A while back, I started to think about paying our mortgage off early. We were at or beyond the max equity exposure I wanted, I was loath to invest in long-term fixed income, and short-term yields were painfully low. How ‘bout using any spare change we had lying around to pay down the ol’ mortgage?
Warning: this is another U.S. income tax-centric post. Please proceed with caution, and know that this is my last tax-related post for a loooooong time.
Our mortgage rate is only 3.125%, and since we itemized deductions, you could say our after-tax rate was much lower. Paying that off wasn’t a great return, but it was still much better than I could earn on cash.
As I started scenario planning with paying down the mortgage and optimizing our itemized deductions, I made an additional discovery. Half of the time, our mortgage had no tax advantage at all.
The reason: doubling deductions.
The Benefits of Doubling Deductions
When doing your taxes, you’re allowed to use the standard deduction or itemize your deductions – the IRS is nice like that.
Many folks just add up their itemized deductions in a year, and, if they’re greater than the standard deduction, they itemize. If not, they take the standard deduction. Your itemized deductions are in an endless competition with the standard deduction.
But what if your itemized deductions and the standard deduction decided to stop fighting, and be friends?
If you can time when your itemized expenses hit, you can cram as many of them as possible into a single tax year, and then take the standard deduction the next year. Doubling up your itemized deductions (aka “bunching” them) can be an effective way to maximize total deductions by combining the benefits of itemizing and the standard deduction.
For a very simple example, let’s consider a couple with only one itemized expense: annual property taxes of $10,000.
$10,000 is less than the projected 2017 married-filing-jointly standard deduction of $12,700 (always check the IRS site for the most current info), so if this couple just paid their property taxes each year, they’d never itemize.
But many taxing authorities allow you some freedom in when you pay. My annual property taxes can be paid in December OR January. The IRS is on board too: to be deductible, a tax “must be imposed on you and you must have paid it during your tax year.”
What if our imaginary couple paid their $10,000 of 2016 taxes in January 2017 and then paid their $10,000 of 2017 taxes in December 2017? They’d have $20,000 of property taxes in a single year – much more than the standard deduction.
Here’s the total deductions they’d have over two years:
YEAR 1 Standard deduction of $12,700 + YEAR 2 standard deduction of $12,700
= $25,400 total deductions over two years
Double deduction strategy:
YEAR 1 Itemized deduction of $20,000 + YEAR 2 standard deduction of $12,700
= $32,700 total deductions over two years
Double deductions looks like the better strategy for them. In years 3 and 4, they can just do it all over again.
This strategy should be explored for anyone with the ability to time when itemized expenses hit.
What types of itemized expenses are good candidates for doubling up?
- Charitable contributions
These are a great candidate for doubling because they’re at your discretion. Do two years’ worth of donations in one year and then skip a year. (If the charity is really depending on you, you may want to give them a heads up…)
- Property taxes
I’m able to combine two years’ worth of property taxes in a single tax year. Your ability to bunch property taxes may differ – some tax authorities bill quarterly or semi-annually so there’s less room to play.
One thing that should be obvious: if your property taxes are included with your monthly mortgage payment to the bank, you won’t be able to play with the timing.
- Medical Expenses
Medical expenses (to the extent you can time them…) make sense to consider for bunching both to breach the AGI threshold for deductibility and to combine with other bunched itemized expenses.
- State Income Taxes
These are harder to time, but some states allow you to pay a 4th quarter estimate in December (instead of January), which could be helpful if it’s a year for itemizing.
There are a lot of other categories that could be in play. Every itemized expense should be examined to see if it can and should be strategically timed.
How to Test
There is no way for me to cover all of the possibilities for double deduction strategies, and I don’t give tax advice anyway. But a good way to examine if a double deduction strategy could provide a benefit is to calculate deductions over a two-year period in two ways and see which is bigger:
- Itemizing deductions each year without trying to double up, versus
- Cramming as many allowed itemized deductions as possible into one year, and taking the standard deduction in the next year
An extra credit question is when someone has variable income: they should explore the tax benefit of matching a higher income year with the higher itemized deduction year.
Analyzing a double deduction strategy is not simple and will likely require the help of a tax professional. But if it makes sense and once it’s in place, it’s fairly straightforward to execute: just remember if this is an “on” or “off” year for itemizing and act accordingly.
Did Doubling Deductions Make Sense for Me?
Pretty much. When I calculated our normal annual itemizing versus a double deduction strategy, it was just about break-even – we’d have about the same deductions over two years with either method. Any additional principal payments (including regular amortization) would make the double deduction strategy start to dominate.
That meant my mortgage was tax-advantaged only half of the time, and it added about .5% to what could be considered my “after-tax” mortgage rate. You might say .5% isn’t that much, but when I was already leaning toward paying it off, it was a meaningful nudge.
The Standard Deduction Never Sleeps…
The standard deduction is always there and always competing against your itemized deductions. Having enough itemized deductions to exceed the standard deduction at least every other year is key.
….And May be Hitting the Gym
Our President is considering a significant increase to the standard deduction. That sounds nice, but it could compromise many a double deduction strategy: if two years’ worth of itemized deductions are still less than the standard deduction, your days of itemizing are probably over.
A big bump in the standard deduction would also make many mortgages go from being partly tax-advantaged to having no tax advantage at all. The silver lining is that many folks with huge mortgages would still get a nice tax benefit.
What Are the Takeaways?
Doubling deductions, by combining one year of itemizing and one year of the standard deduction, could provide more total deductions (and hopefully tax benefits) than other strategies. It’s not a simple analysis, though, so definitely check with a tax professional.
Mortgages aren’t always as tax-advantaged as claimed. This was actually my goal today, and it took far more time and pain than I thought it would. Which brings me to…
Writing about taxes is really, really dull. No more tax topics from me for a long while.
Picture courtesy of Petra
I was going to use the poster for Jean-Claude Van Damme’s seminal work Double Impact. Then I realized no one else has seen that movie. Or likes JCVD anymore. So enjoy your cute calves, but it could have been so much better.
Take it away, Zhang:
[For those keeping score: best tax-themed personal financial post referencing JCVD. Ever.]