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!
Thanks for sharing. I don’t think anyone should base their finances on a tax deduction, no matter the benefit. Mainly because you never know how long it’ll be around. Just look at the Student Loan Forgiveness program for public servants…that may go away and people who counted on that, or worse, took a lower paying job for the benefit are screwed.
However, it is a nice deduction when it applies.
Ha, great point! 30 years is a long time to rely on politicians not to change the rules. Thanks for stopping by!
Comparing the tax code to the Public Service Loan Forgiveness Program (PSLF) is not accurate. Although media outlets may portray PSLF’s demise as easy and immanent, that’s just not true. It’s important to always keep in mind that it’s the news media’s job to be clickbaity, which leads them to produce articles that are sensational but not quite accurate.
Congress is free to pass, amend, or eliminate laws as it sees fit. This is true. This is also why the tax code can change at any time.
PSLF, unlike the provisions in the tax code, is written into the master promissory note (MPN) that every student signs each time he or she takes out a loan. In other words, it is a term in a contract. Congress may be able to eliminate PSLF for NEW borrowers by changing or repealing the statute. But it will still be bound to honor the program for prior borrowers. This is why even Trump clarified that the proposed changes would only affect future borrowers.
This is 100% true. With a Republican House, Republican Senate, Republican President, and conservative Supreme Court, the government has still clarified that anyone currently on PSLF can still rely on it. If that amount of power in a party that disagrees with government spending and encouraging public service can’t undo the promises made on loan forgiveness, then it won’t happen.
Good point. It doesn’t look like this will change any time soon. Even though the government is on the hook for potential losses. 🙂
The bigger issue is that the government shouldn’t let a student borrow $200k for a degree in a field where they’ll never make enough compensation to pay back the loan in full. If students didn’t have access to the financing they’d stop paying ridiculous tuition prices and the costs would come down over time.
The Government putting it’s black card out there for everyone to use is irresponsible and has caused the student debt bubble, which we’re all going to pay for soon.
Good point! I’m sure this contributes to runaway tuition costs!
Very good point. If it’s written into the contract it can’t be changed for existing loans only new ones. Different situation than the mortgage deduction! Thanks for bringing that up!
Ooooh, interesting. I never gave our mortgage interest deduction a second thought, so thanks for mentioning this. Hmm.
That’s the best to treat the deduction! Thanks for sharing! Cheers,
ERN
Big ERN, I always appreciate your insights. Ironically, after being 100% debt free, we’re intentionally taking a mortgage on our new cabin! Why?? It’s a low-cost option for us to potentially defer my pension (which grows ~6% p.a. for every year deferred). We’ll have the cash set aside to pay off the mortgage at any point in time, so we’re in a bit of a unique situation. Interesting perspective, on an interesting topic.
Wow, that’s a great example of leverage/debt used for a good purpose. I can see an interesting future post of yours on “pension hacking” about that one. Thanks for sharing!
ERN
Big ERN,
Have long been on the same side as you are this one. Being debt free, we actually see the standard deduction as a “freebie” and work to use the standard deduction every other year. We pay property taxes in January and December (i.e., two years of property taxes in one year) and only make larger donations during the even numbered years. In odd numbered years, we take the standard deduction and avoid large donations and property taxes. I do refuse to live in a state with state income taxes, so this works out much better for us financially.
Thanks for another great post!
Oh, wow, that’s another fine trick to hack the tax deduction if the property tax is greater than 0.5 times the standard deduction.
I hope we can replicate the zero state tax model as well. We shall see next year! 🙂
Cheers!
8% State Income Tax OUCH haha! You pretty much summed up the entire problem with U.S.Tax policy which is it’s too damn confusing! Every American should be able to easily understand the net benefit of owning home, but sadly this isn’t the case.
I agree 100% with the earlier poster that your really shouldn’t even factor a tax break into owning a home and should just consider it a potential perk. Leverage is still a great thing to utilize if done responsibly, but your home should neber be the majority of your net worth EVER.
Exactly! I’m sure lots of people don’t even know what’s their net benefit from the tax deduction. Every time I do my taxes with the tax software at home i double check and run the numbers with/without the mortgage. Just to make sure! I hope more people would do that.
And yes, people would be best served to have a smaller home and accelerate the net worth with real productive assets.
Cheers!
ERN
As usual, what is sold as for the little man, actually benefits the big man more. Kinda the same in Belgium with multiple tax advantages.
Yup! There is a whole industry of lobbyists who specialize in writing the tax code the way it best serves a small number of constituents! That’s true in many counties!
Thanks for stopping by!
I personally love being free of debt, though I know it can certainly be used as a tool to generate a bit of return, depending on circumstances. Just seeing that Big ERN interest paid of $24K makes me gag. I agree with Matt also…your home should not represent the majority of your net worth. Mine is at about 9% and I still groan over property tax payments. Interesting article…thanks!
Wow, 9% is a very impressive number! If we buy a home again in FIRE we will definitely target a number like that too. In a lower cost location that should get us a really nice home!
Thanks for sharing!
When we hit retirement, we might choose to rent like you are if that is what makes the most sense for our lifestyle. But if we do decide owning is the better option, we will always have a mortgage payment as long as the amount we’re paying on interest on the loan is lower than what we can earn on the market.
