Homeownership Tax Benefits
There are three major tax benefits for homeowners: deductibility of mortgage interest, deductibility of real estate taxes, and the capital gain tax exclusion for principal residences.[2] Taken together, these benefits significantly reduce the cost of homeownership. Each represents a significant provision of law. According to the Congressional Joint Committee on Taxation, for fiscal year 2008 the tax expenditure (approximately the size of the program in terms of tax savings) of the mortgage interest deduction totals $67.0 billion, the real estate tax deduction equals $24.6 billion, and the capital gain exclusion sums to $16.8 billion.[3]
As seen in these estimates, the largest benefit for most homebuyers is the ability to deduct home mortgage interest. The tax code permits homeowners who itemize their federal income tax deductions to reduce their taxable income by the annual amount of mortgage interest paid on a first (and second) home, up to $1 million in total home mortgage debt. Further, taxpayers may deduct interest allocable to up to $100,000 of home equity loans.[4] For the purpose of the Alternative Minimum Tax [AMT], taxpayers may deduct non-home equity loan interest from AMT taxable income as well.[5] Itemizing homeowners may also deduct state and local real estate taxes paid on an owner-occupied home.[6]
Finally, taxpayers may exclude from capital gains taxation the proceeds from the sale of a principal residence. Taxpayers are limited in the amount of gains that may be excluded from tax: $500,000 of gain for married homeowners and $250,000 for single homeowners. Recent changes in tax law reduce these maximum exclusion amounts proportionally for the amount of time the home is actually used as a principal residence. Periods of ownership prior to January 1, 2009 are treated as periods of principal residence use under a grandfathering rule included in the law.
Measuring the Tax Benefits of the Mortgage Interest and Real Estate Tax Deductions
Calculating the net benefits of the major homeownership benefits seems straightforward but can lead to overestimation if not done in the context of other income tax rules. At first glance, the monetary value of the deductions is equal to the sum of the deductions times the marginal tax rate. For example, a homeowner who deducts $10,000 of mortgage interest and real estate tax deductions and who is in the 25% tax bracket would theoretically realize a tax savings of $2,500 on his/her income tax return.
However, this calculation overstates the benefit on average by failing to account for the fact that the taxpayer must itemize in order to receive a net benefit from these deductions. Unless the sum of the taxpayer’s itemized deductions exceeds the standard deduction (the deduction available in lieu of itemization), it is not to the taxpayer’s advantage to itemize.
This itemization decision implies that a certain amount of the summed itemized deductions yields no net benefit to the taxpayer because of the standard deduction. For example, if a taxpayer in the 25% tax bracket has a standard deduction of $5,700 and a set of itemized deductions totaling $6,000, the net value of the deductions is not equal to $1,500 (25% times $6,000). Even with no itemized deductions available, the standard deduction is available to reduce tax payment by $1,425 (25% times $5,700). So the true, incremental value of the itemized deductions in this example is equal to the difference between $1,500 and $1,425 or $75. Of course, the marginal value — the value of the next dollar of deductions — is equal to 25 cents, but it is the average net value that is important in determining the realized value of the homeownership tax benefits.
Calculating an Example
We can now estimate the true tax benefits of homeownership for examples of various taxpayers. Consider a homebuyer with gross income of $60,000 who purchases a principal residence in tax year 2009 with a mortgage of $180,000. Assuming a mortgage interest rate of 5.86%, the first year mortgage interest payment is approximately equal to $10,580.[7] Conservatively, assume that the buyer uses a downpayment of 20%, so the purchase price of the home is $225,000. Further assume that property taxes are equal to 1.2% of the market price.[8] Thus, this taxpayer also pays $2,700 in potentially deductible state and local real estate taxes in the first year of ownership.
Assuming the taxpayer is married and files a joint return, the household could claim a standard deduction of $11,400 in 2009. Clearly, with $13,280 in itemized deductions from mortgage interest and real estate taxes alone, the taxpayer will not claim the standard deduction, thus itemizing their deductions on Schedule A of their 1040 income tax return. However, to calculate the net benefit of the housing tax deductions, we need an estimate of all the other itemized deductions in order calculate the incremental value.
Using Internal Revenue Service Statistics of Income data for 2006, we estimate the average sum of all non-housing itemized deductions by income class. For this stylized taxpayer, the estimated total is equal to $6,936 in charitable, state and local income or sales taxes, personal property taxes, and all other itemized deductions. With this information, we can calculate the taxpayer’s taxable income (gross income minus itemized deductions) and marginal income tax rate of 15%.
Now we can estimate the net value of the housing benefits. The net value is equal to the sum of itemized deductions ($13,280) minus the difference of the standard deduction ($11,400) and sum of the non-housing itemized deductions ($6,936) times the marginal tax rate of 15%. This calculation yields a net benefit for the first year of homeownership equal to $1,322.
Using this approach and adjusting the declining annual mortgage interest payment consistent with a self-amortizing loan, we can calculate average tax savings for certain income classes and mortgage amounts. [9] Table 1 provides these amounts for the first year of homeownership.
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