Why the Tax Benefits of Owning Your Home Aren’t as Big as You Think

Why the Tax Benefits of Owning Your Home Aren't as Big as You Think

A couple of weeks ago I sent a newsletter detailing the true cost of owning a home. The point was essentially to illustrate that owning a home is an expense, not an investment, even when you make a smart purchasing decision.

I included this spreadsheet that summed up the annual costs of owning a home each year, subtracted the equity you build along the way, and arrived at a total net cost after each year of home ownership. That net cost was then turned into an equivalent monthly rent so you could evaluate whether you’d be better off buying or renting over a given period of time.

Of course, I have a lot of smart readers who looked at this spreadsheet and all replied with the same question: Why did I ignore the tax benefits of owning a home?

It’s a good question. Owning a home does come with a few potential tax breaks and in some cases those tax breaks can tilt the scales even more in favor of buying. And I did ignore them, meaning that I potentially underestimated the value of owning a home.

But there are a few reasons that I left taxes out of the equation and they all come back to the same general premise: the tax benefits of owning a home are often drastically overstated.

So today I’m going to break down the big potential tax breaks that come with owning a home and why each one is often less valuable than it’s made out to be.

The 3 biggest tax breaks from owning a home

There are three big tax breaks homeowners are eligible for that renters are not:

  1. Mortgage interest deduction – You are allowed to deduct the mortgage interest you pay from your income each year.
  2. Property tax deduction – You are also allowed to deduct the property taxes you pay from your income each year.
  3. Capital gains tax exclusion – When you sell your home, you are allowed up to $250,000 in tax-free gains, as long as you’re selling your principal residence. Couples filing jointly can exclude up to $500,000 in gains from their taxable income.

These are each potentially valuable tax breaks, but there are also reasons why each one may be less valuable than you think.

Let’s break them down individually.

1. Mortgage interest deduction

Before you can estimate the value of the mortgage interest deduction, you need to figure out whether you’re even benefiting from it at all.

Because the truth is that you may not be. It all comes down to whether you claim the standard deduction on your tax return or whether you itemize deductions.

For 2017, every individual taxpayer is allowed a standard deduction of $6,300. For married couples filing a joint return, the standard deduction is $12,600. This amount is automatically deducted from your taxable income, reducing the amount of taxes you have to pay. There are some cases in which you’re not allowed to take the standard deduction, but for the most part it’s available to you no matter what.

The alternative to taking the standard deduction is to itemize your deductions. Basically, there are certain expenses that you’re allowed to deduct each year, like medical expenses, charitable contributions, and others. If the sum of all those expenses in a given year is more than the standard deduction, it can make sense to itemize since you’d get a bigger deduction and therefore pay less in taxes.

So what does all of that have to do with the mortgage interest deduction?

Well, mortgage interest is an itemized deduction. Which means that you only get the benefit of the deduction IF the amount of interest you pay PLUS your other itemized deductions is larger than your allowed standard deduction. If not, then you’d simply take the standard deduction and you’d be no better off than if you were renting.

And even if your itemized deductions ARE larger than the standard deduction, you still may not get the full benefit of the deduction.

For example, let’s say that you pay $10,000 per year in mortgage interest. And let’s say that your other itemized deductions total $4,000. Add them together and you get a $14,000 deduction, which is $1,400 more than the standard deduction for a married couple filing jointly.

In other words, if you’re making a true comparison to renting, your mortgage interest didn’t really get you a $10,000 deduction. You were really able to deduct $1,400 more than you would have otherwise. That’s certainly a benefit, but it’s not as valuable as it first appears.

The overall point here is that because of the standard deduction, many people don’t get any additional additional benefit from the mortgage interest deduction. And many others only get a partial benefit.

It’s a discount, not a free ride

Here’s the other big point to keep in mind: even if you get the full benefit of the mortgage interest deduction, it’s still simply a discount. It’s not free money.

Let’s again assume that you pay $10,000 per year in mortgage interest, but this time all of it is deductible ABOVE the standard deduction. And let’s say that you’re in the 25% tax bracket.

What happens is that $10,000 is subtracted from your taxable income, saving you $2,500 in taxes. That’s a big savings, but it also means that you are STILL paying the equivalent of $7,500 per year in mortgage interest.

That interest is still a cost. It’s just a smaller cost than it would have been if it wasn’t deductible.

The big takeaway here is that the deduction should never be an incentive to take on a bigger mortgage. A bigger mortgage means more money out of your pocket, even when it leads to a bigger deduction.

The mortgage interest deduction is a discount, not a free ride.

2. Why the property tax deduction is often overrated

Everything you just read about the mortgage interest deduction applies to the property tax deduction as well.

It’s an itemized deduction, so your total itemized deductions need to be larger than your standard deduction in order to get any benefit from it.

And even if you do get the deduction, it simply leads to a discounted cost. It’s not free money.

3. Why the capital gains tax exclusion is often overrated

The IRS allows you to exclude up to $250,000 in gains from the sale of your principal residence. If you’re married and file jointly, you can exclude up to $500,000 in gains.

So if you’re married and you buy a house today for $300,000 and sell it years later for $800,000, that entire $500,000 gain will be tax-free. That’s pretty cool!

But is it better than other investment opportunities?

To answer that question, you need to compare the expected return on your house to the after-tax expected return you could get elsewhere.

