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Buy a Home, Not a Deduction

There are a number of reasons to purchase your own home. For example, you can have truly wall-to-wall shag carpeting -- as in, shag carpet on the walls, and the ceiling -- something your landlord would never allow. Plus, there are several tax deductions available to homeowners.

However, tax savings shouldn't be among the biggest reasons to buy a house, especially if you're in the market for a moderately priced home. While the interest that you pay on your home mortgage likely will reduce your taxable income and your overall taxes, make sure that this deduction is really all it's cracked up to be.

Many of you (far too many) still believe that if you pay $100 in home mortgage interest, you'll reduce your tax bite by that same amount. That's just not the case. Taxes are a percentage game. If you're in the 25% marginal tax bracket (as are the majority of taxpayers), then that $100 in mortgage interest paid actually reduces your tax liability by only $25... maybe.

Why maybe? Because of something known as the standard deduction. You see, every taxpayer receives the benefit of the standard deduction. It allows you to reduce your taxable income by a certain amount just for being a tax-paying citizen. For 2004, a single person will receive a standard deduction of $4,850. The standard deduction for married taxpayers is $9,700.

If you pay home mortgage interest, should you care about the standard deduction? You'll itemize your deductions (using Schedule A) and the standard deduction doesn't apply to you, right? Wrong. The tax law allows you to claim either the use of the standard deduction or itemized deductions, whichever is greater. Therefore, in effect, your itemized deductions reduce your taxable income only when they exceed your standard deduction.

Not clear how it all works? I'll give you a real-life example.

Just last week, I met with John and Mary. They were new clients, and they were simply giddy about having their taxes prepared this year. When questioned about their glee, they said that they had purchased a home early in January of 2003, and just couldn't wait to see how big their tax refund would be with all of the mortgage interest that they paid last year.

After counseling them against letting Uncle Sam hold their money (interest-free), I inquired about their new housing arrangements. I found that they had left their rental, on which they were paying about $800 per month, and moved into a beautiful new home. They paid $165,000 for the home, and got a loan for $140,000. At current interest rates, their payment was about $817 per month, and the total interest paid on the loan for 2003 amounted to $8,000. They also had property taxes to pay of about $2,000 annually, not to mention private mortgage insurance (which is not tax-deductible) in the amount of about $300 annually.

After running some quick computations, I told them something that they already knew: They were struggling a bit to make the payments. Their housing costs increased by more than $200 a month, and we hadn't even discussed repairs, maintenance, and homeowners' insurance. But giddy they remained since they just knew that their tax refund would more than cover that additional $200 monthly outflow. And here is where the story gets grim.

They had combined wages of about $84,000 and virtually no other income. I pointed out that, given their standard deduction of $9,500 for 2003, their additional itemized deductions weren't that great. They had another $975 in state income taxes paid, personal property taxes, and charitable contributions, and that was about it.

I ran the computations and pointed out that their "excess" deductions over their standard deduction amounted to only $1,475. And their "additional" tax savings on that excess would amount to about $375, far below the thousands and thousands of tax refund dollars they were hoping for. I can still see the look on John's face as he tried to leap across the desk and grab me by the throat.

Am I advocating renting? Not at all. I believe in home ownership as a supplement to other financial arrangements, not to mention all of the intangible reasons for owing a home, including personal freedom and pride of ownership. While the tax benefits are a consideration, they aren't the only consideration. Other folks, given their personal situation, feel differently -- like Fool Dayana Yochim, as explained in her article Why I Won't Buy. To each his (or her) own. And there are certainly many things to consider when you're thinking about Renting vs. Buying.

As the amount of your mortgage increases (along with your deductible interest expense), the impact of the standard deduction decreases accordingly. So when you're thinking about that little $1 million bungalow on the beach, don't give the standard deduction much consideration. But if you're like most Americans, you'll want to consider all of the aspects of home ownership, including taxes, before you sign on the dotted line.

Your real estate professional can help, as can our Home Center. But I strongly suggest, with respect to the potential tax savings, that you use the services of a qualified tax pro to help you see how large of a bicuspid your mortgage interest deduction will take out of your tax bite.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.


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