We often hear that owning a home with a mortgage provides a tax benefit at income tax time since mortgage interest is tax deductible, but there’s a bit more to it. Many people think that the full amount of their mortgage interest paid throughout the year is subtracted from their income taxes, but mortgage interest is a deduction, not a subtraction. Deductions lower (or modify) our taxable income amount, which in turn lowers our tax payment. So the tax deduction for mortgage interest is a percentage of the amount of mortgage interest that we pay. Not the full amount.
The percentage of the tax benefit is based on our tax bracket, and our tax bracket is determined by our taxable income. Most of our tax deductions are handled this way, so the impact of taxes in personal finance is well worth considering. We’ll walk through an example to show how this is calculated. As a point of reference, the tax brackets for 2012 based on taxable income for single individuals and those filing married joint returns are listed below. A large majority of Americans are in the 25 percent bracket.
If I’m single and have $86,000 in taxable income, I would be in the 25 percent tax bracket, and the tax benefit from my mortgage interest would be just $0.25 for each dollar of interest that I pay. Let’s calculate the tax with and without the deduction to show the results in dollars.
Without the deduction, I would pay $21,500 in income tax, which is 25 percent of my $86,000 in taxable income (shown below).
Income Tax Based on Taxable Income
Taxable income x Tax bracket = Income tax
$86,000 x 25% = $21,500
If my mortgage interest paid for the year is $8,299, then that amount is subtracted from my taxable income (not from my taxes). The new taxable income amount is then used to determine the amount of taxes that I will pay. The new or adjusted income amount will be lower, and therefore my taxes will be lower.
Income Tax Based on Adjusted Taxable Income
Taxable income – Mortgage interest = Adjusted taxable income
$86,000 – $8,299 = $77,701
Adjusted taxable income x Tax bracket = Income tax
$77,701.00 x 25% = $19,425.25
Mortgage Interest Deduction Benefits
Income tax without the deduction $21,500.00
Income tax with the mortgage interest deduction $19,425.25
Benefit of mortgage interest deduction $2,074.75
Without the deduction, my income taxes are $21,500, and with the deduction, they are $19,425.25. The difference in taxes paid as a result of the mortgage interest deduction is $2,074.75, even though I paid $8,299 in mortgage interest during the year.
Keep this in mind if you’re considering buying a home, or paying down or paying off an existing mortgage. You’ll lose the deduction, but the benefits from mortgage interest are not as large as we often think. In addition, Congress frequently considers limiting or eliminating this tax deduction, so keep an eye out for changes or check with a tax professional.