We've all heard it before: Buy a home and save a ton of money on your income taxes! While it may sound enticing, it's not always true -- or at least as true as some would have you believe. Consider the following exchange between Steve and Mimi Buyer and their friend, Ms. Informed (also known by her close friends as Unn).
The Buyers are getting ready to sign the final documents on their very first home. They have never itemized their deductions in the past, and are looking forward to that big home mortgage deduction, their property tax deduction, and the ability to complete their Schedule A Itemized Deduction form the very next time they file their tax return. They know that the annual interest they'll pay on the loan will amount to about $9,000. Their annual property taxes will amount to about $1,200.
And the Buyers have the following conversation with their friend, Unn:
Buyers: How much do you think that we'll save on our income taxes this year because of our new interest and property tax deduction?
Unn: Well, what's your tax rate?
Buyers: We're in the 28% tax bracket.
Unn (turning to her calculator): Well, your interest and property tax deduction will save you about $2,856 in federal taxes. It's easy math. If you're in the 28% bracket, you simply take your new itemized deductions in the amount of $10,200 and multiply those deductions by your tax bracket. The result is your tax savings.
The Buyers, flushed with joy, run off to the title or escrow company to sign the final papers on the loan and purchase that brand-new home (after learning how to get the best mortgage at The Motley Fool Home Center, of course). Everything is beautiful until they complete their tax return early in the following year.
Did they do something wrong? After they process the numbers, they find that their ACTUAL tax savings only amounts to about $196. Somehow they "lost" about $2,660 in tax savings that Unn Informed said they could expect. How? Why?
Sadly, Ms. Informed forgot to factor in the Buyers' standard deduction into the equation.
Ms. Informed forgot that only the itemized deductions in excess of their standard deduction will do them any good for tax purposes.
Remember that itemized deductions are applied against your adjusted gross income (AGI), thereby allowing you to arrive at a lower taxable income, and thus a lower income tax (yippee!). But itemizing your deductions is something that you're allowed to do, not necessarily something that you must do.
If your situation is such that you have itemized deductions greater than your standard deduction, you can report your itemized deductions. But if you don't have any or many itemized deductions, you're allowed to take the "standard" deduction. You get the standard deduction simply for being you -- an enriched and happy Fool. So it's your choice, your decision. You basically compare your itemized deductions to your standard deduction, and use the larger of the two results to reduce your taxable income.
For 2003, the standard deduction for folks filing married-joint amounts is $9,500. For single filers those filing married-separate, the standard deduction is $4,750. If you qualify for head of household status, your standard deduction is $7,000.
The Buyers' real tax-savings computation
So, in the Buyers' case, the correct computation should take their total itemized deductions of $10,200, reduce those deductions by the Buyers' standard deduction of $9,500, and then take the 28% tax rate against the difference in order to determine the Buyers' net tax savings: $10,200 - $9,500= $700 x 28% = $196 in actual tax savings.
This example obviously assumes that Steve and Mimi's only itemized deductions came from the interest and property taxes on the home. However, it's very likely that they will have some other itemized deductions that were of no tax consequence to them in prior years that will now become very important. They usually make $1,000 a year in charitable contributions. In past years, these contributions were not enough to get over the standard deduction hump. But now, with the added deductions brought about by the mortgage interest and property taxes, these contributions become additional itemized deductions.
The same might be said for their vehicle license fees, state income taxes paid, medical expenses (over 7.5% of AGI), and miscellaneous itemized deductions (over 2% of AGI). So the Buyers may now find a number of other itemized deductions that they were never able to use in the past. That being the case, things might not be as bleak for the Buyers as they originally thought. Once they get over the standard deduction hurdle, each and every dollar of additional itemized deduction will save them 28 cents in federal taxes. So the Buyers must remain vigilant to keep their records and receipts to allow them to support those additional deductions.
Something else that Steve and Mimi might want to consider: adjusting the withholding on their wages in order to have less withholding to match their tax savings. There's no reason to have a large refund at the end of the year. Why would you want Uncle Sammy to hold your money interest-free, only to pay it out to you in the form of a tax refund. It's your money, right? If anybody should be holding it, it should be you.
So if your tax situation will change because of the purchase of a new home (or for any reason), you should really consider making changes to your wage withholding to reflect the changes in your tax situation. In order to do this, you'll need some help. You can download IRS Form W-4 from the IRS website. That form will walk you through all of the computations necessary to revise your wage withholding. Heck, the IRS even has an online calculator to help you with your wage withholding decisions.
One word of warning: Please don't adjust your withholding without going through the computational exercise. Selecting the wrong withholding allowances could lead to IRS penalties.
Remember that whenever you are dealing with tax issues, things can get complicated. Unless you are well versed in the tax laws, trying to determine your savings on the purchase of a new home may lead you to incorrect assumptions and bad decisions. So you might want to engage the services of a qualified tax pro to estimate your tax savings and help adjust your wage withholding.
Your home purchase should certainly be based on much more than just tax savings. The joy of home ownership is worth more than any tax deduction. But since the deduction is there and available to you, it's your duty to reduce your tax liability as much as possible. As a Fool, you shouldn't have it any other way.