Why? They think they’re going to get a huge tax break with the mortgage interest tax deduction.
Those people are in for a shock when they complete their first tax return after being a homeowner.
The mortgage interest tax deduction may have originally been for the average family, but it has always provided more benefit the rich more.
Why? The mortgage interest tax deduction allows you to deduct the interest paid on a mortgage on your primary and/or second home based on mortgage debt of up to $1,000,000. You can also deduct the interest on up to $100,000 of home equity debt.
The normal American cannot afford anywhere near these limits stated in the mortgage interest tax deduction rules. Even if an average married person can afford a $300,000 home, the tax deduction won’t even help you one bit unless you have other itemized deductions you can claim.
How can this be? The following example may shock you.
A $300,000 Home And No Mortgage Interest Deduction For Some
Let’s say you buy a $300,000 home. You put 20% down, so you’ll have to take out a mortgage for $240,000. Today you could easily get a 30 year fixed rate mortgage with a 4.5% interest rate if you have good credit. In the first full year of paying off your mortgage, you’ll only pay $10,720.29 in interest payments.
Unfortunately, that won’t help many people one bit. Why?
Itemizing Deductions Replaces Your Standard Deduction
When you itemize your deductions, you give up the standard deduction. In 2014, the standard deduction is $12,400 for married couples filing jointly and $6,200 for those filing single.
If you’re married and have no other itemized deductions, which is admittedly unlikely, you won’t even itemize because the standard deduction would give you a bigger tax benefit. Your mortgage interest tax deduction is essentially useless in this case.
If you’re single and have no other itemized deductions, you’ll actually get to itemize your deductions. However, don’t think for a second you get $10,720.29 in deductions as your benefit. Instead, the only tax deduction benefit you’ll gain is the amount by which your itemized deductions exceed your standard deduction.
So, as a single person, you’d get $4,520.29 in additional deductions due to the mortgage interest deduction. If you’re in the 25% tax bracket, this would save you $1,130 in federal income tax. As a married person, you’d get no benefit at all. Not one penny saved in federal income tax. Sad! [Related: How Tax Rates Work In America]
Keep in mind, you pay the most interest in the first year of your mortgage. Every year after the first year, your mortgage interest tax deduction will shrink because you’re paying less interest each year.
On top of that, the standard deduction generally increases with inflation. That means your benefit will shrink even more as inflation increases the standard deduction.
How The Mortgage Interest Tax Deduction Favors The Rich
Let’s pretend I’m rich and am swimming in money. I’ve decided to take out the maximum mortgage amounts allowable under law to maximize my mortgage interest tax deduction. I have $1,000,000 in mortgage debt at 4.5% and a $100,000 home equity loan, also at 4.5% both on a 30 year amortization schedule for simplicity’s sake.
With this maximum level of mortgage debt, I’d pay $49,136.97 in interest that would qualify for the deduction. I’d assume because I can afford such a large mortgage, I’m probably in a higher tax bracket. I’d likely have a 28% or 33% marginal tax rate depending how much of my income is derived from wages vs investment income.
As a single person, I’d get an additional $42,936.97 in deductions. At the 28% tax bracket I’d save $12,022.35 in federal income tax and at the 33% tax bracket I’d save $14,169.20 in federal income tax.
As a married person, that would result in an additional $36,736.97 in deductions. At the 28% tax bracket I’d save $10,286.35 in federal income tax and at the 33% tax bracket I’d save $12,123.20 in federal income tax.
The rich person who can afford $1,100,000 in mortgages gets to save anywhere from $12,000 to $13,000 more in federal taxes paid than the normal person with a $240,000 mortgage! That’s messed up! Why are we subsidizing homes for the rich? Why not help the normal Americans looking to buy a home more?
Granted, they are paying more in interest to the bank, but why subsidize it?
Normal Americans Used To Benefit From The Deduction
Normal Americans used to be able to benefit more from the mortgage interest deduction. Unfortunately, that’s because they were paying a lot more in interest.
Mortgage rates are currently at one of the lowest points in history. If you had the same size mortgage now vs 20 years ago, you’d be paying less in interest today.
Paying less in interest is a much better deal than getting a bigger tax deduction. Tax deductions only reduce your taxable income, not the tax you pay, you only save a fraction of each dollar you pay in interest on your tax bill. However, let’s run the numbers real quick.
In 1994, mortgage rates were as high as 9% on a 30 year fixed rate mortgage, essentially double today’s rates. On a $240,000 mortgage, you’d pay $21,533.46 in interest in the first year.
For a single person in the 25% tax bracket that would result in a $3,833.37 reduction in their federal income tax due and for a married couple filing jointly, also in the 25% tax bracket, it would result in a $2,283.65 reduction in their federal income tax due.
But The Rich Have Always Had A Larger Benefit
While normal Americans used to benefit more from the mortgage interest tax deduction, the rich have always received a larger benefit. Using the same 9% interest rate, a rich person with $1,100,000 in qualified mortgage debt would see a larger reduction in their tax bill. They would pay $98,695.02 in interest in their first full year of their mortgage.
For a single person in the 28% tax bracket, their federal taxes would be reduced by $25,898.61 and for a single person in the 33% tax bracket, their federal taxes would be reduced by $30,523.36.
A married person in the 28% tax bracket would see their federal taxes reduced by $24,162.61 and in the 33% tax bracket they’d see their taxes reduced by $28,477.36.
Keep in mind, there are many other calculations that go into tax calculations and the rich do have their itemized deductions phased out at a certain point. Normal Americans will likely have other deductions they can itemize, too. [Related: Be Wary Of Year End Charitable Contribution Phone Calls]
No matter what, the home mortgage interest tax deduction is no longer as useful as it once was for the ordinary American. It has always benefited the rich more.
That said, why is the limit on mortgage debt $1,000,000 or $1,100,000 with home equity debt? Wouldn’t something like a $500,000 still help the average American while not subsidizing housing for the rich? I’d love to hear your thoughts! Let me know what you think in the comments below.
Photo by: LipBomb Text added by: Lance Cothern