nominally at 5% but can have zero or negative real “appreciation” after all input/carrying costs are considered.

You instead could invest the $225k cash in stock or other investments to earn net 5% ($937.50/mo) and keep your $225k stock equity while the interest/dividends/appreciation income pays your rent, maybe in perpetuity (depending upon exact rent, inflation, etc.).

The Good Cliche: There Is No Such Thing as a Free Lunch in Housing

Housing is consumption when you own as well as when you rent so do not be surprised by the possibility that homeowner’s net costs might be similar to renter’s net costs.

More Misleading Housing Cliches (Parts 1-9, in reverse order):
"Renting doesn't build equity like my house payments do!"
"I'm debt-free! . . . with a $500,000 mortgage."
"My mortgage rate is really 1/3 less and I want to get as big a tax deduction as possible!"
"Buy as much house as you can afford!"
"My mortgage is free because I'm renting to myself!"
"My mortgage doesn't count as an expense because you have to live somewhere!"
"I really increased my ROI by leveraging as much as possible with no-money-down!"
"Never prepay your mortgage!"
"I borrow against my house to invest in the stock market!"

Next: Home Decorating Costs: Housing Myths Part 11

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

Do Not Inflate Net Worth: Ignore Taxes at Your Peril

Hat Tip: Ed provoked this post.

Part of series: Biggest Net Worth Mistakes: Is Your Net Worth Accurate or Useful?

Do not deceive yourself by inflating your net worth.

Yes, it is difficult to estimate some items but it is better to underestimate your wealth and later be pleasantly surprised than to overestimate and lay a trap for yourself.

The taxman cometh.

People often leave taxes and regulatory costs off their liability list but you can be sure that the government will ignore such creative accounting and will not forget to take its slice ("But look, my blog says I don't have a tax liability because I typed it that way.").

Remember what "net worth" is.

Net worth is a snapshot of what you would have if you liquidated now. If liquidating your IRA now would incur a 35% income-tax rate plus 10% penalty, then the accurate net worth of your IRA now is about half of what your account statements say.

To say that you would not liquidate now and things will be different later is to ignore net worth. If you use a non-net-worth measure, do not call it net worth.

It is better to understand the limitations of a measurement than to cook the books.

Even if you somehow accurately predict a $1 million nest egg for retirement and dismiss your tax liability on it as "only" 10%, leaving the tax liability off your books is a $100,000 error.

To estimate what your net worth will be decades from now is a very difficult endeavor because you would have to guess at fluctuating IRA and home values, variable inflation rates, uncertain future income and saving rates, and the competing compounded interest/returns of both investments and debts.

That difficulty is why it is easier to estimate your net worth now with all liablities from current tax brackets and current laws.