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I am trying to ascertain the effect of the mortgage tax deduction on my bottom line. The various calculators I found are confusing to me. Specifically, I want to know how much less I'll pay in taxes, if I buy a home.

Doesn't the savings depend on my income? The mortgage tax deduction is a deduction, not a credit, so how can the calculator give me a result? If my line of thinking is correct, the calculator would have to ask me my taxable income.

Or am I wrong on this?

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2 Answers

up vote 3 down vote accepted

You are correct, but I can explain what they're trying to do.

They don't need to ask for your income because they ask for your tax bracket instead. The default value assumes 25% marginal tax rate.

The amount you save is really calculated as:

Interest Paid * Marginal Tax Rate

So if you pay $10k in interest this year and you're in the 25% bracket, you save $2500 on your tax bill. That is why the calculator doesn't ask for your income.

However, this isn't perfectly accurate, because if you are on the edge of a tax bracket then your deduction will actually change your marginal tax rate. This is a little more complicated scenario. Let's say you are a single filer making $85k per year and are paying $10k in interest. You'd put 28% tax bracket into the calculator, and it would tell you that you are saving:

S = $10000 * .28 = $2800

But actually this isn't right, because you're only paying 28% on income beyond $83600 (the lower limit of the 28% bracket) and you're paying %25 on income between $34500 and $83600). The accurate calculation has to take this into account:

S = ($85000 - $83600) * .28 + ($10000 - ($85000 - $83600)) * .25

simplifying:

S = $1400 * .28 + $8600 * .25
S = $392 + $2150
S = $2542

So you may actually save less if you are near the edge of a tax bracket than what that calculator is estimating.

In my mind, it would make a lot more sense for them to ask for your income, for two reasons:

  1. It leads to a more accurate calculation.
  2. Most people know their income, but may not know their marginal tax rate.
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You address the marginal rate perfectly. Keep in mind, though, if the taxpayer is single, they have a standard deduction, $5800 in 2011. For someone in a state will low or no income tax, he is likely to take the standard deduction and needs to account for this when looking at the benefit. In other words, $10K in interest in the 25% bracket will not always produce a benefit of $2500 as some may be lost to the standard deduction (which you get if you don't itemize). –  JoeTaxpayer Sep 11 '11 at 19:18
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As I answered in a similar question, the effect depends on whether or not you already have enough deductions to past the standard deduction. If you do, you mortgage interest is fully deductible, and the effect is that you save (interest * tax bracket). Indeed, people can have different brackets, and not be above the standard deduction so the effect of the mortgage interest deduction is different depending on your situation.

I'll also refer you to Fairmark, a publisher of tax books and info. They keep a current chart showing clearly (a) your standard deduction, and (b) tax brackets.

The deductions the house provides ongoing are the interest and property tax. For the year of purchase you may also take points charged on your loan. (for refinancing, points charged are taken over the life of the loan, and remaining amount in full upon sale or next refinance.)

The exact benefit to your taxes depends on how much you already had to take as an itemized deduction and your taxable income which determines your marginal rate.

On a side note - you may discover the deductions from the house put you in the 15% bracket, for example, and this influences your decision to go Roth in your 401(k) or IRA, as going pretax in the 15% bracket may not benefit you. This is just something to think about for those pondering the original question. It's not that these things are so complex, just multiple interactions among your financial picture.

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Why would "going pretax in the 15% bracket" not benefit you? If deductions push you in a lower tax bracket, isn't the Roth IRA an even better deal? –  Pete Feb 26 at 3:39
    
In general, I recommend that one use pretax deposits to avoid the 25% bracket, and Roth deposits on 15% money. If one went pretax for all their deposits, they'd have a greater chance of being in a higher bracket at retirement, so my strategy is a balance, with a goal of averaging out your marginal rate and paying 25% on as little income as possible. –  JoeTaxpayer Feb 26 at 4:51
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