Monday, April 7, 2014

Calculate effect of mortgage-interest deduction

Over a Bogleheads we came across the following discussion: Calculate effect of mortgage-interest deductionPostby TSR » Mon Apr 07, 2014 12:58 pm
Friends,


This post was inspired by numerous recent threads about paying off one's mortgage, as well as my anxiety that we may be collectively over-selling the benefits of the mortgage-interest deduction.


It appears that the short-hand on this board for how to view the benefit of the mortgage-interest deduction is to subtract one percentage point from your interest rate (assuming that rate is somewhere near 4% and that your marginal tax rate is somewhere near 25%). That is, if your interest rate is 4.0% then the mortgage-interest deduction will make it more like 3.0%. From that, one can presumably then calculate, for example, whether it is better off to pay off a mortgage or to invest elsewhere, setting aside all the other psychological/emotional merits of that argument.


But other threads I've seen remind us that the above assumption is wrong for many (most?) people because it may fail to take the standard deduction into account. For example, if one's total annual mortgage interest were barely above the standard deduction, and one did not have many other deductions, one could easily derive essentially NO benefit from from the mortgage-interest deduction, despite the fact that the deduction (just barely) pushed you into itemizing teritory.


Questions:
1. Is there an equation one can use to reach the actual value of the mortgage-interest deduction, expressed as a (reduced) percentage of one's mortgage rate? I am assuming that this would involve many, many variables, and would essentially require redoing one's entire tax return, but maybe it's less complicated?


2. Is there a better approximation that we could use on these boards than the "subtract 1%" strategy without getting too deep into each poster's personal situation? Or even some general criteria? (E.g., "people making between $50K and $200K annually typically only derive x% reduction in their mortgage rate from the deduction," or "people with a mortgage of more than $x typically derive x% reduction in their mortgage rate"?)


(Please forgive me if the assumptions behind these questions are wrong -- I was an English major back in the day and really have no math skills to speak of. I appreciate your thoughts.)
Posts: 206
Joined: 19 Apr 2012


____________________________________________

Re: Calculate effect of mortgage-interest deductionPostby DSInvestor » Mon Apr 07, 2014 1:11 pm

If your deductions excluding the mortgage interest are sufficient to itemize deductions, then you receive a tax benefit for every dollar of mortgage interest paid. In this case, the after tax mortgage rate is Rate X ( 1 - your marginal tax rate). You'd need to add up your property tax, state/local income taxes paid or sales tax paid/table , charitable donations, medical expenses etc.


If your deductions without the mortgage interest is not sufficient to itemize, then the amount of your total deductions above your standard deduction receives the tax benefit.


You don't have to redo the tax return to see the effect of the mortgage interest. Enter everything but the mortgage interest in your tax return and see what the total Fed and State tax is, then add the mortgage interest. Note the changes in tax liability.


If you've already completed your tax return, you know your fed and state tax liability with mortgage interest. Save the file to another name, and then go into the return and zero out the mortgage interest. How did the tax liability change? If you removed 10K of mortgage interest from your tax return and saw your tax liability go up $2500, you received a 25% tax break. If your mortgage rate was 6%, your after tax equivalent rate would be 4.5%. If you removed 10K of mortgage interest and saw your fed tax liability go up $100, you didn't get much tax benefit.
Last edited by DSInvestor on Mon Apr 07, 2014 1:26 pm, edited 1 time in total.
Posts: 5748
Joined: 4 Oct 2008


____________________________________________

Re: Calculate effect of mortgage-interest deductionPostby kenyan » Mon Apr 07, 2014 1:25 pm

If the taxpayer would itemize deductions with or without mortgage interest, then he/she is getting the benefit that everyone assumes. This is a relatively small fraction of people. The fraction of people who would itemize without either mortgage interest or property taxes (the relevant number when discussing rent-versus-buy) is smaller yet.


Many people who receive some tax benefit, aside from those in high-tax states with high income, will be itemizing only because they purchased a house, and thus receive less of a tax benefit than the full marginal rate. I fall into this category. As noted, there is no quick-and-dirty formula, but it needs to be tailored to the individual.


