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, not as true as some would have you believe. Consider the following exchange between Steve and Mimi Buyer and their friend, Ignor Ant.
The Buyers are getting ready to sign the final documents on their very first home. They've never itemized their deductions in the past, and they're 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. (The Buyers, it can safely be assumed, don't get out much.) They know that the annual interest they'll pay on the loan will amount to about $11,800, while their annual property taxes will amount to about $2,200.
Buyers: "How much do you think we'll save on our income taxes this year because of our new interest and property tax deduction?"
Ignor : "Well, what's your tax rate?"
Buyers: "We're in the 25% tax bracket."
Ignor (turning to his calculator): "Well, your interest and property tax deduction will save you about $3,500 in federal taxes. It's easy math. If you're in the 25% bracket, you simply add your new itemized deductions for a total of $14,000, then 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. 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 $1,000. Somehow they "lost" about $2,500 in tax savings that Ignor Ant said they could expect. How? Why?
Sadly, Mr. Ant neglected to factor the Buyers' standard deduction into the equation.
Mr. Ant forgot that only the itemized deductions in excess of their standard deduction would do the Buyers any good for tax purposes.
Itemized deductions are applied against your adjusted gross income (AGI), allowing you to arrive at a lower taxable income, and thus a lower income tax. But itemizing your deductions is an option, not a requirement.
If your itemized deductions prove greater than your standard deduction, you can report your itemized deductions. But if you have few or no itemized deductions, you're allowed to take the "standard" deduction instead -- it's your choice. You basically compare your itemized deductions to your standard deduction, and use the larger of the two results to reduce your taxable income.
For 2005, the standard deduction for folks filing married-joint amounted to $10,000. For single filers, the standard deduction was $5,000. If you qualified for head-of-household status, your standard deduction was $7,300. And for those of you filing married-separate, your standard deduction was also $5,000.
(Please note that we are using tax year 2005 standard deduction amounts for illustrative purposes only. The standard deduction amounts increase slightly each year. Make sure to use the most current standard deduction amount when undertaking your own tax planning. For 2006, the standard deduction for folks filing married-joint amounts to $10,300. For single filers, the standard deduction is $5,150. If you qualify for head-of-household status, your standard deduction is $7,550. And for those of you filing married-separate, your standard deduction is also $5,150.
The Buyers' real tax-savings computation
In the Buyers' case, the correct computation should take their total itemized deductions of $14,000, reduce those deductions by the Buyers' standard deduction of $10,000, then apply the 25% tax rate to the difference in order to determine the Buyers' net tax savings. The result: $1,000 in actual tax savings.
This example obviously assumes that Steve and Mimi's only itemized deductions came from the interest and property taxes on their home. However, it's very likely that some other itemized deductions that were of no tax consequence to them in prior years will now become vital and valuable. The Buyers usually make $1,500 a year in charitable contributions. In past years, these contributions were not enough to get over the standard deduction hump. But now these contributions become additional itemized deductions.
The same might be said for their vehicle license fees, state income taxes paid, medical expenses (greater than 7.5% of AGI), and miscellaneous itemized deductions (greater than 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. If so, things might not be as bleak for the Buyers as they originally thought. Once they get over the standard-deduction hurdle, every dollar of additional itemized deduction will save them $0.25 in federal taxes. So the Buyers must remain vigilant in keeping their records and receipts in support of those additional deductions.
The Buyers might also want to consider reducing the withholding tax on their wages 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 Sam 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? Shouldn't you be the one holding it?
If your tax situation will change because of the purchase of a new home (or for any other reason), you should really consider making matching changes to your wage withholding. The W-4 Form at the IRS website will walk you through all of the computations necessary to revise your wage withholding. Heck, the IRS even has an online withholding calculator to help 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. A qualified tax pro might best be able to help you estimate your tax savings and adjust your wage withholding appropriately.
Your home purchase should certainly be based on more than just tax savings. The joy of home ownership is worth more than any tax deduction. However, since the deduction is available to you, you should make the most of it to reduce your tax liability. Just make sure that you have all of the facts when you're making those computations.
When he's not dealing with tax issues, Roy Lewis is a motivational speaker living in a trailer down by the river. 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.