Is Your Mortgage Tax Deductible?

Debt has a pretty bad name, but there’s one shining exception: mortgage debt. It’s “good” debt, you see, because it not only helps you buy a home and achieve the American dream but also also has income tax advantages in the U.S.

Note to non-U.S. readers, people who are big-time enough to owe the Alternative Minimum Tax and/or to phase out itemized deductions, and people who hate taxes: this post may not be of interest to you. Feel free to take the rest of the day off, and have a great weekend!

We’re told that mortgages don’t cost their stated rate – they cost less. Specifically, an “after-tax” mortgage interest rate is supposedly:

After-Tax Mortgage Rate = Mortgage Rate  x  (1 – Marginal Tax Rate)

If your mortgage is 3.25%, and you’re in the 28% tax bracket, your after-tax mortgage rate is calculated as 2.34% (3.25% x .72). Yeah!

The way to achieve this greatness is to include any allowable mortgage interest expense with the itemized deductions on one’s tax return. That should reduce taxable income and save taxes with every single dollar of mortgage interest paid (e.g., if one is in in the 28% bracket, 28¢ is saved for every $1 of mortgage interest). This is an awesome deal – just like when the missus gets a 20% off promotion and goes on a saving spree at the store.

There is one small catch. To get the benefit of itemizing your mortgage interest expense, you need to (wait for it…) itemize your deductions.

And to itemize your deductions, you’ll want them to be greater than the standard deduction.

Who Will Win? Itemized versus Standard Deduction

The standard deduction is projected to be $6,350 for individuals and $12,700 for families in 2017. (Those could change – even this year – so check the IRS website for the most current.)

Let’s see how this works in practice. I’m going to go with simple figures and limited categories to keep the examples easy and widely applicable. I’m also going to assume no AMT or phased-out itemized deductions because I told those folks they could head out.

Let’s consider some random couples (married filing jointly) with a 3.25% mortgage and a 28% marginal tax rate. We’ll assume all of the amounts are actually allowable deductible expenses (remember there are all sorts of limits and restrictions on itemizing).

Couple #1:

Property taxes $10,000
Charitable contributions $10,000
Mortgage interest expense $10,000

I’ve got great news for these folks. Their total itemized deductions of $30K are way more than the standard deduction of $12,700, so they should itemize. They get the full benefit of deducting their mortgage interest expense, so their after-tax mortgage interest rate is only 2.34%.

Couple #2:

Property taxes $2,000
Charitable contributions $2,000
Mortgage interest expense $5,000

Their total itemized deductions are $9K. That’s less than the assumed standard deduction of $12,700, so they shouldn’t itemize. And in a sad twist of fate, that means their mortgage interest expense is doing them no good at all on their taxes. Their after-tax mortgage rate = their mortgage rate = 3.25%. They should really buy a much more expensive house – think of all the taxes they could save!

Couple #3:

Property taxes $5,000
Charitable contributions $5,000
Mortgage interest expense $5,000

Hmmmmm. They have $15K of itemized deductions, which is greater than the standard deduction of $12,700. They should itemize, but their mortgage isn’t delivering full value tax savings, is it? If they didn’t have a mortgage, they’d take the standard deduction and still get some of the tax benefit.

To see this issue – where the mortgage helps, but not fully – let’s consider the extreme example of…

Couple #4:

Property taxes $4,000
Charitable contributions $3,800
Mortgage interest expense $5,000

These guys have a total of $12,800 in itemized deductions. That’s $100 more than the standard deduction of $12,700, so they should itemize. But with a marginal tax rate of 28%, their itemizing only saves them $28. Said another way, they’re paying $5,000 in mortgage interest to save $28 on their taxes…

 

Is Your Mortgage Tax-Deductible?

One’s mortgage interest expense could therefore give a range of tax benefits:

1. Full Benefit

Itemized deductions excluding mortgage interest expense are greater than the standard deduction.
The mortgage interest expense is gravy on top.

After-Tax Mortgage Rate = Mortgage Rate  x  (1 – Marginal Tax Rate)

2. No Benefit

Itemized deductions including mortgage interest expense are less than the standard deduction.
Sorry – no gravy for you.

After-Tax Mortgage Rate = Mortgage Rate

3. Partial Benefit

Itemized deductions excluding mortgage interest expense are less than the standard deduction, but including mortgage interest expense are greater than the standard deduction.
Some of the gravy missed the plate.

Mortgage Rate  x  (1 – Marginal Tax Rate) < After-Tax Mortgage Rate < Mortgage Rate


A mortgage may not be “good” debt after all. It may just be debt.

The above examples are simplistic, and don’t even include other common categories of itemized expenses (e.g., state income taxes, medical expenses). I offer no tax advice, and your own situation will dictate any tax benefits from a mortgage.

The point is that you should do the calculation to examine how much your mortgage really does cost. If a credit card company told you, “Your rate may be 15%, or then again it may be 20%” you’d want to know which.

A mortgage interest rate may be much lower, but the principal often dwarfs any other debt you have. The difference (if any) between a pre-tax and after-tax mortgage rate could be material to your finances.

Taxes Are Lame and This Is the Most Boring Post Ever. What’s Your Point?

Tell me about it. You’re just having to read it – I had to write it!

But I have a plan. In my last post I considered risk, and established that most humans are, indeed, risk-averse. In this post, we’ve considered that a mortgage may have limited or no tax advantages, which is important to how much this debt actually costs.

In my next post, I’ll add a layer of complexity – the situation where you think your mortgage interest is giving you full benefit, but you’re wrong (there is no greater tease than a tax tease…).

Once I have all of my building blocks in place, I’ll finally be able to address the question: when does it make sense to pay off a mortgage? So you’ve got that to look forward to!

 

Do you like taxes? Are you getting a fat tax benefit from your mortgage? Or are you stuck with a standard deduction while supporting the east and west-coast bourgeoisie’s tax-advantaged mansions?

 

 

4 thoughts on “Is Your Mortgage Tax Deductible?

    • I think it’s just an either / or thing – interest expense can be part of your itemized deductions, but they (along with the rest of your itemized deductions) are always competing against the standard deduction. If you have modest itemized deductions, your mortgage interest may not be giving you much of a tax advantage after all.

    • Nice work on a paid off mortgage. The fat tax benefit is indeed nice, but it’s worth remembering you need to pay even more in mortgage interest to earn it. I’ll definitely want your thoughts when I finally get around to arguing the pros / cons of paying off one’s mortgage.

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