The myth of mortgage interest deduction

The mortgage interest deduction is one of the most celebrated tax deductions in all of tax deduction-dom. It’s cited as one of the benefits of homeownership, right behind “you’re not throwing your money away,” and it is repeated over and over again. Unfortunately, I believe it’s misrepresented. It’s not as good as you think.

I’ll explain why.

To claim the mortgage interest deduction, you have to itemize your deductions. For those who aren’t familiar with the idea of claiming itemized vs. standard deductions, you have two options when you file your return. You can either list all of your deductions, such as the mortgage interest deduction, or you can just claim the “standard,” which requires no proof.

• Countown to Tax Day

The reason the deduction is a myth has to do with the size of the standard deduction, which you get even if you don’t own a home. Here are the standard deductions by filing status for 2009:

• Single -- $5,700.
• Married filing jointly -- $11,400.
• Married filing separately -- $5,700.
• Head of household -- $8,350.
• Qualifying widow(er) -- $11,400.

I recently received my Substitute IRS Form 1098, which is a form my mortgage lender files with the IRS. The form lists, among other things, all the interest I paid toward the mortgage last year: $11,521.87.

If we didn’t have mortgage interest, we would claim $11,400 as our standard deduction. To claim the $11,521.87, we have to pay $11,521.87 to our mortgage company. If you assume we’re in the 25% tax bracket (2010 IRS tax brackets), here’s how we make out from a cash-flow perspective:

"Interest paid" is how much money was spent throughout the year for each case, and in this case it's $11,521.87 for the homeowner and $0 for the renter (to use simpler terms). "Deduction" compares the mortgage interest deduction of $11,521.87 against the standard deduction of $11,400 or $5,700, depending on filing type. The "tax refund" is simply 25% of that, since we are assuming the 25% tax bracket. The net cash is to the taxpayer: Take the refund they received and subtract the interest they paid. The delta is the difference between the homeowner and the renter.

As you can see, in both cases, the homeowner pays more. Much more (and interest, unlike equity, isn’t something you get to keep).

Did you know that you can deduct real-estate taxes if you claim the standard deduction? It’s Line 7 of Form L and you can deduct up to $500 (single) or $1,000 (married filing jointly) of your real-estate taxes. This makes the mortgage interest deduction even less appealing since you can deduct part of your real-estate taxes and claim the standard deduction.

• Bing: The most-overlooked tax deductions

Of course, that’s not the whole picture, because there are many other factors. There are tax deductions made available to you when you itemize, such as charitable deductions. Also, when you rent, the idea of “throwing your money away” does have a bit of truth to it because you pay for a portion of the landlord's mortgage interest and property taxes without getting the deduction for it. Of course, at that point it's more a debate about the broader qualitative and quantitative aspects of the rent vs. buy question.

So, why do people buy homes if there's such a big difference? The difference in what homeowners pay in interest really amounts to what renters pay in housing costs. The table above omitted that because we were looking strictly at the interest deduction, not at housing costs as a whole. People buy homes because when they make a mortgage payment, part of it increases their equity in the home. When you rent, none of the payment goes toward owning more of that home or apartment. As the years pass and the principal portion of the mortgage payment increases, you get closer and closer to owning a home.

But when you look strictly at the mortgage interest tax deduction, it just doesn’t add up financially.

Thoughts?

Related reading at Bargaineering:

• What are mortgage accelerator programs?
• Best places to hide money at home
• Find and plug your money leaks