The fallacy of buying a home for the tax deduction

“You need a tax deduction”
Many income earners hear that phrase a lot. It makes good financial sense to find ways of reducing our taxes while still paying our fair share to maintain this wonderful country we are blessed to live in. Some advisors recommend buying a home for the tax deduction of interest on the loan. However, they should have a full understanding of the client’s financial status to make this statement only if it truly fits within his/her financial plan. Unfortunately, many other people hear this advice and feel it is a global statement for everyone.

Understanding the deduction of interest on a home loan:
The ability to deduct the interest paid on a home loan is one of the few deductions used by the ordinary wage earner. A few years back, they were able to deduct interest on credit cards and other expenses. No longer. Therefore, they try to buy the largest home affordable in order to have the most interest to deduct yearly. Once the original loan gets paid down to where most of the monthly payment toes toward principle rather than toward interest, they may get a new refinance loan or a 2nd on their home to have cash for “investing” and higher yearly interest to deduct. They stay in debt on their home to the maximum level possible for this tax deduction.

What does it really cost to deduct the interest on a home?
What these people may not realize is that they are paying out over twice the money than the benefits they are receiving from the deduction of interest. The following example will help illustrate this further.

Very simplified example:
Joe earns a yearly salary that puts him in a 40% combined state and federal tax bracket. Joe buys a house with a total of $25,000 interest the first year. This provides a $25,000 x 40% or $10,000 tax benefit. However, note that Joe spent a total of $25,000 to get this $10,000 benefit, or 1 ½ times more than the benefit.

If Joe was in a lower total bracket of 25%, then the benefit would only be $25,000 x 25% or a $6,250 benefit. In this case it cost Joe $25,000 for a $6,250 benefit or four times as much.

These examples are very simplified and don’t take into account all of the tax issues associated with a real situation. However, they do illustrate the point that Joe is spending much more money than he receives from reduced taxes. In addition, over a 30 year loan, the extra money spent is significant.

Must look at each person’s situation to determine what makes sense.
For some people, renting may actually make more sense financially than owning. For others, owning a home is the best option. However, care must be taken to buy a home that fits within an appropriate financial plan for that person. Don’t try to buy the largest home or get the largest mortgage just to have a big interest deduction. There are many other deductible investments you can make that will reduce taxes while providing income. In this way, the money spent actually generates increased income rather than extra expense. Also, consider the benefits of having your home paid off with the funds that once went toward the mortgage payment now available for investing in additional income generating investments. There are investments such as oil and gas drilling ventures that provide a 100% deduction of all invested funds against all income types while not counting in alternative minimum tax (AMT) income. Other tax advantaged investments include government bonds. In these ways, the investor can reduce taxes while increasing income without adding debt.

Summary:
The main point here is not to buy the largest house or maintain the largest mortgage for the tax deduction alone. Be sure to carefully consider your long term financial plan to determine what level of investment in a home best fits within that strategy. Work with a financial planner as needed during this process.

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Copyright 2008 Ole Cram. Ole Cram is President of Marcobe Investments, Inc., a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration to also participate. We are not licensed to sell any interest in a project, nor are we registered advisors. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for other topics to cover in future articles.

This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Past articles can easily be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html. This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision. Sphere: Related Content