“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.

Sadly, Steve’s answer does not really address this issue at all.

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.

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About The Tim

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. Tim also hosts the weekly improv comedy sci-fi podcast Dispatches from the Multiverse.