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I hope everyone enjoyed the Fourth of July holiday.  We made the most of it, watching the local parade, doing a little barbecuing with friends and briefly viewing the fireworks so we could get to bed at a decent hour.  Still, it’s a relatively relaxing holiday and doesn’t require much work to prepare for. I am thankful for the bravery our founding fathers had when they signed the Declaration of Independence, looking to put an end to Taxation without Representation (of course, taxation with representation came sometime later).

One thing that wouldn’t exist without our nation’s independence is the American dream, a significant part of which is buying a family home.  Sometimes I wonder whether owning a home is truly worth all the pride of ownership associated with it. There are times I miss simply being able to call my landlord when something needs to be repaired instead of waiting hours for a contractor to show up and praying I won’t have a heart attack when I see the bill.  Nevertheless, besides owning a place I enjoy, I hope the equity I am building will be a sound investment for a better retirement someday.

This brings me to the subject of this post.  Clients in the process of buying their first home often contact me to find out what effect the purchase, with its theoretically deductible mortgage interest and local property taxes, will have on their federal and state taxes and ultimately, if there will be a decent tax savings to boot.  After I congratulate them on reaching the important milestone, I’ll say what I’ve said before – taxes should not be one of the major driving forces behind any important life decisions.  A home is to enjoy and build equity in an investment; any tax savings you get out of it are just a minor bonus.  Not only do you need to properly budget to pay the mortgage and property taxes every month, the increased standard deductions and limitations on state & local tax deductions under the new tax laws have made buying a home less likely to be much of a tax savings vehicle.

Let’s take a look at a relatively simple example.  The standard deduction for a married couple is $ 24,000 in 2018.

If you itemize, the most common deductions are mortgage interest, state and local taxes and charitable gifts.  In 2018 state and local taxes paid are limited to a deduction of $ 10,000.  Most people who own a home will pay more than $ 10,000 in state income taxes alone, and thus local property taxes paid will not affect their taxable income on the federal return.  Even those who pay less than $ 10,000 in state income taxes will likely hit the $ 10,000 maximum when local property taxes are factored into the calculation.

Since the standard deduction for married couples is $ 24,000, to save any federal taxes mortgage interest and charitable donations must amount to more than $ 14,000 per year.  While the data I found suggested that the average married couple donated approximately $ 4800 to charity in 2017, for couples earning less than $ 200,000 (representing over 94% of the United States per census data), charitable giving fell to an average of about $ 2300 annually (source: Internal Revenue Service data). Adding donations of $ 2300 to the $ 10,000 state and local tax deduction gives us $ 12,300. This means mortgage interest must amount to $ 11,700 before making any impact on a married couple’s federal tax liability.

Today’s mortgage interest rates are hovering around 4% (a little higher in most places, but 4% is a nice round number to work with). The means you would need to borrow at least $ 292,500 before the interest paid reduces your federal tax liability.  If you plan to make the 20% down payment that most banks require (to avoid paying private mortgage interest), you will need to purchase a home with a price of at least $ 365,625.  National Association of Realtors data indicates that more than 2/3 of all homes sold in 2017 were for $ 400,000 or less.  While home prices may change in 2018, I do not think there will be a huge upsurge in home prices (especially since the last real estate bubble is still fresh in many peoples’ minds).

So let’s look at a quick snapshot of a married couple who buys a $ 400,000 home, financing it with an $ 80,000 down payment and a $ 320,000 mortgage at 4% interest:

  • Projected mortgage interest deduction: $ 12,800
  • Maximum state and local tax deduction: $ 10,000
  • Average charitable donation for couples earning less than $ 200,000: $ 2300
  • Total itemized deductions on the 2018 return: $ 25,100

The $ 25,100 in itemized deductions for a couple buying a home at a slightly higher than average price and donating an average amount to charity comes to just $ 1100 above the $ 24,000 standard deduction.  This will not set you up for much of a tax savings, even in the highest 37% federal tax bracket.  Rules for deducting mortgage interest and/or property taxes on state tax returns have not changed much yet (and in many states, there is already little or no deduction for them), and in my experience, the amount of tax savings at the state level was always nominal anyway.

Let’s not forget that some fortunate families who are able to afford payments on a mortgage of over $ 750,000 on a home they purchase this year and in the future will not be able to deduct any interest on the portion of the mortgage that exceeds $ 750,000 and no one (regardless of how much they borrow) will be able to deduct mortgage interest on a separate Home Equity Line of Credit, further taking away the incentive to purchase larger homes with any creative financing.

This has been a long post, and I hope you have been able to follow it.  Feel free to contact me for any questions you might have.  The bottom line? Buying and financing a new home is perfectly fine, but unless your income and the home you buy is at the highest end of the spectrum, any federal tax savings you realize from owning the home should not be a factor in considering the monthly payments you can afford.