By Kevin M                                                        

One of the most compelling reasons for owning a home is the heavily touted tax benefit 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.

None of that is true today, yet the tax savings pitch remains. Standard deductions can exceed $11,000, interest rates are down around 5% and marginal tax rates cap out at 38% (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 2009 is far more taxpayer friendly than it was back when tax benefits had become one of the holy grails of homeownership.

For 2009 the standard deduction is $11,400 for married filing jointly, $8350 for head of household, and $5700 for single.

Marginal tax rates are as follows:

Married filing jointly:
0 – 16,700 10%
16,700 – 67,900 15%
67,900 – 137,050 25%
137,050 – 208,850 28%

Single:
0 – 8,350 10%
8,350 – 33,950 15%
33,950 – 82,250 25%
82,250 – 171,550 28%

The personal exemption is $3650 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 generalize.

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 $3000, both of which are deductible for tax purposes. So far, so good.

But when they go to file 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 $14,600 in personal exemptions (4 X $3650) yields a taxable gross income of $50,400, 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 $11,400 without itemizing. The benefit of owning the home and itemizing will only apply to $8600 in income (20,000 minus 11,400)!

At the 15% marginal tax rate, this translates into a net tax benefit of only $1290 per year! That’s the equivalent of a $107.50 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 ($3000 divided by 12 months) and a $75 per month estimate for homeowners insurance gives a monthly payment on the home of $1399. If we deduct the $107.50 per month tax benefit, that produces a net payment of $1291.

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.