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Many Americans can generally deduct mortgage interest from their taxable income. Property taxes are deductible too, and private mortgage insurance premiums may be as well. These are some of the selling points for homeownership. However, only a close inspection in the context of your own financial situation will reveal exactly how valuable—or not—these deductions will be.
Claiming the Mortgage Interest Deduction
In order to claim the mortgage interest deduction and other deductions associated with your home purchase, you need to itemize your taxes. That means, instead of taking the standard deduction, you'll need to fill out a Schedule A form, which is not so onerous. On the Schedule A, you can also claim any eligible medical and dental expenses (only if they are above a certain threshold as a portion of your adjusted gross income), other state taxes, gifts to charity and certain job expenses and tax preparation fees, among other things.
However, it only makes sense to itemize your taxes if your deductions on the Schedule A exceed what you would be able to claim as the standard deduction. After you add up any eligible itemized deductions, check how they compare against your standard deduction for that year. If the itemized expenses on Schedule A are lower, you'll be better off going with the standard deduction. The table below shows the standard deduction in 2015 for the various tax filing statuses:
2015 Standard Deduction
Married, Filing Jointly
Head of Household
Limits on the Mortgage Interest Deduction
Mortgage interest includes any interest paid on a first mortgage, second mortgage, home equity loan and home equity line of credit. It’s deductible as long as you are the primary borrower, with or without a co-borrower, such as a spouse or your adult child. Interest on mortgage amounts up to $1 million is fair game, but only up to $100,000 of interest is deductible for home equity loans which aren’t used to improve the home. However, if you bought your home before October 13, 1987, more generous rules may apply. You can also deduct mortgage interest related to the purchase and payment of a second home - but not a third. Very high earners, with an adjusted gross income above $258,250 for single people and $309,900 for couples, start to lose the mortgage interest deduction as part of an overall phase-out of personal exemptions.
Average Tax Deductions for Homeowners
In 2015, the median-priced home sold for $234,000. And the typical first-time home buyer made a down payment of 5%. On the median home, this would leave her with a mortgage of $222,300. Her total monthly payment, including principal, interest, property tax (at an average rate of 1.2% per year), homeowners insurance and private mortgage insurance would be about $1,528 per month, or $18,336 per year. Most of that would be deductible as shown on the following table which shows the annual deductible amounts for the sample median home buyer above:
|YEAR 1||YEAR 5||YEAR 10|
Total Home-Related Deductions on Schedule A
With deductions totaling $13,543, this homeowner, if single, would exceed her 2015 standard deduction by about $7,243. This assumes she has no other Schedule A deductions, which isn’t very realistic since most people have at least a few other deductions here, like state income or sales tax. If she were in the 25% tax bracket, she’d save about $1,810 on federal taxes, compared to if she paid rent.
If she were married however, she and her spouse would only exceed their combined standard deduction by $943 total (assuming they have no other deductions), and would save just $234 in federal taxes.
Either way, this tax savings would likely decrease over time, as the homeowner paid less interest as their principal grew, and eventually stopped paying private mortgage insurance once the mortgage loan-to-value ratio dropped below 78% (for most loans).
Who Benefits from The Mortgage Interest Deduction?
Some people benefit handsomely from the tax deductions offered to homeowners. These include people with large mortgages; high property taxes or state income taxes, or other significant Schedule A deductions; and people in relatively high income tax brackets, since the deduction cuts their taxes by a larger percentage.
It is people with the smallest mortgages, as well as those with the very largest incomes, who end up getting little to no benefit from the mortgage interest deduction.
Consider as an example, an older married couple who has built up a lot of home equity over the years and wants to refinance to a lower interest rate. Let’s say the remaining principal on their mortgage is $100,000. That’s about $4,000 in annual mortgage interest at today’s low rates, and far less than their standard deduction as a married couple. Their state taxes, property taxes and other Schedule A deductions might get them past the level of their standard deduction, but you can see how the tax benefits would wane with the size of the loan.
It’s also worth remembering though, you don’t get the tax deductions unless you’re actually paying the expenses of mortgage interest, property taxes, and mortgage insurance. Before you take the plunge and buy a home, tally up these amounts, along with any additional closing costs when buying, subtract your tax benefits, and see how your outlay compares to what you would pay to rent a similar property in your area.
The rent vs. buy decision can be complicated, but depending on your tax situation, the benefits offered by the federal government might ultimately sway your decision.