How to Really Calculate the After Tax Cost of Your Monthly Mortgage Payments

To accurately calculate your tax break, first estimate your total monthly payment:

where: P = principal I = interest

HOI = homeowners insurance

MI = mortgage insurance

Tx = property taxes

HOA = homeowner association dues

Recall that monthly payments may include items other than principal and interest, such as property insurance, HOA fees, mortgage insurance, and so forth. As a starting point, estimate the amount you will pay for each monthly expense. Next, back out only the amounts for interest and property taxes.5 For example, if your total monthly payment of $1,600 includes every item in the list, interest and property taxes might give you a deduction of only $1,200 per month, not $1,600 per month. This amount is all you can deduct (12 x $1,200 = $14,400 as opposed to $19,200).

Once you estimate your future interest and property tax figures, pull out your most recent tax returns. Recompute your income taxes with these amounts as deductions. But here's the catch: To deduct property taxes and interest, you must give up the standard deduction of $7,950 for married couples ($4,750 for individuals filing separately).

So, low- to moderate-income (nonitemizing) homebuyers who purchase modestly priced houses (say, under $150,000) will experience a net gain of no more than $2,000 to $4,000—and maybe less. Nonitemizing

5 Here, I just want to show why the tax break for monthly payments isn't as large as you've probably been told. To actually perform this calculation, you need figures for your home and home loan. In contrast to homeowners, remember property investors may deduct all monthly payment expenses except principal.

middle to upper-middle income earners may net a gain in deductions of around $3,000 to $6,000. If you already incur a number of other deductible expenses but do not presently itemize, you will gain more. If you earn over $150,000 (adjusted gross income), mortgage interest will add nothing to your tax deductions—even if you already itemize.

Tax Deductions Exceed Tax Savings. The figures cited in the previous section for tax deductions do not translate directly into tax savings. To compute tax savings, subtract these and other allowable deductions and exemptions from your adjusted gross income; then turn to the tax tables in the back of your 1040 booklet. Figure your new tax liability, and compare it to the taxes you previously paid. How much difference did you find? If you're like most homebuyers, you'll find that the savings amount to less than the tax savings estimates of most real estate agents and loan reps.

Nothing written here intends to discourage you from buying a home. Mortgage Secrets strongly advocates property ownership. History and demographic forecasts support the fact that property will rank among your best investments. Nevertheless, before you buy or refinance, calculate how much your proposed purchase or refinance will change your after-tax, monthly cash flows. Correctly estimate the tax benefit of mortgage interest deductions. For most homeowners, this deduction doesn't yield the amount of benefits that is widely promised. Compute the savings, if any, that you can expect; then after you know your monthly costs, ask, "Does this amount fit my comfort zone? Does it leave sufficient funds for saving and investing? Can I manage those out of the ordinary, yet always expected budget-busting surprises?"

Definitely, buy a home.6 Enjoy your tax savings. But the odds are, you will save less than you might have figured. In contrast, though, to homeowners, investors may deduct 100 percent of the mortgage interest they pay on the rental properties they own—regardless of their income level, and regardless of whether they itemize personal deductions.

6See, for example, The 106 Common Mistakes Homebuyers Make (and How to Avoid Them), 4th ed. (John Wiley & Sons, 2006). The biggest mistake of all, No. 106, is "Continuing to Rent." Of course, as an investor, I'm glad that many people do choose to rent.

Plan to Close in January or February. If you do not currently itemize income tax deductions, close your financing in January or February. You can use the standard deduction for the preceding year, and you can maximize your mortgage points, interest, and property tax deductions for the year in which you buy.7 If instead you close in June or July, you may not gain enough interest deductions to make itemizing worthwhile.

Understandably, you won't schedule your home buying simply to get a tax break. But if convenient to do so, plan accordingly. As Robert Bruss, the nationally syndicated real estate advisor, points out, "You often get your best deal on a property during the Thanksgiving-Christmas-New Year's holiday season. Because relatively few buyers home-shop during the Christmas season, motivated sellers may accept your low-end offer." Buy in December, close in January. You will get a discount price and maximum tax savings. Sounds like a good tactic if you can arrange it.

7 Homebuyers may deduct all costs paid to compensate the lender for the borrowed funds. In addition to interest, such amounts include origination fees and loan discount points, but not the appraisal, title insurance, or garbage fees.

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