How taxes impact homeownership costs
Real estate ownership has implications for both income taxes during the ownership period and capital gains on the sale.
Some people buy houses because they are “tired of paying so much in taxes.” Homeownership provides the taxpayer the ability to write off the cost of interest on a home mortgage, and they can deduct property taxes as well.
Unfortunately, while these tax deductions may lower the bill to Uncle Sam, they come with a cost, and often in Coastal California, the cost outweighs the benefit. Many people end up paying more in interest than they save in taxes. So while it may relieve a high wage earner to avoid paying Uncle Sam, giving far more money to a banker makes little sense.
Owning real estate has two significant tax benefits: (1) favorable capital gains tax exemptions and (2) income tax benefit through the home mortgage interest deduction (HMID). Be forewarned that this is not an exhaustive treatise on every permutation in the tax code. I am going to look at the general case the most people will find themselves in.
Capital Gains Taxes
If you own a home more than two years, you can ignore the gains on the first $250,000 or $500,000 if your married. If you don’t make more than $250,000 or $500,000 on the sale — which most people don’t — then you don’t pay any capital gains taxes. It is a tremendous tax advantage that favors capital gains and appreciation.
The reason we have a large deduction or excluded amount is because years ago when there was no exclusion, long-term homeowners would be punished with capital gains taxes when they sold a principal residence when most of that gain was due to inflation. Without a method of adjusting the purchase price basis for inflation (like using the CPI), owners are being taxed on the profits created by inflation. They are getting less than their money back when you consider the loss in money’s purchasing power.
Personally, I think it would be a good idea to link the property basis to inflation. An exclusion can be created by linking the basis for the capital gains to the Consumer Price Index, and the tax can be levied on any overage. For instance. If someone purchased a home for $100,000 when the CPI was at 100, then later the property was sold for $300,000 when the CPI was at 200, the tax would be levied on only half the profit:
Adjusted Basis = $100,000 * 200 / 100 = $200,000.
$300,000 Resale Price
$200,000 Adjusted Basis
$100,000 Profit subject to Capital gains tax.
This gets around the issue of inflation taxing while taxing irrational exuberance. Unfortunately, it will likely never happen.
The big tax break for capital gains is what makes life as a mid-term flipper possible. There were many people during the bubble who bought with intention of flipping in two years when their gains would not be taxed. Of course, this tax strategy took second place to the pandemonium of the crazy market rally.
Favorable capital gains tax treatment is really a tax-free retirement savings account Uncle Sam worked into the system to benefit homeowners. If you own a property long enough to have capital gains, and the sale of that home represents a significant portion of family savings (which is usually does), the capital gains tax benefit can have significant financial impact on your financial life in retirement.
Income Taxes and the Home Mortgage Interest Deduction
The tax code allows wage earners the ability to give up the Standard Deduction and write off Home Mortgage Interest against their income on Schedule A. If the taxpayer is already itemizing deductions for expenses not related to home mortgage interest, then the taxpayer receives the full benefit of this deduction.
The deduction is simple. Lenders issue a form 1098 telling a borrower how much interest they paid during the year, and this is put in the tax forms as a deductible interest expense. It does phase out for loans over $1,000,000, and there are exclusions from the deduction, but for most borrowers this is a significant benefit of ownership.
The root of this very popular deduction comes from the need to give owner-occupants the same tax advantages landlords have. Why should landlords get to deduct interest expense and owner-occupants can’t? Whether or not this is justification for the deduction, I don’t know.
Estimating the true tax benefit of the HMID
Most people estimate the tax benefit of the home mortgage interest deduction incorrectly, assuming the interest times their highest marginal tax rate is what they will save on taxes. Like most housing benefits the error generally makes owning look like a better deal than it is.
A good estimation of the benefit of the HMID is to assume the tax benefit is about 10% lower than their highest marginal tax rate. This estimate is based on two factors: (1) not all of the interest deduction would have been taxed at the highest marginal rate and (2) the loss of the Standard Deduction reduces the value of the home mortgage interest deduction. Anecdotally, when people expert in tax matters have run scenarios with tax software, the 10% reduction in effective tax savings has proven a useful estimate.
Let’s look in more detail as to why this effect happens. Assume a borrower has $50,000 in mortgage interest during a tax year, and this borrower makes about $150,000. For this borrower, the portion over $137,050 (2012 tax table) is taxed at 28%, and the amount between $67,900 and $137,050 is taxed at 25%, the gross tax savings would be about $12,888 for an effective marginal tax rate of 25.5%. This is the impact of crossing marginal tax rate lines.
Also, to be more accurate, we must subtract the negative impact of giving up the Standard Deduction of $11,400 for a family (2012 tax table). If borrowers have $50,000 in deductible interest, but they have to give up $11,400 in tax benefit to get it, the net tax write off is $38,600. Crunching the numbers shows the tax savings is $10,038 instead of the $12,888 people thought they are getting. This reduction in tax benefit due to giving up the Standard Deduction.
When you combine these two effects, a good guide is to take 10% off the borrower’s highest marginal tax rate.
Accurately calculating the tax benefit of the HMID
One of the most complex calculations performed behind the scenes on the properties displayed on this site is the calculation of the tax savings. Since the computer can run even the most complex calculations quickly, I set out to be as accurate as possible.
Based on the income requirement to qualify for the maximum size loan, I can determine the borrowers highest marginal tax rate. I take this rate times the mortgage interest and property taxes, then I subtract the same rate times the standard deduction. I have to do this calculation for both State and Federal and sum the two numbers to calculate the total tax savings. If this number is less than zero, which it is on lower-priced properties, then I set it to zero. Each year I update the tax tables to reflect the most recent thresholds and rates.
It took a lot of coding time to get these calculations right, but it was worth the investment to provide accurate information to people who really want to understand the implications of the biggest financial decision of their lives.