“Tax Savings” Far Overshadowed by Interest Paid

This weekend Seattle Bubble favorite Steve Tytler fielded a question from a very confused homeowner in his real estate Q&A column in the Everett Herald.

Couple’s dilemma: To rent out house or sell

Here is a portion of the owner’s question.

We were given a house valued at \$250,000, which is paid for. We have a home that we live in valued at \$300,000 and we owe \$145,000 on the mortgage.

We are thinking about selling the home that we live in and remodeling and moving into the other house, which would allow us to live mortgage-free and give us some cash flow. Since we both still work and make a good income, I feel we will be paying huge taxes every year without a mortgage write-off.

Okay, so what’s wrong with this picture?

If you answered “it doesn’t make any sense to flush thousands of dollars down the toilet on mortgage interest just to get a fraction of that back on your taxes,” then congratulations—you win the grand prize!

Let’s run some quick numbers on this couple’s situation. We’ll make the following assumptions:

• The numbers they gave about their home’s value and its mortgage are reasonably accurate.
• That they put 20% down when they bought their house.
• That the value of their home has roughly followed the Case-Shiller Home Price Index for the Seattle area.
• That “a good income” is \$150,000 (gross).

Working backward, we can determine that the couple asking this question probably purchased their home in early 2000 for around \$215,000. Prevailing interest rates in early 2000 were around 8.3%, but it is probably safe to assume that they refinanced at some point during the period of sub-7% rates that has prevailed since 2003. We’ll run the numbers assuming a 10-year-old mortgage at 8.3% and a 7-year-old mortgage at 6.5%.

2010 Taxes 8.3% 6.5%
Interest Paid (\$12,448) (\$9,709)
Taxable Income w/ Interest Deduction \$126,152 \$128,891
Taxable Income w/o Interest Deduction \$138,600 \$138,600
Tax Bill w/ Interest Deduction (\$23,901) (\$24,585)
Tax Bill w/o Interest Deduction (\$27,052) (\$27,052)
Difference \$3,151 \$2,466
“Savings” (\$9,297) (\$7,243)

The table at right runs the numbers for this couple for 2010, comparing their total tax bill taking just the standard deduction (\$11,400 for 2010) versus if we (rather generously) assume that they if they itemize they can deduct all their mortgage interest paid plus other itemized deductions adding up to the same amount as the standard deduction.

When most people consider the federal income tax mortgage interest deduction, they only get as far as the second-to-last line in the table. They look at how much they would pay in income tax without the mortgage interest deduction, see that it is thousands more than they would pay otherwise, and assume that must mean that they’re saving money.

The missing final step of course is to go back up to the first line in the table and look at how much you paid in mortgage interest to get that tax savings. Paying mortgage interest does not build equity. It is lost money—flushed down the toilet. It’s the rent that you pay to borrow the money from the bank that you used to buy your house.

In the situation that the Everett Herald reader described above, their choice is between paying \$9,000-\$12,000 this year on mortgage interest to “save” \$2,000-\$3,000 on their taxes, or paying zero dollars in mortgage interest and paying the \$2,000-\$3,000 extra on their taxes. Gee, what a dillemma.

As for tax deductions, I am not a big fan of buying real estate as a “tax write-off.” The tax benefits are nice, but they should not be your primary reason for buying or holding a rental property.

The “tax benefits” are not “nice,” they’re non-existant in the situation described by the reader. Paying \$9,000 to “save” \$2,500 is not a benefit, it’s financial idiocy. His answer isn’t too surprising considering the fact that Steve is in the business of selling mortgages. Of course he wants people to believe in the imaginary financial benefits of paying tens of thousands of dollars a year to rent money from the bank. That fantasy is what keeps many loan-peddlers in business.

I would not shed a single tear if the mortgage interest deduction disappeared tomorrow. It is a destructive, backward incentive that only serves to confuse people and encourage them to take on more debt than they should or otherwise would.

Tim Ellis is the founder of Seattle Bubble. His background in engineering and computer / internet technology, a fondness of data-based analysis of problems, and an addiction to spreadsheets all influence his perspective on the Seattle-area real estate market.