Now, there’s no way to know for sure what returns different investments will provide in the future, but we can look at some recent history to get an idea.

According to The Economist, US housing prices increased by about 3.6% per year from 1980 to 2016. If you assume that all of that gain is tax-free, and if you assume that you’re in the 15% long-term capital gains tax bracket, that’s the equivalent of a 4.2% annual return on money that will eventually be taxed.

For comparison, over that same time period, stocks returned about 10.8% annually before taxes and bonds returned about 7.9% annually before taxes.

So if instead of buying a house you had decided to rent and invest the difference, even a conservative mix of stocks and bonds would have produced a much better after-tax return. And if you had used a tax-advantaged retirement account like a 401(k) or a Roth IRA, the difference would have been even greater.

That’s not to say that investing in stocks and bonds will always produce better returns than owning a home. Everything depends on what the markets do going forward.

The point is simply that while the capital gains tax exclusion IS valuable, you shouldn’t assume that it’s more valuable than other options. You may actually be able to end up with more money by going another route, even if that other route ISN’T tax-free.

Count your tax breaks right

At the end of the day, your house is a place to live. It’s a place to raise a family. It’s a place to make yours and be comfortable.

And a big part of being comfortable in your home and your life in general is being comfortable financially. Overextending leads to debt and stress, neither of which are conducive to overall happiness.

So the point here is not to tell you that buying a home is bad. It’s not. In many cases it’s an incredibly worthwhile expense.

The point is simply to help you make a more informed financial decision so that you’re more likely to be comfortable financially, and therefore comfortable in your home and in your life.

The mortgage interest deduction, the property tax deduction, and the capital gains tax exclusion are all potential benefits of owning a home. But they are all often overstated, sometimes nonexistent, and in all cases not a reason to spend more on a home than you would have otherwise.

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6 Comments... Read them below or add one of your own
  • Denis June 20, 2017

    I think there are many more factors that are benefits of owning a home that might not have a dollar amount attached to it. While there are certain life situations where renting does make sense, owning your own home has only been looked down since the recession and specifically by millennial generation.

    1)Security in knowing it is your house. Landlords can and will evict you for numerous reasons you have no control over (decide to sell, bankrupty, lease is up, etc.)
    2)No need to “shop” for a new place to live every year to avoid rent increases or bad landlords. Saves on moving costs and another security deposit.
    3)Lost income from your security deposit. Having a security deposit locked away every year you don’t own a home adds up.
    4)Home modifications or remodels are not possible if you rent. What you rent is what you get.
    5)Lost equity from giving your “mortgage payment” to someone else to make money from. They own the house for a reason…to make money.
    6)If you pay for utilities you can’t control energy efficiencies for furnace, A/C, water heater, insulation, windows, etc. Therefore you pay for what you get. More lost money….
    7) Can’t customize or upgrade kitchen or bath appliances. Again, you get to use what you get.

    I could go on. I just think this is some rather poor advice from a financial planner. Where I have chosen to live, renting my house would cost $3,000 (just the rent) per month. I pay less than $2,300 per month in mortgage, taxes and insurance. This doesn’t include any tax breaks for interest or taxes and I am already ahead $700 per month.

    • Matt Becker June 20, 2017

      Thanks for the input Denis. I completely agree with you that there are many non-financial reasons to consider buying a house, and I also agree that there are situations in which buying a house is absolutely a better financial deal than renting.

      My point here is simply to say that you shouldn’t assume that buying a house is a fantastic financial deal. Sometimes it is and sometimes it isn’t. The tax breaks are one of the big things people often point to as a reason why owning a home is better than renting, but many people don’t get the full benefit of those tax breaks. I believe that people will be in a better position to make the right decision for their personal situation if they have this information.

      There are pros and cons to renting and there are pros and cons to buying. Neither approach is right all of the time.

  • Done by Forty June 26, 2017

    We recently sold our first home and did get to net about six figures in gains without paying tax. That was nice.

    With our new home, I estimate we’ll save perhaps $1,500 or $2,000 in federal income tax now that we can itemize. I guess we’ll have to really see how that works out come tax time.

    However, the big gain might be in additional deductions that are available now that itemizing is even an option. The new house gets us at least in the range of itemizing, where before it was not even a possibility. Things that we would have done normally (like donating to charity) now will save us money at our marginal tax rate. We might donate more, potentially, due to the discount.

    • Matt Becker June 26, 2017

      Congrats! Tax-free money is always nice 🙂

      That last point is an interesting one. If itemizing deductions makes it easier to contribute to good causes, that’s definitely a win.

  • Troy July 8, 2017

    I agree with most of your points. However,you failed to include the power of leverage with regard to investment returns. i.e. If you were to purchase a house for $500,000 with 20 percent down. And,that home appreciated at 3.6% annually that would result in $18,000 in appreciation in year one. Of course compounding in following years. That 20 percent down payment which equates to $100,000 would have to return 18% year one in an all stock portfolio.


    • Matt Becker July 9, 2017

      That’s true, but leverage works both ways. A small loss in home price is actually a much bigger loss compared to the money you put in. Plus, leverage isn’t limited to owning a home. You can leverage your stock market investments as well by buying on margin. You just don’t hear it talked about much because it introduces so much extra risk (back to the idea of it working both ways).

      In other words, I wouldn’t consider leverage an advantage. I would consider it a risk that could work for you or against you.

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