For years we listened to our accountant tell us we needed to buy a house for the tax deduction. Sound familiar? It wasn't her fault: it was, and perhaps still is, part of the common belief about why it's better to buy than to rent. (I could offer quite a list of arguments on the other side, not the least of which are natural disasters, but since we're enjoying our beautiful home, as I hope you are yours, I’ll stick to the tax question.)

There may be quite a few reasons to own a home. But could we pause just a moment and underline the word own? After all, how much better than renting is making-payments-on-this-house till it’s time to move and-make-payments-on-that-house, then move again and do the same thing, forever and ever, ad infinitum?

The Tax Savings Myth

The main problem with spending money in order to save money is that you always have to spend a whole lot more than you save. "Thank you for shopping at Safeway; you saved $22.14 today." Any time I save double digit dollars shopping, I know I've spent triple digit dollars! Is this a surprise to you?

Spending over $100 at the grocery store to save over $20 is similar to deducting mortgage interest expense off your U.S. Federal Tax Return. You spend a dollar on your home to save 30 cents (or whatever tax bracket you’re in…28%, 30% 33%, 35%, 45%…) on the tax deduction.

Here’s little bit more on how this works. And it’s tricky, because of all the different kinds of taxes deducted from payroll checks…the federal rate on the Internal Revenue Service charts is just once teensy-weensy bit of it. That’s why the general rule of thumb—only for purposes of discussion—is that you pay 30 cents out of a dollar. Or in the case of a tax deduction, if you spend a dollar, you can avoid 30 cents in taxes.

Example

Let’s say a family with about $100,000 a year in income owes Federal Tax of $18,330 (besides all the other taxes: state, county, etc.).

Let’s also say that their first year in their home, their mortgage interest is $11,215. If they deduct the entire $11,215 interest from their $100,000 income, their taxable income is only $81,670, not $100,000.

The difference between the tax on $100,000 and the tax on $81,670 is about $3000. So that’s how much the mortgage tax deducters will save for their first year.

Get it? They still have to pay taxes. The interest they pay doesn’t come off their entire tax bill; it comes off their gross income before computing their tax bill. So instead of paying $18,330 in federal income tax, they pay $15,525.

Mortgage Holders Cashflow

Mortgage holders earn	$100,000.00
less mortgage payments of	$12069.36
less federal tax payment of	$15,525.00
CASHFLOW	$72,405.64

Non-Mortgage Holders Cashflow

Cash homebuyers earn	$100,000.00
less mortgage payments of	-0-
less federal tax payment of	$18,330.00
CASHFLOW	$81,670.00

The family without a mortgage is $9264.36 in cash ahead of the smart people holding a mortgage in order to claim a tax deduction.

According to these numbers off the 2005 Internal Revenue Service tax Rate Schedules, the people with the mortgage saved only  2.8% of their gross income ($2805) by deducting their home mortgage interest. Other deductions and dependents could change their tax liability, but we’re trying to analyze only how a mortgage affects savings, right?

The principal of “it’s better to pay cash for your home” does not always apply. If you have a very low interest rate on your home, and a high yield on some stable investments, it could be better to carry a home loan.

But buying a home on time (long-term monthly payments) just so you can get a tax deduction is always the wrong reason to go into debt.