We’re in a relatively unique time in history, interest rates are incredibly low. One of the side effects to these incredibly low interest rates is a reduction in housing interest and ultimately a reduction in a household’s itemized deductions. I submit to you that a lot of people actually get virtually no tax benefit from owning their home. Which people am I referring too? I’m talking about the average “Midwest-ish” family.
To best illustrate this, imagine we’re talking about an individual or a household in the Midwest making $80,000 a year pre-tax. It’s also the cliché family, two kids and the suburban house of $250k @ 4% interest with 5% down, roughly $4k a year taxes, $1.8k a year in PMI and $1k a year in insurance.
Before we go further, guess how much you think this Midwest household will benefit a year in dollars for purposes of taxes for owning their home?
What’s your answer? $7,000 a year? $5,000 a year? $2,500 a year?
What if I told you an optimistic $1,000 but likely less than $500 a year?
Calculations: Tax benefit for this Family
I’ll make a leap of faith and say the household contributes $8,000 a year to a 401k (roughly half the limit) (Note: They should consider maxing ROTH contributions, but we’re going to ignore that for now)
Then you also have the personal exemptions of: $16,000.
So the taxable income for the household is now $80,000 – $24,000 = $56,000 a year.
Let’s imagine for a moment that this household takes the standard deduction for a household and not an itemized deduction. The taxable income after the standard deduction becomes $43,400 ($56,000 – $12,600).
Using the 2015 tax tables, the federal tax liability in this situation would be: $5,587.50 for the taxable year. Roughly 6.9% of the pre-tax income. This represents what the household pays without factoring in the house. You should note that this family is firmly in the 15% federal tax bracket.
Now let’s talk about the “what if they itemized” deduction argument. Assuming they put 5% down, in the first year they would have roughly $9,500 or so of interest on the home (an amount that decreases each year), $4,000 in real estate taxes (an amount that increases each year), another $1,800 or so in PMI (an amount that is criminal to me, and eventually goes to $0 for most loans after 20% equity), and then their likely very low state and local taxes. So that brings the total up to $15,300 + state and local + anything else that qualifies for itemized deduction. It’s hard to factor in everything (especially state and local), but let’s run with roughly $20,000 a year in itemized deduction (kind of assuming you’re in the Midwest and not paying huge state and local taxes). It’s likely this $20,000 is too generous, but if you’re in a similar situation as the example given, take a look at the previous year’s taxes and note your itemized deductions to get an idea of where you fall.
So what is the tax benefit of owning this house? Well without the house, you would likely come in under the standard deduction of $12,600, and with the house you come in at around $20,000. Meaning the difference is $7,400 deduction gain. But what does that translate to for your family?
$1,100 a year, or $92.5 a month.
Let’s not forget your taxable income puts you in the 15% tax bracket, meaning every dollar you net in deduction over the standard would only net your household $.15 on the dollar. Also note that the first $12,600 of the itemized deduction has to be ignored to see a net benefit of owning your home.
So the house that you’re spending roughly $20,000 a year of after tax money on plus maintenance and utilities, gives you roughly $1k a year back. A very optimistic $1k a year.
Now of course there is equity building as well, but that’s not the discussion we’re having. When it comes to “what tax benefit does my house give?” The answer is roughly 5% or less (very likely less) of what you pay for housing if you’re in the situation described above (family in Midwest making $80k or so).
In other words, you don’t really benefit that much. In fact, if you change a few parts of this equation such as a more modest $175k house or putting 20% down (to avoid PMI), the benefit could be close to literally zero dollars per year.
Now the counter arguments would be, if you made $200k a year your net benefit would increase. Or if you lived in a state or local area with tremendous taxes you would also increase your potential benefit. So yes, this example is very specific to a Midwest Family making under $100k. The point is, almost no one actually assesses their net tax benefits to their home. They just assume these tax benefits are happening. More common though, it’s likely they bought the house in conjunction with the idea of having children. Children are $4,000 exemptions each in 2015, and these exemptions don’t have to “clear the standard” before netting a tax benefit.
With all of the propaganda with how you get tax benefits and owning a house, and how owning is the American Dream, is it a shock to realize that many families get virtually no benefit? Does it change your view on buying that house?