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A case against financed home ownership.

Home ownership no longer provides the tax shelter benefits it once did. Although home mortgage interest remains deductible as an itemized deduction, the economic benefits of financed home ownership declined significantly over the past decade. Three factors contributed to the decline:

1. Federal income tax rates declined.

2. Standard deductions increased annually due to inflation adjustments.

3. Many deductions were reduced, phased out or eliminated.

As the standard deduction increases each year and fewer expenses qualify as itemized deductions, itemizers and marginal itemizers typically become marginal itemizers and nonitemizers, respectively. How should CPAs advise this growing group of taxpayers? How can clients who might benefit from early mortgage payoffs be identified? What should be considered in deciding whether to recommend that a client stop itemizing? What planning opportunities might prove beneficial to particular clients, given their unique financial circumstances? This article addresses these questions as it considers the true benefits of using borrowed funds to buy a home.

Note: This article does not address taxpayers in the 31% and higher brackets added by the Omnibus Budget Reconciliation Act of 1993. Such taxpayers are likely to purchase more expensive homes with larger mortgages, which are not addressed by the planning suggestions below.


Maximum tax rates. As individual federal income tax rates declined and became less progressive, the tax benefits of all deductions declined. Consequently, the reductions in high-income itemizers' federal tax liability were less for deductible home mortgage interest dollars spent in 1993 (at a maximum tax rate of 39.6%) than they would have been if the same nominal amounts had been spent in 1981 (at a maximum tax rate of 70%).

Standard deduction. Because standard deductions (as well as Social Security wage bases, personal exemptions, tax table rates, etc.) are indexed for inflation, "standard deduction creep" eliminated the conversion of nonitemizers to itemizers caused by inflation.

In assessing the tax benefits of financed home ownership, only excess itemized deductions, or the amount above the standard deduction, is relevant. For example, if a married couple filing jointly in 1993 has itemized deductions, including home mortgage interest, of $6,000, they still will take the higher standard deduction of $6,200. Home mortgage interest is "deductible" but provides no tax benefit.

Itemized deductions. The Tax Reform Act of 1986 limited the availability of itemized deductions. The medical and dental expense floor increased, sales tax deductibility was eliminated, mortgage interest deductibility was limited, personal interest deductions were phased out and certain miscellaneous deductions became subject to a 2%-of-adjusted-gross-income floor.


From a planning perspective, if a taxpayer with a home mortgage balance already is unable to itemize or is a marginal itemizer, early payoff might provide a higher aftertax return than alternative investments. Here's why.

Assume a home was purchased on January 1, 1993; the mortgage amount is $100,000 at an 8% fixed rate for 30 years. Real estate taxes are $1,500 and are expected to increase 5% annually. Inflation-indexed standard deductions increase at 4% per year (rounded to $50 increments). The owners have no other itemized deductions.

In 1993, mortgage interest of $7,970 and real estate taxes of $1,500 yielded total itemized deductions of $9,470. Married taxpayers filing joint returns would have $3,270 ($9,470 less $6,200) and single taxpayers would have $5,770 ($9,470 less $3,700) in excess itemized deductions. The extra 1993 federal income tax reductions were $916 ($3,270 x 28%) or $491 ($3,270 x 15%) for married taxpayers and $1,616 ($5,770 x 28%) or $866 ($5,770 x 15%) for singles.

The exhibit on page 63, summarizes the federal income tax reductions, for all filing statuses, for taxpayers in the 28% and 15% marginal brackets. The tax benefit of mortgage interest disappears after the 11th, 14th and 21st years of a 30-year mortgage for married couples, heads of households and single filers, respectively. (Total federal income tax reductions over the life of the mortgage in the example also are provided for all filing statuses.)

In 1993, the first year of financed home ownership, the aftertax costs of the 8% mortgage in the example were 6.6%, 7% and 7.2% for singles, heads of households and married filers, respectively. After the last year of mortgage-interest-based federal income tax benefits, aftertax costs equal pretax costs.

Now assume the home was purchased in 1980. (Also assume a constant 28% marginal tax rate.) If historical standard deductions (with consistent projected standard deduction amounts) are used, the tax benefits of mortgage interest will be eliminated completely after the 21st year for married taxpayers (given total federal income tax reductions over the life of the mortgage of $23,006, compared with the $5,597 in the exhibit) and after the 23rd year for single taxpayers (given total federal income tax reductions of $39,626, compared with $21,433).

The differences of $17,409 ($23,006 less $5,597) and $18,193 ($39,626 less $21,433) for married and single taxpayers, respectively, are due solely to the decline in excess itemized deductions. These calculations isolate the effects of inflation indexing on standard deductions and reveal the declining tax-based economic incentives, or reductions of the tax shelter feature, of home mortgage interest deductions.

Given an 8% mortgage, any investment that does not earn an aftertax return of 8% (11.11% pretax for a taxpayer in the 28% bracket) might better be shifted to home mortgage reduction.


The planning considerations discussed below provide a primer for CPAs wishing to serve better the increasing number of clients who might benefit from early mortgage payoff.

Reduce savings and mortgage. For taxpayers already unable to itemize but who still make mortgage payments, money that ordinarily would be used for savings or investments could be used for mortgage reduction. Of course, such a strategy depends on the relationship between the pre- and aftertax rates of return on savings or investments (the pre- and aftertax costs of the mortgage are equivalent).

