Question: My husband and I finally made a decent amount of money last year and we are going to have to pay a fairly big income tax bill for the first time. We don’t own a home so we don’t have a mortgage deduction and therefore we don’t have enough deductions to itemize our income tax return. We’d like to save money on taxes, but we don’t want to increase our monthly rent expense. Is it really worth it to buy a home for the tax savings?
Answer: I would not recommend buying a home just for the tax benefits. However, the savings are significant, so you are missing out on the last great tax loophole available to the average American.
But let’s turn your question around. Rather than looking at how much you’d save in taxes by purchasing a home, let’s see how the tax savings might allow you to buy a home without blowing your household budget.
For example, let’s assume that you’re paying $1,800 a month to rent a nice home in a good neighborhood. How much home could you afford if you keep your housing expense at $1,800 per month?
First, you have to subtract a monthly amount for property taxes and homeowner’s insurance. Property taxes vary from home to home. You can obtain the amount of the actual property tax bill on a given home from the listing agent.
However, if this information is not readily available, you can use this simple rule of thumb to estimate the monthly cost of property taxes: Multiply the sales price of the home by 1 percent. For example, $300,000 times 1 percent equals $300. That means the property tax bill on a $300,000 home would be approximately $300 per month.
Now, this is a very rough calculation, of course, but it’s close enough for our purposes in this illustration. Homeowner’s insurance costs can easily be determined by obtaining a quote from your insurance agent.
Using the $300,000 home as an example, if we assume the property taxes are approximately $300 per month and homeowners insurance costs approximately $60 per month, you would subtract $360 from your $1,800 monthly payment, leaving your with $1,440 per month for the mortgage loan payment.
A 30-year fixed rate mortgage with a 5 percent interest rate and a monthly payment of $1,440 would allow you to borrow about $270,000. So should you limit yourself to a home with a $270,000 mortgage?
The tax deduction would allow you to borrow more money without increasing your actual out-of-pocket monthly housing expense. For example, let’s say you decide to buy a home with a $300,000 mortgage (to keep this simple, I am not factoring in the purchase price and down payment).
The payment on a $300,000 mortgage at 5 percent would be $1,610 per month. Since the house would be slightly more expensive, we will add $390 for property taxes and insurance which would give you a total monthly housing expense of $2,000 which is $200 more than you were paying in rent.
But after one year of payments on this loan, you will have paid about $15,000 in interest plus about $4,000 in property taxes, for a total tax deduction of $19,000. If you are in the 28 percent tax bracket, that deduction would save you $5,320 in taxes, which is $443 per month. So you can see that the tax deduction would enable you to borrow more money and actually end up spending less per month than you did on rent.
Of course, the numbers above have been simplified for illustrative purposes. And I have not factored in the standard deduction available to taxpayers who do not itemize.
But as you can see, the primary benefit of the home mortgage tax deduction is that it allows you to buy a more expensive home with a given amount of income by reducing the true cost of your monthly loan payments.
So is it a good idea to buy a home just to save money on your income tax return?
No. Remember, if you are in the 28 percent tax bracket, you have to spend 72 cents for every 28 cents that you save. And if home prices continue to fall over the next year or two, you may lose more money in decreased home equity than you would save in taxes.
However, if you find a home that you would like to live in long-term (10 years or more) and your income is expected to be stable or increase, then I think it would make sense to buy a home.
Just make sure you are buying it to improve your lifestyle, not just for the tax savings or possible investment return.
Mail your real estate questions to Steve Tytler, The Herald, P.O. Box, Everett, WA 98206, or e-mail him at economy@heraldnet.com.
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