I don't know the exact statistics, but I recall that in the neighborhood of 50% of people with mortgages in the country receive no tax benefit from them. I would be willing to bet that a significant fraction of those people are unaware of this (I've spoken to some).
Retirement investing is a marathon.User avatar
Posts: 2181
Joined: 13 Jan 2011


____________________________________________

Re: Calculate effect of mortgage-interest deductionPostby Kosmo » Mon Apr 07, 2014 1:29 pm

In reverse order:
TSR wrote:2. Is there a better approximation that we could use on these boards than the "subtract 1%" strategy without getting too deep into each poster's personal situation? Or even some general criteria? (E.g., "people making between $50K and $200K annually typically only derive x% reduction in their mortgage rate from the deduction," or "people with a mortgage of more than $x typically derive x% reduction in their mortgage rate"?)


Effective interest rate = interest rate x (1-marginal tax rate). You deduct the interest paid from the top of your earnings, so you use the tax bracket you're in. A 4% mortgage in the 25% tax bracket is 4% x (1-.25) = 3%. That's the exact answer. Size of the mortgage, term, income, make no difference. But this assumes you itemize deductions, which brings us to...


TSR wrote:1. Is there an equation one can use to reach the actual value of the mortgage-interest deduction, expressed as a (reduced) percentage of one's mortgage rate? I am assuming that this would involve many, many variables, and would essentially require redoing one's entire tax return, but maybe it's less complicated?


You need to determine if itemizing deductions is appropriate. Essentially, fill out a schedule A for your tax return and see how that total stacks up to the standard deduction. If it's higher, use it. If not, use the standard deduction. The end result of the "value" of interest deduction if the different in tax owed between the standard and itemized deductions.


A little twist (if you can call it that) is the actual benefit of the itemized deductions compared to the standard deduction. Or in other words, how far above the standard deduction are the itemized deductions. You could think of it as interest is deductible to the extent greater than the standard deduction. If the standard deduction is $12,500 and your itemized deductions are $15,000, then you have an extra $2500 of deductions. So effectively $2500 of your mortgage interest is deductible (because you're going to get the $12,500 deduction no matter what). The math on this gets a little more complicated to determine the effective interest rate.User avatar
Posts: 321
Joined: 5 Sep 2012
Location: Philadelphia
____________________________________________


Re: Calculate effect of mortgage-interest deductionPostby Twins Fan » Mon Apr 07, 2014 1:51 pm

If you believe there is a benefit to paying interest to someone to get a tax break rather than keeping your money and paying taxes on it, you're over-selling it. :D


As mentioned, it is very situational. For high income/high mortgage types paying yearly interest that is twice the standard deduction, sure there's some benefit... and quite a nice one for them as they probably have a low interest rate and the effective rate really lowers for them. For many of us though, myself included, the mortgage interest benefit is little to none. My yearly interest paid is below the standard deduction. I do itemize though, but even with that I'm only slightly over the standard deduction. I get the "benefit" on a couple thousand a year. Better than nothing, but not much to write home about either. :happy


Someone said the 50% number earlier get no benefit group. I read an article recently about the mortgage interest deduction, and I think the number was even higher than that for the folks getting no real benefit from it. Of course numbers can be arranged to fit the author's needs. But, I do think the mortgage interest deduction gets far too much weighting in many discussions about it... My take on it anyway.
Posts: 1000
Joined: 8 Mar 2013
____________________________________________


Re: Calculate effect of mortgage-interest deductionPostby TSR » Mon Apr 07, 2014 2:12 pm

Kosmo wrote:In reverse order:
TSR wrote:2. Is there a better approximation that we could use on these boards than the "subtract 1%" strategy without getting too deep into each poster's personal situation? Or even some general criteria? (E.g., "people making between $50K and $200K annually typically only derive x% reduction in their mortgage rate from the deduction," or "people with a mortgage of more than $x typically derive x% reduction in their mortgage rate"?)


Effective interest rate = interest rate x (1-marginal tax rate). You deduct the interest paid from the top of your earnings, so you use the tax bracket you're in. A 4% mortgage in the 25% tax bracket is 4% x (1-.25) = 3%. That's the exact answer. Size of the mortgage, term, income, make no difference. But this assumes you itemize deductions, which brings us to...


TSR wrote:1. Is there an equation one can use to reach the actual value of the mortgage-interest deduction, expressed as a (reduced) percentage of one's mortgage rate? I am assuming that this would involve many, many variables, and would essentially require redoing one's entire tax return, but maybe it's less complicated?


