As home prices continue to soar here and in many parts of the country, real estate brokers and agents are increasingly eager to point out the tax benefits that go along with home ownership, reminding potential buyers that these breaks can make a house less expensive than it seems.
Some even draw up sheets showing how the deductions for mortgage interest and property taxes reduce the real after-tax cost of the house.
But while the tax benefits are indeed real, the tax laws have become so complicated that a generalized set of calculations, which the agents typically use, may or may not reflect what a buyer will see on his or her actual tax return. Thus, potential home buyers who are thinking of relying on tax benefits to make their new houses affordable should run their own numbers though their computer or take them to an accountant to be sure they don't bite off more house than they can pay for.
The two provisions of today's tax code most likely to rearrange the numbers are the increased standard deduction for couples and the alternative minimum tax for higher-income home buyers, said Bob D. Scharin, editor of Warren, Gorham & Lamont/RIA's Practical Tax Strategies, a monthly journal for tax professionals.
He noted that last year Congress gave the standard deduction a big boost for married couples as part of its effort to ease the so-called marriage penalty on two-income couples. However, it's temporary unless lawmakers extend it, making planning even harder than usual.
And the alternative minimum tax continues to creep up on middle-class taxpayers, despite minor relief enacted recently.
A third key factor is the buyer's tax bracket. The higher the bracket, the more valuable the deductions become. At the same time, a person barely into a higher bracket can see his taxable income reduced to the point where he is mostly in a lower bracket, cutting the benefit.
Here are some examples Scharin put together to illustrate:
In simplest terms, the tax savings from a deduction are equal to your tax bracket. For example, assume Anne and Ben are solidly in the 25 percent tax bracket and already itemize their deductions, such as state income tax, because they exceed the standard deduction of $9,700. If they buy a house for which they will pay $10,000 a year in mortgage interest and real estate taxes, their tax saving will be $2,500 (25 percent of $10,000).
Carol and Dennis have the same income as Anne and Ben, but live in a state with no income tax. Their only expenses eligible for itemized deductions before the home purchase are $700 in charitable contributions. Without any homeowner deductions, they would claim a standard deduction of $9,700. With the extra $10,000 of deductions, they will have itemized deductions of $10,700. Result: Their tax saving from home ownership is only $250 (25 percent of the $1,000 by which their itemized deductions exceed the standard deduction).
A third permutation: Suppose Eva and Fred itemize their deductions. Their income is at a level where only their last $1,000 of income is taxed at the 25 percent rate. (In other words, their taxable income without a home purchase is $59,100, and the 25 percent tax bracket for joint return filers begins with taxable income over $58,100. Taxable income over $14,300 but not over $58,100 is taxed at a 15 percent rate.) When Eva and Fred purchase a home that increases their deductions by $10,000, they fall into the 15 percent tax bracket. Thus, only $1,000 of the deductions cut their tax by 25 percent; the remaining $9,000 of deductions save tax at a 15 percent rate. Result: Their tax saving is $1,600 (25 percent of $1,000 plus 15 percent of $9,000).
Higher up the income scale, other complications set in.
The alternative minimum tax, or AMT, requires taxpayers to recompute their taxable income by using a large standard deduction and ignoring certain deductions they are allowed to take for regular tax purposes. They then figure their AMT, using a 26 or 28 percent rate, and pay whichever is higher, their regular tax or the AMT.
Among the ordinary deductions not allowed under the AMT are state and local taxes. Taxpayers subject to the AMT can take a serious hit because of this.
For example, said Scharin, assume Gail and Howard are subject to the AMT and pay tax at the 26 percent AMT rate. Suppose the $10,000 of homeowner deductions to which they will become entitled is composed of $3,000 in property taxes and $7,000 in mortgage interest. Result: Their tax saving will be $1,820 ($0 for the real estate tax plus 26 percent of $7,000).
Another pothole for upper-income taxpayers is a provision -- sometimes referred to as "Pease," after the congressman whose idea it was -- that causes itemized deductions on Schedule A, where mortgage interest and taxes are listed, to start to phase out for taxpayers above a certain income ($142,700 for a couple). Thus, even taxpayers lucky enough to escape the AMT can see the benefit of homeowner deductions eaten away by Pease.
It's hard to predict where tax laws will go in the next few years, but if rates rise, as many expect, the best guess is that deductions will become more valuable. But also try to gaze into your own future, and see what you think your situation will be.
"Computations become more complex when projecting multi-year tax savings," Scharin said. "Homeowners are likely to find their deductions varying from year to year. It's important to plan as much as possible when buying."