Stott Real Estate, Inc. is not licensed to provide tax advice.  Please consult your CPA or tax advisor to verify that the benefits outlined in this article apply to you.  This article outlines the tax savings that benefit many homeowners.

The interest paid on a mortgage and property taxes are both deductible for federal and state taxes. For simplicity, this example uses even numbers . . . assume a mortgage payment each month of $2,000 where $200 goes to property taxes, $100 goes towards paying off the loan amount (principal) and $1,700 goes towards interest, then $1,900 ($200 + $1,700) is deductible each month. If the owner were in a 25% federal tax bracket and a 8% state tax bracket, then the combined federal and state tax savings each month would be $1,700 x 33% = $561. The total monthly payment would be $2,000 with a tax credit of $561 for an after-tax payment of ($2,000 – $561)  = $1,439.

This simple example does not include a payment for insurance (house) or for a maintenance fee (high-rise or townhouse). Moreover, it is not a static problem. When a mortgage is paid-off in equal amounts each month (amortized), the amount going to interest decreases slightly each month while the amount going to principal increases slightly. However, computing these amounts over a period of time is a relatively simple problem using an amortizing calculator.

If the owner were to do nothing and just let the $561/mo accumulate, the owner would probably have a sizable tax refund. However, most buyers need the tax savings each month to be able to afford their mortgage payment. They accomplish this by filing a revised W-4 form (Withholding Allowance) with their employer and as a result less taxes are withheld.

If a married couple with two children (total of four withholding allowances) were to claim ten dependents on their income tax return (1040), it would be fraudulent and they would likely be in trouble with the IRS. However, there is nothing wrong with claiming additional withholding allowances so that fewer taxes are withheld each month. In fact, the back of a W-4 form contains worksheets to assist a taxpayer in determining how many additional exemptions they should claim to offset expected deductions.

Thumb Rule (Tax Savings)

Assumptions:

Married filing jointly$80,000 taxable income$400,000 30-year mortgage @ 6% interestProperty taxes $150/mo25% federal tax rate in 2012 for taxable income of $67,900 to $137,0508.25% Hawaii tax rate in 2012 for taxable income of $48,000 to $149,000All figures rounded to nearest dollar

Computations:

$400,000 @ 6% = $2,398 (principal & interest)1st year loan balance (PV) using 348 (360 – 12) for n = $395,088$400,000 – $395,088 = $4,912 principal payoff 1st year$4,912 divided by 12 = $409/mo principal payoff$2,398 payment less $409 = $1,989/mo interest payment$1,989 interest/mo + $150 taxes = $2,139 deductible/mo33.25% (25% + 8.25%) of $2,139 = $711/mo actual tax savingsCompared to 30% of $2,389 = $717/mo estimate using thumb rule.

NOTES: The 30% thumb rule works for mortgage rates of 6%-7% and combined tax rates (federal + Hawaii) of about 33%.  For a 7% mortgage the thumb rule is $798 compared to a computed $816.