You need to determine if itemizing deductions is appropriate. Essentially, fill out a schedule A for your tax return and see how that total stacks up to the standard deduction. If it's higher, use it. If not, use the standard deduction. The end result of the "value" of interest deduction if the different in tax owed between the standard and itemized deductions.


A little twist (if you can call it that) is the actual benefit of the itemized deductions compared to the standard deduction. Or in other words, how far above the standard deduction are the itemized deductions. You could think of it as interest is deductible to the extent greater than the standard deduction. If the standard deduction is $12,500 and your itemized deductions are $15,000, then you have an extra $2500 of deductions. So effectively $2500 of your mortgage interest is deductible (because you're going to get the $12,500 deduction no matter what). The math on this gets a little more complicated to determine the effective interest rate.



Thanks. I guess my question was more aimed at your "little twist" at the end -- there's not much benefit to having a mortgage if EVERYONE (homeowners and non-homeowners alike) gets the benefit of the first $12,500 in deductions. That would necessarily mean that saying "you have a 4% mortgage and it's 3% after the deduction" is very frequently wrong. The "real" effective interest rate of your mortgage after the deduction is what I'm looking for.
Posts: 206
Joined: 19 Apr 2012
____________________________________________


Re: Calculate effect of mortgage-interest deductionPostby TSR » Mon Apr 07, 2014 2:18 pm

Twins Fan wrote:If you believe there is a benefit to paying interest to someone to get a tax break rather than keeping your money and paying taxes on it, you're over-selling it. :D


As mentioned, it is very situational. For high income/high mortgage types paying yearly interest that is twice the standard deduction, sure there's some benefit... and quite a nice one for them as they probably have a low interest rate and the effective rate really lowers for them. For many of us though, myself included, the mortgage interest benefit is little to none. My yearly interest paid is below the standard deduction. I do itemize though, but even with that I'm only slightly over the standard deduction. I get the "benefit" on a couple thousand a year. Better than nothing, but not much to write home about either. :happy


Someone said the 50% number earlier get no benefit group. I read an article recently about the mortgage interest deduction, and I think the number was even higher than that for the folks getting no real benefit from it. Of course numbers can be arranged to fit the author's needs. But, I do think the mortgage interest deduction gets far too much weighting in many discussions about it... My take on it anyway.



Right. I agree with the suggestion in your post that this deduction is not a good reason to purchase a home. There is SOME benefit, but it's DEFINITELY overstating that benefit if you just subtract 1% and assume that's the effective rate of your mortgage. And yet a lot of folks here do that. This is especially tricky now because you really can envision a world where someone is wondering whether to pay off their mortgage or invest the money and earning over 3% in the market seems like almost a sure thing (of course it's not actually a sure thing), but they might think differently if faced with the idea that in fact their effective rate after the deduction is essentially identical to their mortgage rate of 4%.
Posts: 206
Joined: 19 Apr 2012
____________________________________________



Re: Calculate effect of mortgage-interest deductionPostby an_asker » Mon Apr 07, 2014 2:18 pm

kenyan wrote:If the taxpayer would itemize deductions with or without mortgage interest, then he/she is getting the benefit that everyone assumes. This is a relatively small fraction of people. The fraction of people who would itemize without either mortgage interest or property taxes (the relevant number when discussing rent-versus-buy) is smaller yet.


Many people who receive some tax benefit, aside from those in high-tax states with high income, will be itemizing only because they purchased a house, and thus receive less of a tax benefit than the full marginal rate. I fall into this category. As noted, there is no quick-and-dirty formula, but it needs to be tailored to the individual.


I don't know the exact statistics, but I recall that in the neighborhood of 50% of people with mortgages in the country receive no tax benefit from them. I would be willing to bet that a significant fraction of those people are unaware of this (I've spoken to some).


+1!


