Writing off the mortgage interest

I was talking with a client over the weekend and she that told me, "she still didn't get how that tax thing worked". I was a bit surprised, considering that was one of the reasons she wanted to go from renting to owning a home. I suppose it's one of those things that you know is good for you and you just accept, sort of like not sticking your tongue on a frozen pole.

Okay, so here goes, and remember to always talk to an accountant or a tax preparer before entering write offs on your tax forms. So having given my official disclaimer...the lawyers are happy now...here's how it works.

In simplest terms the money that you pay toward your mortgage interest, can be deducted from your gross income, the same way you would deduct the cost of a harpoon if you were a whale hunter...and in no way do I endorse harpooning whales, again the lawyers make me say these things...

So if you're wanting a real world example of how this works or how it can influence your decision between renting and owning, lets set up an example. A home with a value of $200,000, where the seller paid your closing costs and an apartment that rents for $1,000 a month

Rent $1,000/month

Mortgage payment principle and interest on a $200,000 loan is $1,199

of the $1,199 principle and interest payment, $1,000 is mortgage interest.

Over the course of a year, $12,000 has been spent on rent, with no tax benefits, its just gone.

Over the course of a year $14,388 has been spent on mortgage principle and interest of which, $12,000 has been spent on mortgage interest. Unlike with paying rent, you can deduct $12,000 from your gross income, meaning you "never made that money and don't have to pay taxes on it" In other words the savings comes in not having to pay taxes on $12,000.

If you are in 15% tax bracket that is a savings of $1,800.

again, if you couldn't deduct mortgage interest you would owe the IRS an additional $1,800

In addition to the tax savings, you've knocked down the principle on your loan by $2,388. So instead of oweing $200,000 you now owe $197,612. If your house has gone up in value by even as little as 1%,(Las Vegas traditionally has gone up in value on average at about 6%-8%, with the exception of 04', 05 where we jumped like 43%), but at 1%, ($2,000), your homes value is now $202,000, you owe $197,612. This means you now have an equity position in your home of $4,388.

Okay back to comparing the rent vs own thing.

Rent end of year cost $12,000, no tax deduction no equity position

Own end of year cost $14,388, tax savings of $1,800, equity position of $4,388

You paid $2,388 more to own your home over 1 year than to rent, but that $2,388 is now equity in your home, (you get it back when you cash out your equity) in this example the home also went up $2,000 (again money you get back when you cash out) and you saved $1,800 in taxes. (money you didn't have to pay).

Okay, now this gets real interesting if you hang onto your home for a few years. The average for first time home buyers before selling is 3 to 5 years...lets call it 3 years.

3 years renting-$36,000 (if by some miracle your rent stays at $1,000/month)

3 years owning-(1% increase in value, 200K initial purchase price, $200,000 loan amount

6% int/ 15% income tax bracket

year 1- $200,000 principle loan amount/$1199/mo. P&I payment- $12,000 to interest $2388

to principle.

$1800 tax savings/home value to $202,000/$2,388 principle reduction.

year 2- $197,612 principle loan amount(original value less principle reduction)/$1199 P&I/mo

$11,820 to interest $2,532 to principle
$1773 tax savings/home value to $204,020/$2,532 principle reduction.

year 3- $195,080 principle loan amount(yr. 2 principle less principle reduction)/$1199 P&I/mo
$11,700 to interest $2,688 to principle

$1755 tax savings/home value to $206,060/$2,688 principle reduction.

End of 3 years

Renting- $36,000 out of pocket, no return on money spent, no tax deductions.

Owning- $43,164 out of pocket

Total tax savings over 3 years-$5,328

Total principle reduction over 3 years-$7,608

Total increase in value of home over 3 years-$6,060

In simple terms, renting over 3 years has cost $7,164 less then owning. Owning has saved you $5,328 in taxes and has created an equity position in your home of $13,668.

Owning over 3 years at 1% increase in value of the home created $11,832 return on investment and provided a roof over your head.

So back to the original reason for this post, how is mortgage interest written off of my taxes? The money you pay for your mortgage insurance is tax free. Again, check with your accountant for your specific situation.