Question: My husband and I finally made a decent amount of money this 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?
P.L., Edmonds
Answer: I wouldn’t 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 if you don’t own a home. 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 $2,000 per month to rent a nice home in a good neighborhood. How much home could you afford if you keep your housing expense at $2,000 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 property tax bill: 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. Homeowners 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 $2,000 monthly payment, leaving your with $1,640 per month for the loan payment.
You can get a lower interest rate by selecting an adjustable rate mortgage or buy down loan program of some kind, but let’s say you’re conservative and you want to stick with a 30-year, fixed-rate mortgage because you like the certainty of knowing exactly what your payment will be each month for the life of the loan. At today’s interest rates, you could get a 30-year fixed rate mortgage of about 6.25 percent without paying points to get a lower interest rate. At 6.25 percent, a $1,640 monthly payment would allow you to borrow about $266,000.
If you stick to a $266,000 amount, the purchase price of the home would depend on the amount of savings that you have to cover the down payment and closing costs on the loan.
The good news is that in today’s slow housing market, you can typically ask the sellers to pay the loan closing costs and prepaid escrows for your property taxes and homeowners insurance on your loan as part of the purchase offer negotiations. Closing costs and prepaids on a purchase in this price range would typically total about $6,000.
If you are a veteran, you can get a VA loan and buy a home with zero down payment. Otherwise, you will typically have to make a down payment of at least 3 percent with an FHA or conventional loan. If you make a down payment of less than 20 percent of the purchase price, you will have to add mortgage insurance to your loan payment (or take out a second mortgage to cover the portion of the 20 percent down payment that you are unable to pay with your own funds).
You could also have a wealthy relative give you gift funds to add to your own funds to make a 20 percent down payment and avoid the complications of mortgage insurance or a second mortgage.
Since the price of the home will vary greatly depending on your cash available for the down payment, I will leave the home price out of the equation and focus only on the loan amount for this example.
I’ve already shown that you could borrow about $266,000 for approximately the same monthly payment as your hypothetical rent of $2,000 per month. Now, let’s look at the tax advantages of home ownership, which was your main question.
After one year of payments on a $266,000 loan at 6.25 percent interest, you will have paid $16,537 in interest plus about $3,600 in property taxes (this will depend on the price of your home), for a total tax deduction of $20,137. If you are in the 15 percent income tax bracket, that deduction would save you $3,021 in taxes, which is $251.75 per month. So after deducting the tax savings, the true cost of that $266,000 mortgage would be $251.75 less than the monthly rent in this illustration.
That means you could actually borrow more than $266,000 for a home purchase loan without increasing your monthly housing expense.
Now, I should point out that I simplified the example above by leaving out factors such as 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.
Mail your real estate questions to Steve Tytler, The Herald, P.O. Box, Everett, WA 98206, or e-mail him at economy@heraldnet.com.
Talk to us
> Give us your news tips.
> Send us a letter to the editor.
> More Herald contact information.