1. 1
BacktoBasic says:

Totally wrong. Assume the rent for similar house for \$1100×12/year+interest tax saving, the owner still ahead than rent. A house purchased in 2000 is still well above water in Seattle (Tim calls this bubble). Interest rate of 8% or 6%, what are you talking about? People are now holding 3.75% ARM/7 year now or 5 % ARM in 2000. Fed rate is near zero and typical saving account interest is 1% today are your are getting 6% or 8% interest. Maybe your FICO is below 600 or filed Bankrupt last 10 years.

2. 2

Tim, I think your analysis may also be too basic. You’re ignoring the fact that they would have some rental income and also a depreciation deduction. Also, the house they were “given” would probably have a low basis (unless they inherited it), in which case living in it could generate other tax savings if they sold it down the road after living there. Conversely, by renting the place they eventually would give up the tax free sale of this residence.

They really need to see a decent accountant.

3. 3
HappyRenter says:

What about tax on the income generated by renting out the house?

4. 4
ray pepper says:

For the love of God…..How is Steve Tytlers BROKER friend doing in Az who Steve boasts continues to Pay on a Mtg owing 500k and is worth less then 250k?

R U STILL FRIENDS STEVE?

IS HE STILL PAYING?

I NEED TO KNOW!

5. 5

RE: HappyRenter @ 3 – I thought I mentioned that. It was the first of three things I said Tim didn’t account for.

6. 6
Really? says:

Do people actually believe this? To me it’s always been pretty clear, yes you are paying a ton of interest to get that deduction. I think the point is just to keep in mind that you DO get the deduction. So rather than expecting an interest bill of X for the year, you know that it’s really going to be more like .75X after the deduction, that’s all. At least among people I know, this is understood. Steve saying that the tax benefit is “nice”, he just means the interest bill is not as big as it first appears since you will get a good chunk of that back. He also states it’s not a good reason on it’s own to buy a home. I would think you’d like that advice, Tim.

It’d be like if your landlord refunded 25% of your rent to you at the end of the year. You aren’t going to rent the place JUST BECAUSE of that, but you do need a place to live so it’s a “nice” benefit, and when you compare it to other places, you are going to keep that refund in mind.

7. 7
mukoh says:

RE: ray pepper @ 4 – Considering homes in AZ are at \$80k with a pool nowadays, jingle payment to the bank would be warranted. :)

8. 8
Scotsman says:

Why did I even read this thread? Talk about depressing. Let’s see- \$450K in assets against \$150K in debt? Yeah, I must need some more debt! Time to leverage up, baby!

Tim’s analysis needs more detail, but that doesn’t fix the problems in the underlying thought process- or lack there-of.

I think they should get a pay-option second on the free and clear house and use the proceeds to buy Power Ball tickets. Dream big!

9. 9
LA Relo says:

Someone tell them they can pay my mortgage AND have the tax write-off, I’m okay with that.

10. 10
Everett_Tom says:

By LA Relo @ 8:

Someone tell them they can pay my mortgage AND have the tax write-off, I’m okay with that.

I’d like to nominate this for the post of the day… in fact, if you can find a person who’ll take this, I’ll buy a house so they can pay my mortgage too.

11. 11
ray pepper says:

RE: mukoh @ 6

Do YOU get the impression from the tone of Tim thats hes not using Steve Tytler for his loan?

I say the Vegas Line has the odds on a Tytler-Tim transaction going off @ 90-1

(That fantasy is what keeps many loan-peddlers in business.)

12. 12

Your mortgage interest deduction tax “savings” is just the tax shield provided by your tax rate against the loan interest. Basic math indicates you will never save more than the loan interest costs. If you are in the 35% bracket, then just 35% of your interest shields income and reduces your taxes paid. This leaves you bearing 65% of the total interest cost.

The only time a high mortgage balance is somewhat justifiable is if your opportunity cost repaying your mortgage principal is greater than your mortgage rate. i.e. can I make a better return in the stock market than the 4.5% rate I have on my 30 year FRM.

It always amazes me that people who own homes aren’t smart enough to figure this out. Perhaps there’s a link.

13. 13
wreckingbull says:

Having a wife with a money-hemorrhaging small business is an even better tax write-off than mortgage interest. Don’t ask how I know this.

14. 14
Your mortgage interest deduction tax “savings” is just the tax shield provided by your tax rate against the loan interest. Basic math indicates you will never save more than the loan interest costs. If you are in the 35% bracket, then just 35% of your interest shields income and reduces your taxes paid. This leaves you bearing 65% of the total interest cost..

