Unless you can afford to buy a home with cash, you’ll be paying some interest on a mortgage if you decide to go from being a renter to being a homeowner. Paying interest to a bank is no one’s idea of a good time. The good news, though, is that with the mortgage interest deduction the IRS lets you deduct that mortgage interest from your taxable income when you file your tax returns.
Find out now: How much mortgage can I afford?
How the Mortgage Interest Deduction Helps
The mortgage interest deduction takes some of the sting out of owning a home and having to make monthly mortgage payments. Just as landlords can deduct mortgage interest on rental properties they own, so can regular folks deduct mortgage interest on the home or homes they buy. Taxpayers who itemize their deductions can deduct their mortgage interest on up to $1 million of debt from a home purchase, plus up to $100,000 of debt from a home equity loan. The deduction doesn’t have to be for your first home or primary residence. It can be for your ski lodge or beach cottage, too.
The mortgage interest deduction was designed to encourage homeownership. Although American homeownership rates are no higher than comparable countries that don’t offer a mortgage interest deduction, our tax break has achieved hallowed status. Many think that eliminating or reforming the mortgage interest tax deduction would be politically impossible. That’s a shame, say critics of the deduction.
Find out now: What happens to my taxes after buying?
What the Critics Say
Critics have a lot to say about the mortgage interest tax deduction. For one thing, they say the deduction favors the rich. Actually, any itemized tax deduction is more valuable the higher your tax bracket. Unlike a tax credit, a tax deduction is more advantageous the higher up the income ladder you go. If your top tax rate is 37.5%, a $1,000 reduction in your taxable income is more valuable to you than to someone who tax rate is 15%.
Plus, because wealthier people buy more expensive homes and because the mortgage interest tax deduction is available on second homes and vacation homes, rich people can reap some serious benefits from it. Research shows that most of the benefits of the mortgage interest deduction go to wealthy families. Those who think the tax structure should do more to help money flow to less advantaged Americans take issue with this.
Another criticism of the mortgage interest deduction is that it doesn’t achieve its stated goal of increasing home ownership among middle-income Americans. Most low- and middle-income Americans don’t itemize their deductions, so they don’t take advantage of the mortgage interest deduction. For most of these folks, the Standard Deduction provides a bigger tax break than itemizing and taking the mortgage interest tax deduction would. Critics say the deduction doesn’t encourage responsible, affordable homeownership among the middle class. If anything, it encourages middle-class and working-class families to go for “reach” houses and take out bigger mortgages. The financial crisis showed us why that can be dangerous. And because most of America’s lowest-income citizens are renters, not buyers, the mortgage interest deduction doesn’t provide them any benefits.
Find out now: Is it better to rent or buy?
Why It Matters
Aside from being an interesting tax policy debate (if you like that kind of thing), the controversy around the mortgage interest tax deduction could have big practical implications. If it is reformed, for example to limit the deduction to a filer’s primary residence, some people will face a bigger tax bill. The current mortgage interest deduction costs the US government over $70 billion in lost tax revenue. Reforming the deduction or replacing it with some kind of affordable housing tax credit could help address budget deficits.
The Congressional Budget Office (CBO) has recommended gradually replacing the current deduction with a 15% nonrefundable tax credit. Under the CBO proposal, the maximum amount of mortgage debt that would be eligible for inclusion in the credit calculation would be $500,000. The credit could be applied only to interest on debt used to buy, build, or improve a first home. No more tax breaks for mortgages on beach getaways. Still, reforming the mortgage interest tax deduction isn’t exactly a high political priority. If you’re buying a new home and you’re looking forward to the deduction, rest easy.
When pondering the rent vs. buy decision, consider the whole picture, not just the mortgage interest tax break. Think about what your monthly payments will be, about closing costs, transportation costs and maintenance costs. The bigger your mortgage and the higher your income, the more valuable the mortgage interest tax deduction will be to you. That’s not to say that you should buy the most lavish house you can possibly finance. Learn from the past and stick to the comfortable affordability limit when you’re making the jump to homeownership.
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