Welcome back to the Early Retirement Now blog! I hope everybody had a safe and relaxing Fourth of July holiday. And if you don’t live in the U.S. and had to go to work yesterday we hope you had a nice Fourth of July, too! We are currently on vacation in Paris and I am sure even here I smelled some barbecue in the air yesterday, so folks seem to celebrate worldwide!
In any case, as we detailed last week, we plan to rent during early retirement, at least in the beginning. But even if and when we buy a house we’d likely pay cash and forego the mortgage deduction. Won’t we miss the deduction? Probably not! We found a few reasons to really appreciate this tax deduction but also two very bad reasons. Let’s start with the bad reasons!
Bad Reason 1: It helps the little guy
There is widespread support for this tax deduction because it’s viewed as one of the last few tax breaks for the middle class. Touching this “third rail,” it is believed, would be political suicide for any politician. Really? Give me a break! The mortgage interest deduction is of very limited use to the little guy. Quite the contrary, it’s one of the biggest giveaways to the upper middle class (and lower upper class if there’s such a thing), I can imagine. I am amazed that despite tight federal government finances the mortgage interest deduction has not come under attack yet.
Don’t get me wrong, I love the mortgage interest deduction because we have benefited so much from it. But I’d be the first to admit that if this tax deduction ended up on the chopping block of tax reform only very few people would miss it! Don’t believe it? Let’s take a look at three different households: Tiny ERN, Little ERN and Big ERN and their respective tax situations. How much can they really benefit from the mortgage interest deduction? See diagram below:
- Tiny ERN has a mortgage but even with the deduction for interest and state taxes paid this household doesn’t get above the annual $12,700 standard deduction (CY 2017) for a married couple filing jointly. An example for Tiny ERN would be a household with $60,000 annual income, $3,000 in annual state taxes, $2,000 in annual property taxes and $6,000 in annual mortgage interest. Pretty much the typical middle-class household that has not enough itemized deductions and thus no benefit from this tax deduction.
- The Little ERN household makes $120,000 per year, pays $6,000 in annual state taxes, $4,000 in property taxes and $12,000 in annual mortgage interest. There is some benefit for this household but it’s limited. First, only $9,300 in itemized deductions are above the standard deduction amount ($6,000+$4,000+$12,000-$12,7000). Multiply that by an estimated 20% marginal tax rate (15% federal, 5% state) and the benefit is $1,860. Not bad. But wait until you see Big ERN’s benefit!
- The Big ERN household reaps the maximum benefits. It has an annual income of $300,000 (not our actual income, this is just an example), pays $18,000 in state taxes, $8,000 in property taxes and $24,000 in annual mortgage interest. Because the other deductions are already easily above the standard deduction, the entire mortgage interest payment is effectively deductible. Also, Big ERN is in the 33% federal and 8% state bracket, so the benefit is a staggering $9,840 per year. The Big ERN mortgage is twice the size of Little ERN’s, but generates more than five times the benefits compliments of the Federal government. As I said, this is a giveaway for the rich upper middle class!
Bad Reason 2: we can “afford a bigger house”
Oh, well, where do we start? A house is a consumption good. It needs to be heated in the winter, cooled in the summer, it costs property taxes, it requires repairs, maintenance, etc. Also, no matter how pretty and modern that brand new kitchen and the bathrooms may look now everything will likely look slightly outdated after 20+ years. Think of pink bathroom tiles! A house is a cost-center and a bigger house is an even bigger cost-center.
So, buying a bigger house because of the tax savings is a bad idea. Think of the following analogy: Imagine you go shopping for a backpack, only to find out that there’s a sale: 50% off! Great, so we can afford a backpack twice the size we were planning to buy initially, right? But why carry around a bigger backpack than we need? Would you consider these two people in the picture smart shoppers?
So, don’t buy more house than you need! Enjoy the tax deduction while it lasts, pocket the money and use it to max out your retirement savings!
Good Reason 1: Renters benefit from the deduction, too!
Just because renters can’t write off their rental payments doesn’t mean that they don’t benefit from the mortgage interest deduction. Their landlord can write off interest as a business expense and part of the savings will be passed on to their customers. Basic economics teaches us that in a perfectly competitive market all the savings will land in the customers’ pockets. Of course, rental markets are not 100% competitive, but as long as a part of the savings are passed on to renters there is still a net benefit. Hey, that’s better than the Tiny ERN household in the example above who gets nothing from the tax code!
Also, let’s keep in mind that the interest deduction is just the start. Landlords get other tax breaks, too, such as depreciation allowance, and tax write-offs for pretty much everything else, like repairs and landscaping. We can’t do that as a homeowner! And the best part is that landlords can always write off every single dollar of mortgage interest starting from the first dollar. There is no threshold like the $12,700 itemized deduction for homeowners!
Good Reason 2: The “Alternative Minimum Tax makes the entire interest payment tax deductible
Another route to ensure that effectively all of the mortgage interest is tax deductible is if you are joining the growing ranks of households subject to the “Alternative Minimum Tax” (AMT). The ERN household has been for many years! Under the AMT, there is no option to pick either a standard deduction or the itemized deduction. In our case, we face an effective 35% federal marginal tax (28% marginal rate plus the AMT deduction phaseout worth another 7%). Add to that our high state tax and we’re in the mid 40% range. Starting from the first dollar, we get almost half the mortgage interest back.
Good Reason 3: You don’t like bonds
If you’ve followed our blog you’ll know we are no big fans of bonds. Expected returns are low and bond diversification is overrated. Besides, we wrote about how young investors can benefit from delaying debt reduction because this can reduce sequence of return risk. So, in our personal portfolio, we have essentially zero bonds. And if you don’t like bonds, what’s even better than having zero bonds? Shorting bonds! Of course, the average investor will have trouble shorting an actual bond, so the easiest way to implement this is to keep your mortgage for as long as possible. Lowering our borrowing cost to less than 2% p.a. after-tax means that we pay a roughly zero interest rate after inflation. Of course, using leverage like this may not be such a great idea in retirement but while working and facing a marginal tax rate this has been very useful for accelerating our savings!