Tax Deductibility

Tax Deductibility (of Interest and Points)

The provision of the U.S. tax code that allows homeowners to deduct mortgage interest payments from income before computing taxes.

Points and origination fees are also deductible, but not lender fees expressed in dollars or any other settlement costs. Interest deductibility is politically untouchable in the U.S., although it is often criticized by economists and is found in few other countries.

Interest deductibility enters a number of decisions made by homeowners or purchasers, sometimes when it shouldn't.

Borrow for the Deduction? It never makes sense to borrow for the sole purpose of obtaining a tax deduction, even if you are in the highest tax bracket. If you are in the 40% bracket, for example, and you borrow $100,000 at 5%, you pay $500 of interest in month one and save $200 in taxes. Your net loss is $300.

If you invest the $100,000, the interest earnings reduce the loss. However, borrowing at 5% to invest does not become a profitable strategy unless you can earn more than 5% on the investment. Since this is not possible without incurring default risk, the required return on the investment must be above 5% plus an increment sufficient to compensate for this risk.

Assuming that the interest on investment is taxable, comparisons of mortgage rate with investment return can be made either before tax or after tax. For example, if the borrower in the 40% tax bracket would pay 5% on the mortgage and earn 4% on investment, the investment is a loser before tax (5% less 4%), or after tax (3% less 2.4%). If the investment is tax-exempt, however, its return should be compared with the after-tax cost of the mortgage.

Note that the very same principles hold when the issue is whether to invest in mortgage loan repayment, as opposed to acquiring some other type of investment. See Partial Prepayments (or Paying Off Early)/Making Extra Payments as an Investment.

Should Mortgage Insurance Also Be Deductible? The IRS is inconsistent in not allowing mortgage insurance premiums to be deducted in the same way as interest. See Private Mortgage Insurance/Why Aren't PMI Premiums Deductible?

References in periodicals archive ?
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