For example, a taxpayer in a 28% marginal bracket earns 8% on investments and pays 8% (both pretax) on his or her mortgage. This taxpayer currently is unable to itemize and is unlikely to be able to do so in the near future. His or her aftertax rate of return falls to 5.8% (8% less 2.2% [8% x 28%]). The aftertax cost of the mortgage remains 8%, while aftertax earnings on investments are below 6%. For all practical purposes, the taxpayer is borrowing at 8% for the privilege of earning less than 6%.


Reduce deferred-compensation contributions and mortgage. A similar argument might be made for deferred-compensation contributions, but there's an additional consideration. Maximum tax rates are at a historical low. Previously, in years that followed low-tax periods, maximum rates more than doubled. Taxpayers today face the possibility of deducting deferred compensation contributions while in the 28% tax bracket and withdrawing them later when they are in a much higher bracket.

For example, assume a taxpayer in a 70% marginal tax bracket made a $2,000 contribution to a deferred-compensation plan in 1980. The $1,400 tax reduction ($2,000 x 70%) would result in an aftertax cost of only $600. Further, assume this amount earned 10% per year for 10 years. If this taxpayer withdrew the pretax proceeds of $5,187 ($2,000 x [1.0 + 10%] for 10 periods) in 1990 while in a 33% bracket, the aftertax proceeds of $3,475 ($5,187 less $1,712 [$5,187 x 33%]) would have provided an average annually compounded aftertax rate of return of 19.2%. This is nearly double the actual rate the investment earned because of the lower aftertax initial contribution.

Now assume the contribution was made in 1990 when the taxpayer had an effective marginal rate of 33% (the lower rate in the year of contribution, instead of the year of withdrawal). The $660 tax reduction ($2,000 x 33%) would result in an aftertax cost of $1,340 for the same $2,000 contribution. Continue to assume this contribution earns a 10% annual rate of return for 10 years before it is withdrawn in the year 2000 when the taxpayer's marginal rate is 70% (as it was in the preceding example, but in this case the higher effective marginal rate is in the withdrawal year instead of the contribution year). Withdrawing equivalent pretax proceeds of $5,187 will result in aftertax receipts of $1,556 ($5,187 less $3,631 [$5,187 x 70%]), providing an average annually compounded aftertax rate of return of only 1.5%.

Increase business debt and reduce mortgage principal. Self-employed taxpayers who do not exceed the inflation-adjusted maximum Social Security wage base each year have an additional incentive to shift debt away from their personal residences. Business interest remains deductible, generally is not subject to any limitation or exclusion (the standard deduction might be viewed as an ever-increasing exclusion amount) and provides for a reduction in earnings subject to the self-employment (Social Security and Medicare) tax.

The self-employment tax, combined with the top federal income tax rate, offers the potential for considerable tax reductions for taxpayers not interested in maximizing Social Security contributions (and related entitlements) just before retirement. Such tax reductions frequently are so significant as to more than offset the higher interest rates of business or personal loans compared with home mortgages.

For example, assume a self-employed nonitemizer with a 28% marginal rate and self-employment earnings slightly below the maximum Social Security wage base buys additional fixed assets for business expansion. Instead of paying cash from personal resources, the taxpayer finances the asset at 13%. Draws from the business (in addition to regular monthly payments) are used to reduce the principal portion of the mortgage balance. The aftertax cost of the business debt is approximately 7.5% (13% less 5.5% [13% x 42.13%]). This is lower than the 8% mortgage cost.


CPAs might determine which clients are likely to benefit from early mortgage payoff by reviewing tax returns to identify marginal itemizers. For example, taxpayers with excess itemized deductions of less than $1,000 for the past two or three years might be contacted to discuss strategies to address the diminishing tax benefits of itemizing.

Self-employed taxpayers with growing business assets and use increased business cash flow to repay home mortgages early. For taxpayers with substantial investments, CPAs will need to calculate the break-even point to determine whether their aftertax returns fall below the aftertax cost of financed home ownership.


As the above examples illustrate, many taxpayers may find maximizing their mortgage balances so they can itemize deductions no longer is a desirable objective. It's possible home mortgage interest no longer may be deductible for any taxpayer in the future. Eliminating all itemized deductions is an idea also under consideration.


* THE ECONOMIC BENEFITS of financed home ownership are declining because of decreased tax rates, increases in the inflation-indexed standard deduction and the elimination or phaseout of other itemized deductions.

* ITEMIZERS AND MARGINAL itemizers should consider the benefits of accelerated mortgage repayment. Early repayment might provide a higher aftertax return than alternative investments.

* AMONG THE RESOURCES homeowners might divert to early mortgage repayment are savings (current and future) and amounts that might otherwise be contributed to tax-deferred retirement plans. Increased business debt might also be used to reduce mortgage balances.

* WITH THE FUTURE of itemized deductions (particularly the home mortgage interest deduction) unclear, CPAs may wish to begin identifying clients who would benefit from early mortgage repayment.
COPYRIGHT 1994 American Institute of CPA's
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Copyright 1994, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Author:Cataldo, A.J., II
Publication:Journal of Accountancy
Date:Jun 1, 1994
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