Does A Home Purchase Really Help With Taxes?
To continue renting or to purchase a home? It’s a very common question. The concept is that purchasing a home allows you to build equity so that when you sell the home and purchase a smaller one later in life you have a bit of nest egg to enjoy in retirement.
Taxes are one factor in considering a home purchase. It is likely unwise to purchase a home for the sole purpose of saving money on income tax.
Summary: There are certain tax advantages in owning a home such as the ability to deduct mortgage interest and property taxes. Under average circumstances for taxpayers in the greater Portland metropolitan area these tax savings are marginal at best when considering the increased costs of home ownership. There is an advantage to home ownership when real estate values rise.
Basic Home Buying Guidelines
You should never purchase a home that is more than you can afford. Depending on where you look, the recommendation varies from 25% of your monthly take home pay all the way to 30% of your monthly gross income to be allocated toward housing.
Lenders will use other factors as well in determining how much you can borrow for a home. Some factors would be student loans, auto and credit card debt, child support (either as income or an expense), numbers of dependents, etc.
Since we are trying to focus only on taxes we will assume these other factors to not contribute to the overall amount you can afford for a home. We will also use the extreme end of lending guidelines and assume you will be spending 30% of your gross monthly income on housing.
Down Payments And Costs
Lenders will qualify you for a loan amount based on your ability to repay not the size of the home you wish to purchase. If a bank will lend you $250,000 based on all their criteria that does not limit you to purchasing a home in that amount. You have to add your down payment to the amount of the loan and then go house shopping.
Keep in mind a large down payment has other advantages as well that can increase the amount of money you are able to borrow. Substantial down payments can lower interest rates, or eliminate the need for mortgage insurance thus increasing the amount of money you can borrow.
The more you put down, the more you can borrow, but the bigger the house the more expensive the property tax and home owners insurance.
Assumptions: John and Mary live in a two bedroom apartment with their two children David aged 9, and Alison age 13. They pay $1,650 per month in rent for a two bedroom apartment which represents 30% of their $66,000 annual household income. Their rent includes water and garbage collection. They pay electric on their own.
Taxes While Renting
Since they are renting, John and Mary’s tax return is very straight forward. They have no substantial tax deductions and are unable to itemize deductions on their return. They have a combined tax liability between federal and Oregon of $6,756.
Taxes With Home Purchase
Using the same assumptions, let’s further assume John and Mary purchased a home on January 1st and lived in the home the entire year making all payments in a timely manner. Their entire mortgage payment remains $1,650 which consists of principal and interest, property tax, and home owners insurance. The bank gave them an interest rate on a thirty year loan at a rate of 3.25%. Assuming $275/month is set aside for taxes and insurance they are paying $1,375 for principal and interest.
Working the numbers backwards, they have a mortgage of $315,942.10 and will pay mortgage interest of $10,174.45 in the first year of the loan. Property taxes are assumed to be $2,400. For tax purposes the purchase price of the home is not important, the only tax consideration being the amount of property taxes and mortgage interest paid. To keep it simple we will assume there was a down payment large enough to not require mortgage insurance which, under current law, is also tax deductible.
In this scenario, John and Mary’s combined tax liability between federal and Oregon is $5,554 which represents a tax savings of $1,202 or just over $100 per month. The home purchase has enabled John and Mary to itemize their deductions on their tax return. This now opens the door for additional tax deductions such as charitable contributions and maybe certain work expenses or medical expenses depending upon their overall amount.
The implication here is that John and Mary could spend an extra $100 month and save a little more in tax as well as get more house to enjoy. However, the $100 per month tax savings will likely be consumed with increased utilities (now they have to pay water) and property maintenance that had previously been provided by the landlord. Remember their maximum mortgage payment is based on their income so increasing their debt and apply the tax saved toward the additional debt is not sound financial advice.
From a tax point of view this may not be a smart move. From an investment point of view the opportunity to increase net worth by building equity as the loan is paid down and market value increases may be a good move.
Care should be taken when a lender tells you “you’ll save a ton on taxes” That may not be the case.
The Bigger The Better
The previously discussed examples are based on typical assumptions for the area. Tax savings could be considerably higher if your income is higher and you still allocate 30% of your income toward housing. A higher income will mean a higher tax bracket making the tax savings on all tax deductions larger.