When my wife and I were shopping for our first home, we faced a common fear that many first time home buyers struggle with. Although the monthly mortgage payments that we were potentially facing were within our means, we were afraid that there would not be any money left over at the end of each month for much else. One of the factors that we had not accounted for in our budgeting, however, was the federal income tax benefits that we would receive as a home owner. Federal income tax benefits are how the United States government helps make owning a home affordable. As a home owner, these benefits are provided to you in the form of income tax deductions that can lower your tax liability and increase your monthly take-home pay. When you own your home, in most cases the IRS allows you to deduct the interest payments that you make on your mortgage and the property taxes you pay on your property from your taxable income.
Before explaining income tax deductions in more detail, I want to first provide an overview of mortgage interest and property taxes. Most of the mortgages available today are amortized in such a way that each of your monthly mortgage payments include a portion that goes towards paying off your loan principal and a portion that goes towards paying interest to the bank. In the case of tax deductions, only the portion of your mortgage payment that gets applied to interest is what is considered. You can use a mortgage calculator to help understand how your monthly mortgage payment gets split between principal and interest. Property taxes, on the other hand, are annual taxes that you pay to your county. In many cases, your entire property tax payment can be counted as a tax deduction.
The mortgage interest and property tax deductions that the IRS allows can make a significant positive impact on how much federal tax you pay each year. As an example, assume that last year you earned $100,000 in income and were in the 21 percent federal tax bracket. If you did not have any deductions, last year you would have paid $21,000 in federal taxes. Now, assume that you bought a home this year on which you pay $25,000 each year in mortgage interest and $5,000 in property taxes. As a home owner, the federal tax benefits that are available to you allow you to deduct these payments from your $100,000 income. This deduction reduces your federal taxable income to $70,000 and lowers your federal tax bracket to 17 percent. By reducing your federal taxable income to $70,000 and your federal tax bracket to 17 percent, your federal tax payment this year will be $13,000, an $8,000 savings over the $21,000 you paid last year.
You do not have to wait until the end of the year, when you file your tax returns, to get the benefit of your home ownership tax deductions. By using a mortgage calculator to project how much you will pay per year in mortgage interest and property taxes, you can adjust your tax withholdings amount on your W4 so that the amount your employer withholds in taxes each month reflects the refund you will receive at the end of the year. By doing so, you can spread your federal tax benefits across your monthly paychecks. By updating your W4, in our example above, the $8,000 annual federal tax benefit can mean that your monthly take home pay will increase by over $660 every month.