A Case against Financed Home Ownership

Home ownership no longer provides the tax shelter benefits it once did. Although home mortgage interest remains as an itemized deduction, the economic benefits of financed home ownership declined significantly over the past decade. Three factors contributed to the decline: 1. Federal income tax rates declined. 2. Standard deductions increased annually due to inflation adjustments. 3. Many deductions were reduced, phased out or eliminated. As the deduction increases each year and fewer expenses qualify as itemized deductions, itemizers and marginal itemizers typically become marginal itemizers and nonitemizers, respectively. How should CPAs advise this growing group of taxpayers? How can clients who might benefit from early mortgage payoffs be identified? What should be considered in deciding whether to recommend that a client stop itemizing? What planning opportunities might prove beneficial to particular clients, given their unique financial circumstances? This article addresses these questions as it considers the true benefits of using borrowed funds to buy a home. Note: This article does not address taxpayers in the 31% and higher brackets added by the Omnibus Budget Reconciliation Act of 1993. Such taxpayers are likely to purchase more expensive homes with larger mortgages, which are not addressed by the planning suggestions below. CONTRIBUTING FACTORS Maximum tax rates. As individual federal income tax rates declined and became less progressive, the tax benefits of all deductions declined. Consequently, the reductions in high-income itemizers' federal tax liability were less for home mortgage interest dollars spent in 1993 (at a maximum tax rate of 39.6%) than they would have been if the same nominal amounts had been spent in 1981 (at a maximum tax rate of 70%). Standard deduction. Because deductions (as well as Social Security wage bases, personal exemptions, tax table rates, etc.) are indexed for inflation, standard deduction creep eliminated the conversion of nonitemizers to itemizers caused by inflation. In assessing the tax benefits of financed home ownership, only excess itemized deductions, or the amount above the deduction, is relevant. For example, if a married couple filing jointly in 1993 has itemized deductions, including home mortgage interest, of $6,000, they still will take the higher deduction of $6,200. Home mortgage interest is deductible but provides no tax benefit. Itemized deductions. The Tax Reform Act of 1986 limited the availability of itemized deductions. The medical and dental expense floor increased, sales tax deductibility was eliminated, mortgage interest deductibility was limited, personal interest deductions were phased out and certain miscellaneous deductions became subject to a 2%-of-adjusted-gross-income floor. DOES EARLY PAYOFF WORK? From a planning perspective, if a taxpayer with a home mortgage balance already is unable to itemize or is a marginal itemizer, early payoff might provide a higher aftertax return than alternative investments. Here's why. Assume a home was purchased on January 1, 1993; the mortgage amount is $100,000 at an 8% fixed rate for 30 years. Real estate taxes are $1,500 and are expected to increase 5% annually. Inflation-indexed deductions increase at 4% per year (rounded to $50 increments). The owners have no other itemized deductions. In 1993, mortgage interest of $7,970 and real estate taxes of $1,500 yielded total itemized deductions of $9,470. Married taxpayers filing joint returns would have $3,270 ($9,470 less $6,200) and single taxpayers would have $5,770 ($9,470 less $3,700) in excess itemized deductions. The extra 1993 federal income tax reductions were $916 ($3,270 x 28%) or $491 ($3,270 x 15%) for married taxpayers and $1,616 ($5,770 x 28%) or $866 ($5,770 x 15%) for singles. …