Hmmm, interesting! Will you plan to have a bond portfolio? I can see that the mortgage/leverage makes sense if you plan a 100% equity portfolio. But if you plan to have an 80/20 portfolio, why not pay down the mortgage with the bond holdings? Just a though! 🙂
I have made the argument from your Bad Reason 1 and 2 to people before. The mortgage interest deduction is very popular with people that use it, but economists on both sides of the aisle hate it. As you noted, it is essentially a government handout to upper middle class people that don’t need handouts. On top of that, economists have found that housing prices have adjusted to incorporate the savings from the deduction, so the consumers aren’t actually saving any money. Instead, they’re getting a tax deduction from an artificially inflated price that ultimately brings them back to what they would have been paying anyway.
That’s a good point, I’ve never thought about housing prices adjusting to incorporate the tax deductions received from owning a home. But it makes sense.
Exactly! The deduction has helped me tremendously. But it’s also a regressive policy. Richer people have 1) larger mortgages 2) higher marginal taxes and 3) an easier time jumping over the standard deduction threshold. Hence the perverse situation of people with 2x the mortgage getting 5x the tax benefit. Kind of inefficient from an economic point of view!
Cheers!
I’ve been following your blog for a few months now, and in that time you’ve published some great analysis and great posts.
However, I think claiming that the mortgage interest deduction is “a giveaway for the upper middle class” is misleading. It’s true to an extent, but any analysis of the its value is flawed if it fails to mention the Pease limitation on itemized deductions. Whether coincidence or not, this kicks in just above your chosen $300k-salary example. For married filing jointly, anyway. For other filers, it’s present below that level.
True! That’s why I called it a giveaway to the upper middle class and lower upper class. Once your income gets into the high six-figures, low seven figures this becomes less useful! 🙂
The mortgage interest deduction is unfortunately a major impediment to tax reform. It has the allusion of helping working middle class families but it really has a much smaller benefit for the majority of people. It’s really only helpful for people who own an expensive house and don’t make enough to be affected by the AMT or Pease limitation.
It’s also definitely more helpful for people in higher cost of living areas like California and the Northeast. It tends to be much easier to be able to itemize your deductions in those areas because their cost of living is higher than other parts of the country.
Ha, good point. It’s not just helping rich people much especially the rich people in the expensive, high state tax locations along the coasts!
Not too long ago, I was having a “retire early” conversation with an associate. I don’t really remember the context but somehow the concept of not having a mortgage came up, and he said “Well you gotta have the mortgage to get that tax benefit!”
To which I replied, “I will trade you 25 cents for a dollar every day of the week.”
The first law of taxes is that it is always better to have more money than less.
Like you we’ve enjoyed the mortgage interest deduction over the years. We’re somewhere between little and big ERN (lower-upper class?). I’m glad to have it, and am certainly not giving it back. Still I believe that any kind of meaningful tax reform discussion really should consider it (although rarely does).
I do have to quibble with the statement that “only very few people would miss it”, if the deduction were taken away.
For one thing, there are a lot of people like my math-challenged associate who think they “need” the deduction.
For another, I think there are plenty of folks in the “little ERN” category who at least benefit somewhat. The reason it would be such a windfall for a tax reformation is because there is so much mortgage interest deducted from Americans 1040s every year. By definition that means that a lot of people would “miss it”.
Whether it’s a good use of the government’s resources is a totally different question.
Haha, thanks for sharing. You are right, more people would “miss” it but mostly because they are confused about how much or little they benefit from it. Thanks for sharing!
I enjoyed the charts! Especially the Big ERN one. I think the ideal mortgage amount is $1M, if you can afford it. I enjoyed having a mortgage to help me own and live in several SF properties I couldn’t afford to pay cash. But at the age of 40, I decided to simpify and pay off one mortgage rental prop, and sell off another rental property. I was overly levered.
It was a great run, but now I’d rather reinvest the proceeds into the heartland of America where valuations are much cheaper. SF is ridiculous at 25X – 30X annual gross rent for selling prices!
Do you currently rent now in FIRE?
Sam
I don’t blame you! For some, the mortgage is the best form of leverage if we take into account the mortgage deduction. But I also don’t blame you for paying off the mortgage right around the retirement date. That’s when the bond share should be the highest, so mortgage=short bond loses a bit of its appeal.
We currently own in a high cost, high tax state and like to relocate to a friendlier location. We will sell our place here and likely rent for a while in the new location until we settle down.
Thanks for sharing!
Big ERN here and enjoying the mortgage deductions.
We pay a lot in taxes with CA state tax 9%+. Our mortgage rate is 3.625% so we feel it’s low enough where our money could earn better returns elsewhere.
We’re in our early thirties and will probably ride out this mortgage to term because 1) renting doesn’t make sense for us in Los Angeles 2) we don’t feel over leveraged 3) better returns with our money in other assets 4) will probably rent out this house in the future and have tenant pay down the mortgage.
Thanks for sharing, Kevin! Exactly, you and I and lots of other folks are the perfect examples of people benefiting from this. High-income, living in income areas in high-income states. It’s best to milk this one of the few remaining tax deductions for as long as possible. 🙂
Cheers!
We are actually trying to save up for a downpayment for our next home, then rent out our current primary home, and get further deductions by playing landlord. Gotta take advantage of the leverage. Rinse and repeat every every few years, (or downturns) and we should have a pretty solid rental portfolio heading into (early) retirement for semi-passive income.