What You’ll Learn
Which mortgage interest payments and property taxes the IRS allows homeowners to deduct
How marginal tax rates, tax credits, and tax deductions work
How to determine the true cost of your mortgage payment
A home loan is typically the largest debt that someone will take on.
Fortunately, you might be able to deduct some of the costs related to owning a home, including mortgage interest. When you take into account the deductions available to homeowners, you may find that the true cost of your home mortgage is significantly reduced.
Let’s take a look at how you might be able to deduct some costs of homeownership from your taxes.
Home mortgage interestThe IRS allows homeowners to deduct interest paid on a mortgage under these conditions:
- The mortgage is for your first or second home (think primary residence and vacation home)
- You file your taxes with a Form 1040 tax return (most people do this) and itemize deductions on Schedule A
- The mortgage is a secured debt on a home in which you have ownership
Deductible mortgage interest falls into one of three categories:
- Mortgages you took out on or before October 13, 1987
- Mortgages you (or your spouse if married filing a joint return) took out after October 13, 1987, and prior to December 16, 2017, but only if the mortgage debt totaled $1 million or less ($500,000 or less if married filing separately).
- Mortgages you (or your spouse if married filing a joint return) took out after December 15, 2017, but only if debt totaled $750,000 or less ($375,000 or less if married filing separately).
The dollar limits for mortgages made after Oct 13, 1987 apply to the combined mortgages on your primary home and second home. It’s important to note that the size of your mortgage loan may limit the deductibility of your loan interest.
Let’s take Sally for example.
On December 31, 2018, Sally took out a $200,000 mortgage at a 4% interest rate. Using a mortgage calculator, we’ll say Sally paid $7,280 in loan interest for 2019. She also paid $2,000 in property taxes in 2019.
(Mortgage interest and taxes are deducted on Schedule A of Form 1040. For more fine print, the IRS Publication 936 explains the home mortgage interest deduction.)
Home mortgage interest and points are deducted on Schedule A, line 8. Sally paid points on the home purchase in 2018, and there is no deduction for 2019. Here are Sally’s itemized deductions for 2019:
- Mortgage interest: The bank provided Form 1098, which listed the $7,280 in loan interest.
- State and local taxes: She paid $4,500 in state and local taxes, and $2,000 in property taxes in 2019, for a total of $6,500.
- Charitable donations: $1,500.
Her itemized deductions total $15,280, which is more than the $12,200 standard deduction in 2019, so Sally uses the higher itemized amount on her tax return.
The true cost of Sally’s mortgage is reduced by the taxes and mortgage interest that she can deduct on her tax return. The dollar value of the deduction is based on Sally’s marginal tax rate.
Marginal tax rates
Individuals pay taxes at several different tax rates. For tax year 2019, single taxpayers may be subject to as many as seven different tax rates, depending on the individual’s taxable income. Marginal tax rates work by applying different rates for each bracket of qualifying income. For example, Sally pays a 10% rate on her first $9,700 in earnings, and 12% on earnings between $9,701 and $39,475. If she earned $70,000 she would be taxed at a 22% marginal tax rate.
Sally’s mortgage interest and property taxes total $9,280 and those expenses reduce her taxable income. If Sally rented an apartment, she could not deduct the interest and property taxes since renters don’t pay interest on a mortgage loan or property taxes on a home.
Therefore, the true cost of Sally’s mortgage is ($9,280 interest and property taxes — $2,041 tax savings), or $7,239. If Sally’s taxable income was higher, the deductions could potentially be worth more.
Let’s say instead that Sally’s taxable income is $85,000, which puts her in a 24% marginal tax bracket as a single filer. The true cost of Sally’s mortgage would be ($9,280 interest and property taxes — $2,227 tax savings), or $7,053. The higher deduction lowers the true cost of Sally’s mortgage.
It’s also important to understand the difference between a tax deduction and a tax credit.
Tax credit vs. tax deduction
Assume that Sally’s state provides a $500 tax credit to homeowners who install solar panels. If Sally takes the credit, her state tax liability (the amount she owes) is reduced by $500.
A tax deduction, on the other hand, reduces your taxable income rather than your tax bill. Sally’s $85,000 of taxable income is reduced by the mortgage interest and her property taxes paid. It’s important to understand the difference between a tax credit and a tax deduction, so you can file your taxes correctly and avoid surprises.
How to determine mortgage interest deduction
Take these steps to determine the true cost of your mortgage:
- Gather your tax documents. You should receive a Form 1098 that reports your mortgage interest, and your local government will send a statement that reports your property taxes paid. If you bought a home during the tax year, you can also deduct the points paid.
- Verify your total mortgage debt. Sally took out her loan in 2018, and current tax law states that her mortgage debt must be less than $750,000 in order to deduct 100% of the mortgage interest.
- Determine if you can take the itemized deduction. The mortgage and property tax deduction only apply if you itemize.
Since Sally’s itemized deductions are greater than the standard amount, it’s better for her to itemize. And since her mortgage balance is less than $750,000, she can deduct paid interest and taxes on her home.
Ultimately, the true cost of her mortgage depends on her taxable income. Higher taxable income generally generates a higher marginal tax rate, and the marginal rate is used to calculate the value of the tax deduction.
The hypothetical above is for illustrative purposes only. It is not intended to be tax advice and does not guarantee tax results. This publication is designed to provide general information. It is not intended to provide, and should not be relied upon, for tax, legal or other financial advice. For advice on your taxes and how to properly make deductions based on homeownership, you should consult your tax, legal and financial advisors.