When comparing the cost of renting vs. buying,
factor in the tax benefits that you will receive as a homeowner.
The three primary tax benefits of home ownership:
How does the mortgage deduction affect my monthly housing expense?
You can deduct home mortgage interest and property taxes from your taxable income within IRS rules. The mortgage interest paid on a maximum of $1.1 million dollars in total mortgage debt, whether on your primary residence or a second home, as well as all of the property taxes, are fully deductible. In California, depending on your tax bracket and subject to other IRS limitations such as the alternative minimum tax, this tax benefit can offset 25% or more of your monthly housing expense.
Determining your tax benefit is essential to figuring out the real monthly cost of your new home, and you may find that you can comfortably afford a more expensive house. Figuring your monthly housing cost is easy when you are renting—it’s the rent, and it seems logical to decide how much you can afford to pay when purchasing your first home based on the affordability of your current rent. For example, if you are paying $2500 in rent, and putting $1000 away in savings each month, then you will logically assume that you can afford to pay up to $3500 a month when you buy a home. However, if your income tax bill will be more than $6,000 lower after you buy, then $4000 a month may be affordable.
One concern that first time homebuyers often express is cash flow; although a home buyer may save $6000 in taxes, if that saving doesn’t come until April of the following year, it doesn’t help make the payment. A simple solution for most salaried borrowers is to adjust their withholding by filing a new form W-4 with their employer, so that the $6000 in annual savings becomes a monthly paycheck that is $500 larger. The IRS offers an interactive withholding allowance calculator and a couple of worksheets on page two of form W-4 to help figure out just what changes can be made to the withholding amount.
Figuring your tax savings on a monthly basis and subtracting that number from your pre-tax monthly housing expense will let you see what it costs to own your home after taxes. This is the ‘rental equivalent’ of your monthly housing expense.
What other tax savings are available to homeowners?
- When you purchase your home, most of the closing costs are not tax deductible, with one exception—loan discount points, also called origination fees. These fees are tax deductible regardless of who pays them; even if the seller or the lender gives you a credit for closing costs, you can still deduct these fees.
- You can make a profit of up to $500,000 when you sell your home and pay no income or capital gains taxes if you have owned and occupied it for at least two of the past five years and are married (the deduction for a single person is $250,000). You don’t have to reinvest the proceeds to take advantage of this exclusion.