A Taxing Reason to Not Buy a Home

There are two potentially large tax breaks that come with buying a home. But listen to me: I never think it is a good idea to factor in the tax breaks when deciding if you are ready to buy your first home. Nor do I ever want anyone to decide on a mortgage budget based on the after-tax net cost. Here’s why:

The Breaks May Not Be Worth More than Your Standard Deduction. The annual interest you pay on a mortgage and your property tax can be claimed as a tax deduction only if you file a federal return with itemized deductions. And it only makes sense to itemize if the total of all your deductions will be more than the standard deduction everyone can claim. (You must choose between the standard deduction or itemizing.)

In addition to your mortgage and property tax, other big-ticket payments that can be claimed as an itemized deduction include state and local income tax payments (or state sales tax paid) and charitable contributions.

In 2016 the standard deduction for a married couple is $12,600. Given today’s low interest rates, chances are you are not generating gobs of interest payments. For example, a $200,000 mortgage financed with a 30-year fixed rate loan charging 3.75% interest will generate a total of less than $7,500 in interest in the first year. (Interest payments are highest in year one, and then decline every subsequent year.) Property tax rates vary widely, but if you live in a state (and county) where the combined levy is around 1%, that would add another $2,000. You’re still not near the $12,600 standard deduction.

That said, if you live in a state with high property taxes, and/or a steep state income tax, and you are very charitable, itemizing could indeed pay off for couples.

For single filers the standard deduction in 2016 is $6,300. Clearly, that lower threshold tilts the odds that itemizing may be the way to go. But keep reading. I still don’t want you to factor the value of your itemized deductions into your home-buying decision.

Only Buy a Home That You Can Afford Without Tax Breaks. Please avoid the temptation to talk yourself into a more expensive home on the theory that the money you “save” by reducing your tax bill, effectively reduces the cost of owning that home. While that is technically correct, it’s nonetheless a dangerous way to over-reach.

For starters, it’s important to understand that your monthly mortgage has two main components: principal and interest. In the early years of a mortgage the bulk of your payment is indeed (deductible) interest. But over time, more of your payment is the principal. And there’s no tax break on principal payments. For example, using the same example as above, when you hit the 10th year of repaying a $200,000 mortgage at 3.75%. your total interest payments will fall below $6,000. Meanwhile, 10 years from now the standard deduction will be even higher, as it is adjusted periodically to keep pace with inflation. Put those two factors together and you can see that for married couples especially, the value of the mortgage interest deduction dramatically declines over time.

Moreover, whenever I hear people talking about the net cost after factoring in the tax break I know they are buying too much house. If you need to justify the cost based on tax breaks-one of which is not permanent-you’re asking for trouble.

If you do decide to itemize, here’s how I want you to think about your home-related tax breaks: as bonuses that help reduce your tax burden. Great to have, but not central to determining your housing budget.