The US government has blessed us with the ability to deduct our mortgage interest expense from our income, thereby lowering our tax liability. If you go to Canada, Australia, Asia, and Europe, there is no such benefit. At least they’ve got cheap healthcare!
Given the US has a progressive tax system, the higher your income, the more valuable your mortgage interest income deduction. Homeownership with a mortgage is absolutely the best tax shield for everyday folks out there. I knew my income would rise over time and wanted to match the timing of my home purchase when I entered the 28% tax bracket.
Take a look at the latest marginal tax rates for singles and married couples.
Single Filing Status For 2015
- 10% on taxable income from $0 to $9,075, plus
- 15% on taxable income over $9,075 to $36,900, plus
- 25% on taxable income over $36,900 to $89,350, plus
- 28% on taxable income over $89,350 to $186,350, plus
- 33% on taxable income over $186,350 to $405,100, plus
- 35% on taxable income over $405,100 to $406,750, plus
- 39.6% on taxable income over $406,750.
Married Filing Jointly or Qualifying Widow(er) Filing Status For 2015
- 10% on taxable income from $0 to $18,150, plus
- 15% on taxable income over $18,150 to $73,800, plus
- 25% on taxable income over $73,800 to $148,850, plus
- 28% on taxable income over $148,850 to $226,850, plus
- 33% on taxable income over $226,850 to $405,100, plus
- 35% on taxable income over $405,100 to $457,600, plus
- 39.6% on taxable income over $457,600.
What’s important to note is that if you are in the top tax bracket, you get 39.6 cents back for every one dollar in interest you pay on your mortgage.
If you also pay State tax, you can see how your marginal tax rate can easily reach 45% on your last dollar of income earned! The beauty of the mortgage interest deduction is that it applies to your marginal income, and therefore your highest marginal tax rate.
For those in the 15% Federal tax bracket or below, I would not rush to buy a home. There are more costs to ownership that just a mortgage and property taxes and you’ll qualify for the standard deduction. When you’re in the 25% marginal tax bracket, that’s when homeownership starts making more sense provided you follow the 30/30 rule for home buying.
HOMEOWNERSHIP IS WORTH MORE TO HIGHER INCOME EARNERS
Example #1: Say you earned $588,350 in 2015. Your income from $388,350 to $588,350 will be taxed at a 35% Federal Tax rate. If you paid $50,000 in mortgage interest for 2012, you get to reduce your taxable income by $50,000 from $588,350 to $533,350. As a result, you are paying $50,000 X 35% = $17,500 less in Federal taxes!
Example #2: Say you earned $85,500 in 2015. About $50,000 of your income will be taxed at a 25% federal tax rate. If you somehow managed to pay $50,000 of mortgage interest for 2015, your taxable income is only $35,500. As a result, you are paying $50,000 X 25% = $12,500 less in Federal taxes.
Analysis: As a lower income earner, the mortgage interest tax shield is worth $5,000 or 29% LESS than someone who makes more, even though the lower income earner paid the same amount of mortgage interest! One can therefore conclude that owning a home with a mortgage is more beneficial for those who have higher incomes. One can also conclude there is an asymmetric benefit for those who have higher incomes.
INCOME PHASEOUT WARNING
In a perfect world, the above example will hold true. Unfortunately, we live in a world where the government discriminates between different income groups. The rules are complex and have created massive multi-billion dollar industries to help decipher and administer such rules e.g. tax law, tax help, accounting.
If you have an adjusted gross income of over $166,800, your mortgage interest starts to get phased out. For every $100 of income over $166,800 you lose $3 of itemized deduction X 33.3% up to a maximum loss of 80 percent of your itemized deductions. Talk about another overly complicated rule the IRS/government has implemented!
Example: You make $266,800 and you have $50,000 in mortgage interest deductions. Take $266,800 – $166,800 = $100,000. Then take $100,000 X 3% = $3,000. Finally, take $3,000 X 33.3% = $999. You can now only deduct $49,001 ($50,000 – $999) from your income instead of originally $50,000.
In my example of the person making $588,000 and paying $50,000 in mortgage interest for the year, the homeowner can only deduct about $45,800 given the phaseout. As a result, the homeowner has to pay $2,000 more in taxes.
Note on The Alternative Minimum Tax: The A.M.T. bars any deduction for interest payments on a home equity loan when loan proceeds are used for purposes other than home improvements. Regardless of your income, you can deduct the mortgage interest. However, deductions for property taxes and for state and local income taxes and exemptions for the taxpayer and dependents must be added back to arrive at the taxpayer’s alternative minimum taxable income. If the tax to be paid using this method is higher than that from the regular computation, the higher amount must be paid.
