Over the years I’ve had lots of clients tell me that they’re buying a house, and they’re expecting to save so much money in income taxes. I’ve also had clients who asked me ahead of time to run some numbers, to tell them how much they can really expect to save in income taxes. Similar to the questions I’ve gotten about leasing a car vs. buying, and tax savings for dependents, one of the first replies I give people is “you can’t live your life for tax consequences”. I know, I’m a CPA, taxes are my job, and I’m supposed to help people save taxes, and I do that. But sometimes there are other factors involved that can outweigh income tax savings, and that’s what I want to toss out in this article.
A few months ago I brought up an imaginary couple, Bristol and Levi. I’d like to revisit them, as they’re considering making a major financial decision that could have income tax and other consequences. Between the two of them, they make $100K in wage income, and their investment income (interest and dividends) is negligible, so for tax purposes, their adjusted gross income is $100K. They’re currently renting a 1 bedroom/1 bathroom apartment in Ballston for $2K/month. Since that rent isn’t deductible, their joint federal tax return shows a standard deduction plus two exemptions, their taxable income is about $81K, and the federal tax is about $13K.
Bristol and Levi just found out that they’re going to be parents, and realize that the apartment will be too small for three occupants, so they decide it’s time to buy a house in the burbs. With all the income tax they’re going to save, it’ll be easy to buy all those Pampers, right? Not so fast, folks! They soon discover that things aren’t that cheap in the burbs, plus they realize that they can’t move too far from DC, because the commute will be a killer. They decide to focus on Fairfax, and find a nice place that has four bedrooms and two bathrooms, which sells for $420K. As they move forward with the process, they find out that the real estate taxes are $4K/year, and a 30 year fixed rate mortgage has a 4.5% interest rate. Armed with that information, they soon find out some surprising results.
As homeowners, they’re entitled to itemized deductions for mortgage interest and real estate taxes. Taking a mortgage for 80% of the value ($336K), the total interest they’ll pay in year one will be about $15K, which will be their itemized deduction, along with the $4K of real estate tax. Assuming no other itemized deductions (medical, charity, etc), their projected taxable income will be about $74K, and federal tax will be about $11K, or about $2K less than if they rent. Woohoo, that’s a lot of Pampers…isn’t it?!
O.K., so they save a couple of thousand dollars by renting, but is that really enough financial incentive to buy a house? Let’s look at cash flow, since it’s not just taxes we’re talking about here. Renting is costing them $2K/mo, or $24K/yr. The monthly mortgage payment is about $1700/mo, or just over $20K/yr. The real estate taxes are $4K/yr, so when all’s said and done, the savings in cash flow is pretty much just the $2K saved in federal tax. There are all sorts of other “intangible tangible” things to think of too, including
-they’ll need to accumulate the 20% down payment of $84K, or else the interest rate will probably be higher, or they may not even qualify for a mortgage
-they’ll have to pay homeowner’s insurance
-their monthly utility bills will probably be a lot higher (electric, gas, oil, water)
-they’ll have to pay for lawn care, snow removal, etc
-they’ll have to pay for repairs and maintenance (roof, a/c, etc)
-if the house needs upgrades, they’ll have to pay for those, or take a home equity loan, if they can get it
I’m sure there are other things that I’ve left out of this computation, which are beyond the scope of this discussion (such as time value of money/opportunity costs), but the bottom line here is to remember that tax consequences can’t be the sole basis of a financial decision, in spite of what any CPA might say.
Please leave a comment, and let me know if you have questions, or if I can help you with running some numbers.