Home Ownership and Taxes: The Home Buyer/Home Owner Perspective

In two other commentaries, we looked at two federal income tax benefits for home owners at a macro level: the mortgage interest deduction and the state and local property taxes deduction. In this commentary, we’ll examine these two together from the individual home buyer’s perspective: how the life cycle of ownership affects the deductions a home owner takes; and how that may translate into differences in the tax benefits to tax payers of various age categories.

What does a new buyer deduct?

Let’s assume a home buyer is looking to purchase a home valued at $200,000. Assuming the buyer makes a 10 percent down payment¹ and secures a mortgage with a 5.5 percent interest rate, the monthly payment will be $1,022 for principle and interest. Of this amount the interest paid is $825 per month — or $9,900 total during the first year. Annual property taxes of 1 percent would add another $167 per month or $2,000 per year. This means, in the first year, the home owner can deduct a total of $11,900 in housing-related deductions from their federal income tax. As the mortgage is paid down, the amount of interest paid decreases. Assuming a constant property tax rate, annual property taxes will increase with the rate of home appreciation — let’s assume a modest 3 percent rate. Thus, in the 7th year of ownership, mortgage interest paid is $8,959 and real estate taxes paid are $2,388 for total housing-related deductions of $11,347. The chart below shows the amount of mortgage interest and real estate taxes paid by our buyer over the first thirty years after he or she purchases a home.

How do deductions for the owner change over time?

Above you can see that the increase in annual real estate taxes paid is not larger than the decrease in mortgage interest paid annually. Therefore, the total amount of housing deductions decreases over time. This is seen more clearly in the following figure which compares total housing-related deductions to the standard deduction. The figure shows the total amount of housing-related deductions (blue diamonds) against the standard deductions for tax filers of various statuses. The chart also clearly shows that, assuming deduction amounts are constant, housing-related deductions alone exceed the standard deduction regardless of filing status in the first 6 years of ownership.

What other changeable factors affect the owner’s deductions?

The standard deduction is adjusted annually for inflation. In fact, tax firm CCH has releasedprojected inflation adjustments to various tax parameters for the 2011 tax year. The IRS typically confirms these amounts by the end of the calendar year. In the figure below, we assume that the projections by CCH are correct for 2011 and make a 2.5 percent adjustment for inflation in successive years. We see that a married home buyer with only housing-related deductions to itemize would still have housing-related deductions that exceeded the standard deduction in the first two years after the home purchase. For filers of other statuses, the housing-related deductions exceed the standard deduction for a decade (head of household) or two decades (single filers). Of course, for many tax payers the housing-related deductions are not the only deductions that can be itemized; therefore, even when housing-related deductions alone may not be sufficient to warrant itemizing, when combined with others, they are a significant component of total itemized deductions that may together exceed the standard deduction.

What are the implications for policy?

One interesting feature that is clearly seen in the figure above is the downward sloping nature of the housing-related deductions curve over time. As a mortgage is paid down, the amount of interest paid and therefore the mortgage interest deduction decreases. Because this process takes time, it can be understood from a life-cycle perspective. In a recent study, the National Association of Home Builders used tax data on the age of filers to examine the life cycle of housing-related deductions. They found that younger buyers benefit importantly from the mortgage interest deduction from both an aggregate and an average benefit perspective. This evidence, taken from the IRS data, fits with what we know happens to the amount of mortgage interest paid over the life of a mortgage. However, highlighting these facts reminds policy makers of the distributional aspects embedded in the current system and the importance of these benefits to younger buyers.

¹While a down payment of 10 percent would generally result in the borrower paying some form of mortgage insurance which is also tax deductible, we will not consider that additional factor in this article.