You need to go back up to the piece again and read about the standard deduction. In both the 8.3% and 6.5% examples you’re bearing about 75% of the cost. I would guess other limitations on the deductions would kick in for most people before they even approached paying only 70% of the interest cost.

15. 15
Don’t ask how I know this.

You know business losses don’t require that you itemize?

That raises another issue. If this property becomes rental property, I’m not sure that the interest deduction would require that they itemize. If not, then they could get the standard deduction and deduct the interest. Any accountants out there?

16. 16
wreckingbull says:

RE: Kary L. Krismer @ 15 – I do. :) I was quite happy to still take the standard deduction in addition to the “wife is finally following her dreams” deduction.

17. 17

RE: Really? @ 6

I’ve Heard This One Too

I don’t save money to get interest because I then owe taxes on the interest income….LOL

If tax deductions on home mortgages were apples on a tree, you gave up about 10 to get about 3. And remember, you have to pay house payment interest out of your net pay, not your gross pay….hades, you never see your gross pay.

18. 18
Jonness says:

R U STILL FRIENDS STEVE?

IS HE STILL PAYING?

I NEED TO KNOW!

Ray:

It’s becoming increasingly clear. A house is not an investment; it’s a place to live. This will become even more apparent after the second leg down. :)

19. 19
Jonness says:

By Really? @ 6:

I think the point is just to keep in mind that you DO get the deduction. So rather than expecting an interest bill of X for the year, you know that it’s really going to be more like .75X after the deduction, that’s all. At least among people I know, this is understood. […]

It’d be like if your landlord refunded 25% of your rent to you at the end of the year. You aren’t going to rent the place JUST BECAUSE of that, but you do need a place to live so it’s a “nice” benefit, and when you compare it to other places, you are going to keep that refund in mind.

You are correct in pointing out that’s how most people believe it works. Unfortunately, it would be like your landlord keeping the first 11 grand and giving you 25% of the rest. So if your total interest is 15K, It’s like your landlord refunding 6.7 percent. IOW, the benefit gets bigger the more you borrow. Thus, rich people get the filet mignon, and the poor suckers in the middle get the bone. So if you can rent the same place for 6.7% less than buying, maintaining, and paying taxes, how much have you saved?

That being said, I agree with Steve, if it pencils out, keep it in mind, but don’t buy just to get it. I think Tim’s point is, by keeping the statement abstract, it perpetuates the myth, believed by most people, you get a 25% refund of all the interests you pay.

20. 20
WestSeattleDave says:

RE: bubblebuyer @ 12 – “If you are in the 35% bracket, then just 35% of your interest shields income and reduces your taxes paid.”

I think this is a common misperception. If you are in the 35% tax bracket, that does not mean that you pay 35% of your income in taxes. The “bracket” refers to the nominal tax for withholding purposes. Your actual tax will be considerably less than that. I would think it’s closer to 20% than 35%, and could be even lower than that due to other deductions/credits the taxpayer may take advantage of.

21. 21
Steve Roth says:

>If you answered “it doesn’t make any sense to flush thousands of dollars down the toilet on mortgage interest just to get a fraction of that back on your taxes,” then congratulations—you win the grand prize!

While this is true as a standalone statement, it doesn’t really put across the reality or complexity of the long-run bet.

1. With a mortgage you’re making a leveraged purchase — really the only opportunity normal people have for an LBO. Upsides and downsides, of course. But the upside can be profoundly good — earning appreciation on 100% of the home’s value while only investing 10% (plus interest payments and other costs over time).

2. By reducing those interest payments by maybe 10, 20, maybe 25%, the MID can make long-term numbers work out much better.

But it’s all a matter of future appreciation — whether the percentage increase on the 100% home value outweighs the costs (opportunity cost for the down payment, out-of-pocket plus opportunity cost for the after-tax interest payments, property taxes, insurance, and maintenance, some of which you wouldn’t incur as a renter — all minus the opportunity costs of rent you would pay out otherwise).

So to predict whether to buy or rent, you need predict future appreciation and future opportunity costs (i.e. what you would get on cash invested in “the market”).

In other words, in order to predict the future you have to predict the future. Sigh.