Cash vs a Mortgage

By: Mike Eden, First Western Trust

U.S. citizens have the ability to deduct mortgage interest expense from income thereby lowering tax liability. If you live in Canada, Europe or Asia you have no such deduction available.   With the progressive tiered tax system the mortgage interest deduction is more valuable for higher income earners.   Owning a home with a mortgage begins to make sense from a tax standpoint when a consumer reaches the 25% tax bracket or taxable income in 2015 or above $37,000.  

In the highest tax brackets for those earning over $400,000 the savings is up to 39.6 cents for each dollar you pay on your mortgage or mortgages.

State tax and other deductions such as property tax continue to benefit the higher tax earners.   The IRS has implemented Income Phase out calculations so high income earners do lose some of the benefit depending on their income levels.   The maximum mortgage interest indebtedness one can have in order to be able to deduct the interest is $1,000,000.   You can also have a $100,000 home equity line (HELOC) for home improvements for a total of $1.1 million. The HELOC is subject to rules and is open to interpretation as to the use of the funds for home improvement.

In many cases with high wage earners a calculation can be done to determine the cost/benefit of having a mortgage.   There is generally a tipping point as which the net taxable expense of a mortgage payment is beneficial in comparison to investing the cash retained by not making an “all cash” purchase.      At the end of the day, it really is an emotional decision.  Being debt free provides great comfort to many investors and can outweigh the benefits of the mortgage deduction.

Example:

Assuming a $1 million mortgage at 4.0% interest and annual interest cost of about $40,000 if you are in the 33% tax bracket your tax savings could be $13,320.   This effectively lowers your borrowing rate to 2.66%.   For purchasers who want great liquidity or who feel they can invest the funds at higher than 2.66% then taking advantage of the mortgage interest deduction makes sense.  As interest rates rise (as they are expected to do) locking in long term debt and applying the tax savings from mortgage deduction gets more attractive. Of course, with the complex US tax code, it always makes sense to consult with a tax advisor or financial planner prior to a purchase to determine how your individual tax situation would be effected.

In states that have a Homestead exemption having a mortgage can help protect your home against future creditors. In many cases when you pay cash for your home and there is no 3^rd party lender to protect you can lose this benefit. In Wyoming the homestead exemption is $20,000 per person or $40,000 for a married couple.

For Second Homes a purchaser can combine mortgage interest deductions on multiple homes as long as they are not rental properties. If you rent your home 14 days per year or fewer it is considered a true second home and mortgage interest deduction rules apply.   You can rent your home for 14 days per year and earn the income tax free. You are still subject to the total mortgage interest deduction limit of $1.1 million.   This is total and not per home!   Once you rent your home for greater than 14 days it becomes a rental property and different tax rules effect what you will pay. You cannot deduct mortgage interest expense on a rental property.

In a hot real estate market it may be beneficial to make an “all cash” offer in order to increase chances of winning the bid and then applying for a mortgage shortly thereafter to take advantage of the interest deductions.

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