Counting on Tax Deductions? Be Sure to Count Them Right

Second in a series of articles

"The avoidance of taxes is the only intellectual pursuit that carries any reward."

-- John Maynard Keynes

"But it's deductible!" How often have you heard that when people talk about mortgages? What does it mean to you?

Let's say you plan to purchase a condominium for $300,000 and put $30,000 (10 percent) down. You will need a $270,000 mortgage loan.

One lender has offered you a fixed-rate 30-year mortgage at 6.25 percent, with a monthly payment of $1,662.45. Another lender is trying to persuade you to take an adjustable-rate mortgage that will stay fixed for three years at 5.5 percent interest. The monthly mortgage payment for the first three years will be $1,533.04. (These numbers include only principal and interest, not taxes and insurance.)

You analyze the numbers and see that there is a difference of $129.41 per month between the two loans. But that's not the end of your inquiry. You know that you are in the 25 percent income tax bracket, meaning that you are married and jointly you earn between $61,301 and $123,700.

That means that for every dollar you pay in mortgage interest, you can deduct 25 cents on your income tax return. So when you plug in these deductions, the difference between the two mortgages drops to $97.06 a month.

You should ask yourself whether the monthly saving of $97.06 for the three-year ARM is really worth it, taking into account that the payment on that loan could jump considerably if loan rates are higher when it is recalculated in three years.

The deductibility of mortgage interest is one of the big breaks the tax code gives to homeowners. Points paid when you take out a mortgage are also deductible.

Mortgage interest: Interest on mortgage loans on first or second homes is fully deductible, subject to the following limitations: acquisition loans may total up to $1 million, and home equity loans may total $100,000. If you are married but file separately, the limits are split in half.

For debt to qualify as an acquisition loan, you must buy, construct or substantially improve your home with that money. If you refinance for more than the outstanding indebtedness, the excess amount does not qualify as an acquisition loan unless you use it to improve your home.