How Tax Deductions Work

A great amount of people know that the interest paid on a mortgage is deductible on their income taxes. But they don't understand how the process actually works.

The moment you understand the way a tax deduction works, you should be able to estimate the amount of tax relief you would receive from owning your own home and paying a mortgage. 

First, you need to know what is deductible.  Many times, homeowners are allowed to deduct the amount of mortgage interest paid from their income.  They are also able to deduct the amount of real estate property taxes paid on the property. 

Let’s give out the following example: 

Let’s say there is a homeowner and a renter who both make the same annual income of $60,000. 

The renter pays $1,000 a month in rent and gets no tax benefits from renting a home. 

The homeowner has a $140,000 fixed rate mortgage which has a 7% interest rate.  He pays a total of $1,100 a month for his mortgage payment.  He has to pay $1,500 in real estate property taxes.  The amount of mortgage interest paid for this tax year was a total of $9,755. 

Now, here is where the taxes really make a difference.  The owner is able to deduct $11,255 from his income before he calculates his tax liability.  The renter, however, has no deduction from his income and is taxed on $11,255 more than the owner. 

Let's try to keep it simple and imagine that the homeowner and renter are both in a 25% tax bracket.  In this case the renter will owe the IRS $15,000 in taxes on his income of $60,000.  The owner's taxable income will be reduced to $48,745 after his tax deductions.  The owner will only owe $12,186 for his income tax amount.  The home owner will be saving $2,814 in taxes every year.  That corresponds to a savings of $234 every month. 

On the whole, the after tax monthly payment for the homeowner is actually $866.  The renter is still going to be paying $1,000.  Not to mention the fact that in the end, the homeowner gets to keep his house. 

There are different variables that can affect the amount of mortgage interest you pay in any given year.  Nevertheless, you could often say that you can take 20% off of your mortgage payment to get a rough idea of the tax benefits of home ownership. 

Ask your lender.  A good loan officer should be able to give you a reasonable estimate of your mortgage interest and tax payments over a given period of time.  Many times lenders will give you a schedule when you close on your home. 

If you need to determine what your tax bracket and deductions are, ask your CPA or tax attorney for advice.  Your loan officer will not be able to help you with tax details. 

The main thing is that owning your own home has many financial advantages. If you are tired of spending your paycheck on rent, but is getting you nowhere, owning a home can actually prove to be a more affordable solution for you in the long run.