THE BEST INCOME TO MATCH THE IDEAL MORTGAGE AMOUNT
Given the analysis, I say the ideal income a homeowner should shoot to earn is roughly $300,000 per married couple or $250,000 per individual. $250,000-$300,000 is a high enough income to allow for a good life, no matter where you live in America. With a mortgage interest deduction among other deductions, you can bring your AGI down to $200,000 to $250,000 to fly right under the radar of the government’s income threshold to increase taxes.
I used $50,000 in mortgage interest for simplicity purposes. However, given one can now get a 5/1 ARM jumbo mortgage for 2.625% or a 30-year fixed jumbo mortgage for 3.65%, a more appropriate mortgage interest number is $26,250 – $38,750.
Why do I use $26,250 – $38,750? It’s because the ideal mortgage amount one should have who is making roughly $250,000 – $300,000 is about $1,000,000. The law stipulates that $1,000,000 is the maximum mortgage interest indebtedness one can have to be able to deduct the interest from their incomes. Any more is disallowed. You can take a $100,000 HELOC to use towards the improvement of your home and deduct that interest, but that gets messy and is open for interpretation.
There have been lots of talks by the government to limit the mortgage interest deduction to the 28% tax bracket ($178K for singles, $217K for married couples). Therefore, if Federal taxes are raised and the interest deduction is lowered, the ideal income is probably closer to $225,000 for singles and $275,000 for couples. With this income level, the largest mortgage I recommend is $900,000.
* Homeownership is worth more to higher income earners, but only up to a point.
* Mortgage interest phaseout starts at $166,800 and has a maximum phaseout of 80% of the mortgage interest.
* The ideal income to earn for homeowners is around $250,000 for singles and $300,000 for couples.
* Earning more than $250,000-$300,000 doesn’t do much to improve happiness. Might make you mad due to higher taxes.
* The ideal mortgage amount for the ideal income is therefore around $750,000 – $1,000,000 (3-3.5X income).
* The US government is pro homeownership, therefore take advantage of the benefits.
* You get $250,000 in tax-free profits if you sell your house and are single, double the amount if you are married.
* Single filers get a standard deduction of $5,950 (roughly double for married couples) for 2012. The government allows you to automatically choose between standardized or itemized, whichever is greater. Given we are talking about $1 million dollar mortgages as the ideal mortgage amount, itemized deductions will always be chosen.
* Check out this excellent mortgage interest tax deduction calculator. You’ll learn that not only is mortgage interest and charitable contributions tax deductible, state, local, and foreign income and personal property taxes are also tax deductible. See IRS website for a list of deductible taxes.
Note: I am not a real estate lawyer or accountant. But, I do have a multiple property portfolio valued at well over $3 million dollars and have spoken to many accountants and real estate lawyers about this subject. I am an active manager of lowering my tax bill and building wealth for the long run.
Recommendations For Saving Money And Increasing Your Wealth
1) Check Your Credit Score: The average credit score for rejected mortgage applicants is 729. How do you stand? You can check your credit score for free at GoFreeCredit.com. I highly recommend it because you don’t want to caught with your pants down not knowing what your score is if you have a late payment. I had no idea I had an $8 late payment for a utility bill from two years ago that crushed my score from 790 to 680 and caused massive delays in my latest mortgage refinance.
2) Refinance Your Mortgage. LendingTree Mortgage Refinance offers some of the lowest refinance rates because they have a huge network of lenders to provide mortgage loans, home equity loans, and home equity lines of credit. If you’re looking to buy a new home, consider using LendingTree to get multiple offer comparisons in a matter of minutes. Interest rates are back down to all-time lows in 2015 due to tremendous volatility and chaos in Europe. When banks compete, you win.
3) Manage Your Finances In One Place: Get a handle on your finances by signing up with Personal Capital. They are a free online platform which aggregates all your financial accounts in one place so you can see where you can optimize. Before Personal Capital, I had to log into eight different systems to track 25+ difference accounts (brokerage, multiple banks, 401K, etc) to track my finances. Now, I can just log into Personal Capital to see how my stock accounts are doing and when my CDs are expiring. Their best feature is their Portfolio Fee Analyzer which is saving me $1,700+ in annual fees I had no idea I was paying. It takes less than one minute to sign up and it’s free.
Photo: Pacific Heights Mansion, 2015.