How Tax Deductions Work

Many people know that the interest paid on a mortgage is deductible on their income taxes. But they don't understand how it really works.

When you understand the way a tax deduction works, you should be able to estimate the amount of tax relief you would receive from owning your own home and paying a mortgage.

First, you need to know what is deductible. In many cases, homeowners are allowed to deduct the amount of mortgage interest paid from their income. They are also able to deduct the amount of real estate property taxes paid on the property.

For example, we have a homeowner and a renter who both make the same annual income of $60,000.

The renter pays $1,000 a month in rent and receives no tax benefits for renting a home.

The homeowner holds a $140,000 fixed rate mortgage with a 7% interest rate. His total mortgage payment is $1,100 a month. He pays $1,500 in real estate property taxes. His total mortgage interest paid for this tax year was $9,755.

Here's where the taxes make a difference. The owner is able to deduct $11,255 from his income before he calculates his tax liability. The renter has no deduction from his income and is taxed on $11,255 more than the owner.

Let's keep it simple and assume that both are in a 25% tax bracket. The renter will owe the IRS $15,000 in taxes on his income of $60,000. The owner's taxable income has been reduced to $48,745 after his deductions. He only owes $12,186 in income taxes. The owner saves $2,814 in taxes each year. That's a savings of $234 each month.

Basically, the homeowner's after-tax monthly payment is actually $866. The renter is still paying $1,000. The homeowner gets to keep his house in the end.

There are many variables that can affect the amount of mortgage interest you pay in any given year. But, you could often say that you can take 20% off of your mortgage payment to get a rough idea of the tax benefits of owning.

Ask your lender. A good loan officer should be able to give you a reasonable estimate of your mortgage interest and tax payments over a given period of time. Many lenders will give you a schedule when you close on your home.

When it comes to determining your tax bracket and deductions, ask your CPA or tax attorney for advice. Your loan officer can't really help you with tax details.

The bottom line is that owning your own home has many financial advantages. If you are tired of spending your paycheck on rent, but getting nowher, home ownership may prove to be a more affordable solution for you.

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