Mortgage Deduction

Tax Savings for Home Ownership Are Very Overrated (Especially Under 2018 Tax Reform)

Gen Y Finance Guy Financial Analysis 13 Comments

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Do you believe that one of the primary benefits of owning a home in the USA is the tax savings from itemized deductions like mortgage interest, and property taxes? Weeeellll…I have some bad news for you. Despite the fact that this idea is so ingrained in most of us that we don’t even question it, any of that savings is a lot less than you – and I – might have been led to believe. Personally, I have to be the first to admit that I have overvalued these primary residence “tax savings.” And this was before the 2018 tax reform, which has only made things worse. For most of the homeowners in the USA this tax benefit has now been eliminated due to the increase in the standard deduction and to a lesser extent new limits imposed by SALT (state and local tax caps). Since our new reality is based on the 2018 tax reform, this post will be written with the new rules in place.

[If you are interested to see some analysis on this prior to the 2018 tax reform, please check out this post from The Money Commando. The big revelation I got from this post was that the “tax savings” from the ability to itemize should only be calculated on anything incremental to the standard deduction because everyone gets the standard deduction no matter what. It’s obvious now and makes so much sense – I’m embarrassed I missed it for so long. The good news is that I never let that misunderstanding influence my decision to buy a house or pay it off early.]

Conventional Wisdom

Most people have been trained to believe that there is a huge tax savings that comes along with home ownership. However, there was always only a potential tax savings, and the hurdle to capture it has gotten much higher. Plus, accepted conventional wisdom says that you can estimate your tax savings by taking your marginal tax rate multiplied by the sum of the interest and property taxes you will pay, but that is an incorrect calculation and leads to an incorrect conclusion.

Let’s look at an example, for a lovely couple we shall call Mr. and Mrs. GYFG:

Mr. and Mrs. GYFG buy a $500,000 home with 20% down and finance the remaining 80% ($400,000) with a 30-year 4.5% interest rate loan. California property taxes will be about 2%, or $10,000 (1% for normal property taxes and 1% due to Mello Roos). Their marginal tax rate is 30% and they have no other deductions outside of interest and property taxes (due to 2018 Tax Reform and the $10,000 Maximum SALT deduction).


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Note: I have conveniently kept this example simple by ruling out any other itemized deductions and taking the max SALT deduction allowed in the 2018 tax reform.

In year one, the itemized deduction for the GYFG household would be calculated by adding interest of $17,868 (at 4.5%) and property taxes of $10,000 (at 2%), for a total itemized deduction of $27,868. Following conventional wisdom to estimate their tax savings, they multiply $27,868 by their marginal tax rate of 30%, which would indicate an annual tax savings of $8,360. The GYFGs do a little happy dance in their heads.

Then tax time comes…and they realize that their math was significantly off. They forgot to account for the fact that the standard deduction is now $24,000 for a married couple and that their tax savings is only the difference between their itemized deductions and the standard deduction (because they would have had a $24,000 deduction regardless of their itemized deductions).

They do the math and find that their tax savings from home ownership should actually be calculated off of $3,868 ($27,868 – $24,000 = $3,868). Multiplying that figure by their marginal rate of 30% they realize their tax savings is a paltry $1,160 (only 14% of their original assumption). Happy dance ends…

In hindsight, I realize that I should have based this example on the real position of the GYFG household, and not a fictional one that still resulted in a bit of tax savings, albeit tiny. In reality, for 2018 our itemized deductions will be approximately $22,000 ($12,000 mortgage interest, $7,500 property taxes, and $2,500 in state income taxes – far less than we will actually pay but all that is allowed under SALT), so we will be taking the standard deduction. The GYFG household gets zero tax benefits from home ownership, least of all for the debt interest we pay via our home mortgage. This is yet another motivating factor that convinced us to pay our house off even faster than we had originally planned.

What About the Average American?

The median home price (for a new home) in 2017 was $335,400. I don’t think I even have to do the math for you to see that the value of being able to itemize mortgage interest and property taxes is worthless to most taxpayers in the USA. Nonetheless, for the sake of thoroughness, and because we all know that MATH IS KING, I will show you the math. We will use all the same assumptions except we will assume that the median home price is the mortgage amount (which is a generous assumption that tries to make this a more favorable outcome).

Say the average American pays interest of $14,982 (at 4.5%) and property taxes of $6,708 (at 2%), for a total deduction of $21,690. As you can see, this is less than the standard deduction, so there is therefore no tax benefit to the average taxpayer. (Even worse, the average property tax paid in this country is even less than California’s 2% at 1.19%, further eroding the possibility of deduction benefit.)