It is also ironic that this benefit helps those who are non-Bogleheadish and spend way more than they should for their house, as their mortgage interest is much more.
Posts: 235
Joined: 27 Jun 2013
____________________________________________



Re: Calculate effect of mortgage-interest deductionPostby jsl11 » Mon Apr 07, 2014 2:21 pm

There is an additional complication in trying to figure the tax benefit of a mortgage. If your itemized deductions are near the standard deduction, either a little more or less, then you can gain by bunching your deductions into alternate years. There is not too much you can do with the mortgage payments. You may be able to make 13 payments one year, and 11 the next. However, you may be able to shift all of your real estate taxes into alternate years. If you do this, you would also try to shift as many other deductible items as possible into those years. All of this makes your calculation more complicated.
Jeff
Posts: 2893
Joined: 27 Feb 2007
Location: Cleveland, OH

Posted on 2:11 PM | Categories:

Itemized tax deductions: Friend or Foe?

We came across an interesting article from Adam Spiers @ Community Ladders, he writes: Are itemized tax deductions working for you? We make lots of choices based on the potential for taking a tax deduction, but it turns out that itemizing tax deductions isn’t always to your benefit!

We hear about all kinds of tax deductions: mortgage interest, charitable donations, and even state and local tax deductions. Every year, Americans dutifully keep records of tax-deductible items in order to get some relief from Uncle Sam at tax time. Some even make decisions — such as taking on a larger mortgage loan — because of the allure of specific tax deductions. This is decidedly bad for one’s financial health. In many instances, these decisions do not pay off: most taxpayers receive a greater benefit from taking the standard deduction over itemizing their deductions.

But let’s be perfectly clear up front — not all potential deductions fall under the itemized deductions category. Some deductions, such as student loan interest, moving expenses, and the first $250 of unreimbursed teacher expenses, are deductible regardless of whether you itemize or take a standard deduction. These are technically “adjustments to income” and found on the first page of your 1040 form.

Who benefits from itemized deductions?

Approximately one-third of taxpayers file tax returns with itemized deductions, according to the Congressional Budget Office. People with higher incomes tend to be the ones who itemize their deductions, as taxpayers in higher tax brackets disproportionately benefit from itemized deductions. For instance, over 50% of the total tax benefits go to taxpayers whose earnings are in the top 20%; a full 17% of the total tax benefit goes to taxpayers whose earnings are in the top 1%!

Why do high-income earners disproportionately benefit from itemized tax deductions?

Income tax is calculated by multiplying the tax rate of a tax bracket by the taxable income in that that bracket. Deductions reduce taxable income, which in turn reduces the amount of taxes you have to pay.

Our tax system is progressive — meaning that income in higher tax brackets is taxed at a higher rate than income in lower tax brackets. As a result, high-income individuals get more benefits from an income deduction because their tax rate is higher on the last dollar of their income.

An example:

Al earns $50,000 a year, and the last $10,000 of his income is taxed at a rate of 10% (marginal tax rate). If he is able to deduct $10,000 from his income due to the mortgage interest deduction, he would save $10,000 * 10% = $1,000.

Betty earns $150,000 a year, and the last $10,000 of her income is taxed at a rate of 40%. If she is able to deduct $10,000 from her income due to the mortgage interest deduction, she would save $10,000 * 40% = $4,000.

Although Al and Betty paid an equivalent amount in mortgage interest and both were able to deduct an equivalent amount of $10,000 from their incomes, Betty’s benefit was four times greater than Al’s because her marginal income was taxed at a higher rate.

Why don’t more taxpayers itemize their deductions?

Each taxpayer must elect to either itemize deductions or take the standard deduction. If your standard deduction exceeds your itemized deductions, you should take the standard deduction. For the 2013 tax year, the standard deduction is $6,100 for an individual and $12,200 for a married couple filing jointly. The standard deduction often exceeds the value of itemized deductions that the average taxpayer accrues during the year, so most taxpayers don’t actually benefit from itemizing deductions.

Conclusion:

Itemized deductions can offer significant tax benefits — but only when the taxpayer itemizes his or her deductions, which typically only makes sense for higher-income earners. In other words, in many instances, itemized tax deductions don’t actually translate into actual tax savings! Making financial decisions based on a gut-level expectation of an itemized tax deduction may be very bad for your financial health.
 

About the author Adam Spiers

Adam is currently a law student at the University of Maryland School of Law. He holds a Master in Public Policy from the University of Maryland School of Public Policy, and as well as bachelor degrees in Economics and History from the University of Maryland, College Park.
Posted on 11:45 AM | Categories: