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Mortgage Interest Deduction Myth

The mortgage interest deduction is one of the most celebrated tax deductions in all of tax deduction-dom. It’s cited as one of the benefits of homeownership, right behind “you’re not throwing your money away,” and that fact is repeated over and over again. Unfortunately, I believe it’s misrepresented. It’s not as good as you think and I’ll explain why.

To claim the mortgage interest deduction, you have to itemize your deductions. For those who aren’t familiar with the idea of claiming itemized vs. standard deductions, you have two options when you file your return. You can either list all of your deductions, such as the mortgage interest deduction, or you can just claim the “standard,” which requires no proof.

The reason why the deduction is a myth has to do with the size of the standard deduction, which you get even if you don’t own a home. Here are the standard deductions by filing status for 2009:

I recently received my Substitute IRS Form 1098, which is a form my mortgage lender files with the IRS. The form lists, among other things, all the interest I paid towards the mortgage last year – $11,521.87.

If we didn’t have mortgage interest, we would claim $11,400 as our standard deduction and we get that for free. To claim the $11,521.87, we have to pay $11,521.87 to our mortgage company! If you assume we’re in the 25% tax bracket (2010 IRS tax brackets [3]), here’s how we make out from a cash flow perspective:

Married Filing Jointly Single
Itemized Standard Itemized Standard
Interest Paid: $11,521.87 $0 $11,521.87 $0
Deduction: $11,521.87 $11,400 $11,521.87 $5,700
Tax Refund: $2880.47 $2,850 $2880.47 $1,425
Net Cash: -$8641.40 $2,850 -$8,641.40 $1,425
Difference: -$11,491.40 -$10,066.40

Interest paid is how much money was spent throughout the year for each case, so $11,521.87 for the homeowner and $0 for the renter (to use simpler terms). The deduction compares the mortgage interest deduction, of $11,521.87, against the standard deduction of $11,400 or $5,700, depending on filing type. The tax refund is simply 25% of that, since we are assuming the 25% tax bracket. The net cash is to the taxpayer. Take the refund they received and subtract the interest they paid. The delta is the difference between the homeowner and the renter.

As you can see, in both cases, the homeowner pays more. Much more. (and interest, unlike equity, isn’t something you get to keep)

Did you know that you can deduct real estate taxes if you claim the standard deduction? It’s Line 7 of Form L [4] and you can deduct up to $500 (single) or $1,000 (married filing jointly) of your real estate taxes. This makes the mortgage interest deduction even less appealing since you can deduct part of your real estate taxes and claim the standard deduction.

Of course, that’s not the whole picture because there are many other factors. There are tax deductions made available to you whenever you itemize, such as charitable deductions. Also, when you rent, the idea of “throwing your money away” does have a bit of truth in it because you pay for a portion of the mortgage interest and property taxes without getting the deduction for it. Of course, at this point it is more a debate about the broader qualitative and quantitative aspects of the rent vs. buy question [5].

So why do people buy homes if there’s such a big difference? The difference in what homeowners pay in interest really amounts to what renters pay in housing costs. The table above omitted that because we were strictly looking at the interest deduction, not at housing costs as a whole. People buy homes because when you make those mortgage payments, part of it goes towards the home. When you rent, none of the payment goes towards owning more of that home or apartment. As the years pass and the principal portion of the mortgage payment increases, you get closer and closer to owning a home.

When you look strictly at the mortgage interest tax deduction, it just doesn’t add up financially.


(Photo: orvaratli [6])