Concluding Thoughts

I think the most obvious takeaway is to operate on a policy of trust but verify. Yes, there is potential for some tax savings through home ownership but it’s probably less than you think, and it might actually be zero. Don’t forget that the 2018 tax reform also set another new limit and now says that only the interest on up to a $750,000 mortgage is deductible (inclusive of interest paid on a HELOC; previous limits were $1M for mortgage and $100K for HELOC).

This also points out how fast the rules can change. It’s probably not a great idea to buy a house if your primary motivation is tax savings.

Also important to learn from this: debt is debt. With few exceptions – and getting fewer all the time – there is no “good debt.” Build your wealth-building structure on firm ground, without using debt of any kind as a long-term element of your foundation, and make sure that you aren’t spending a dollar to save 30 cents. Not only is that not smart, but even that savings can be taken away by forces beyond your control.

For the GYFG family, in particular, this is another incentive to pay the mortgage off early!

– Gen Y Finance Guy



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Comments 13

  1. In past years, there was a significant tax deduction due to a lower standard deduction and the lack of a SALT cap, meaning that high earning couples could deduct all of their interest and property taxes, plus all of their state and local income taxes, putting them way ahead of a much lower standard deduction.

    So prior to 2018, there were significant benefits.

    It’s really a function of the tax law which provides greater tax savings in some areas, and limits them in others, that makes the overall additional benefits of homeownership tax deductions more difficult to obtain.

  2. We live in the same general area of Southern Calfifornia as you. Where we currently live in LA County the tax rate is 1.18, but we’re looking to move to the I.E. (Eastvale or Temescal Valley areas) where the standard rate is 1.5%-2%.

    My question for you I guess is how did you get over the hurdle of paying so much more in taxes when you moved out there from the OC? I understand you get all the new roads, schools, etc but an extra $2k-$4k for pretty much the entire life of living in the property just seems so steep. To me it’s almost like having an expensive HOA, but I know it’s just the nature of the beast in the area of the country we live in.

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      Hey Aaron!

      I pay the extra property taxes without a second thought. The lower cost of living more than offsets the extra money you pay in property taxes.

      We bought a 3,300 sqft house one a quarter acre in 2014 for $370K. That same house in the OC would have been $900K+. We couldn’t even buy a condo for that price in the OC.

      We live in the Temecula/Murrieta area, so not to far from Temescal.

      Dom

      1. Yes, I agree with you that the tax savings is crazy overrated. Higher property taxes are cutting into the amount of money that people have to spend. I live in Illinois, and people here say that one of the reasons, (aside from the weather of course) they’re moving out of this State is the real estate taxes. It’s a factor, but I think the main factor is better employment and not taxes.

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          Bernz JP – Our property taxes are about $7,500/year or about 2% of what we paid for our house. If it weren’t for the special bond they would be half that. That said, we have never contemplated moving out of California because of the property taxes but we have considered moving to a state with no income taxes. This is especially appealing with the new SALT limit.

          Dom

  3. We paid our house off last year after having refinanced to a 15 year mortgage from a 30 year loan. Never came close to itemizing once. I can’t even remember now if we ever itemized when we had the 30 year loan and the full mortgage to pay off. Perhaps, but I doubt it.

    Lots of great reasons to own vs. rent, but for most folks, the tax advantages aren’t one of them.

    But you’re absolutely right – it’s an ingrained bias.

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      1. LOL – I wouldn’t quite go that far, but at least the house is paid off. 😉

        What does feel good – or rather what makes me feel bad for others – is that homes in our neighborhood are now being RENTED at prices that are anywhere from 30-50% above what our former monthly mortgage payments were (which also had insurance and taxes rolled in).

  4. Thanks for the shout-out. This sort of analysis is what got me into blogging in the first place – I love examining the conventional wisdom and finding out where it’s wrong.

    I was just as surprised as you were when I realized just how little benefit I was getting from our mortgage deduction.

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  5. I actually had it calculated. With the SALT limit, increased deduction and lower tax bracket it zero’d the tax advantage. (from 270 a month to zero) So every bit of tax advantage went away (until/if the tax code resets in a few years)…..
    Now mind you, the net cost (maintenance, interest and taxes… basically excluding the principle payment, since that is decreasing the debt and moving the balance sheet greener) for me is less than what it would cost me to rent a comparable location.

    But yes, in short the change effectively torpedo’d this argument for now

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  6. Pingback: September 2018 - Detailed Financial Report #45 - Net Worth $870,156 | Income $35,981 - Gen Y Finance Guy

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