Starting Friday, January 20, 2017 we’ll have a Republican President, a Republican House, and a Republican Senate. With a single party controlling both the legislative bodies and the executive branch it’s a foregone conclusion that fairly major tax policy changes are coming in 2017. Most of the implications of these changes are obvious – taxes will probably be lower in 2017 and 2018 than in 2016, so you should defer income and accelerate deductions as much as possible (which is what you should do every year). However, the proposed changes have an interested side effect that I haven’t seen anybody mention.
Likely changes in 2017
First, let’s talk about the proposed tax changes. Although Trump and Congress have put out slightly different plans, they do agree on a few broad themes.
First, the number of tax brackets will be reduced. Trump has proposed 3 brackets – 12%, 25%, and 33%. Congress has proposed something similar. For most people this will result in lower marginal taxes.
Second, the standard deduction will be increased. Trump has proposed increasing the standard deduction to $15k for singles and $30k for married couples (just over double where it is now). The GOP Congress proposal eliminates all itemized deductions other than the mortgage interest and charitable contributions.
Standard deduction vs. itemized deductions
First, a quick refresher on the standard deduction and itemized deductions. Under current tax law, you can choose to either take the standard deduction or you can itemize deductions. The standard deduction for singles is $6,300 and for married filing jointly it’s $12,600.
The existence of the standard deduction reduces the value of your itemized deductions by the amount of the standard deduction. Here’s why – since you take either the standard deduction or itemized deductions, you’ll only take itemized deductions if they are greater than the standard deduction. The value of your itemized deductions is in effect reduced by the amount of the standard deduction.
Example 1: You and your spouse own a house. Your mortgage interest in 2016 is $10,000 and you have no other itemized deductions. Since the value of your itemized deductions is less than the standard deduction, you take the standard deduction.
Tax deduction value of your mortgage interest = $0.
Example 2: You and your spouse own a house. Your mortgage interest in 2016 is $15,000 and you have no other itemized deductions. You are in the 25% tax bracket. Since the value of your itemized deductions is more than the standard deduction ($12,600), you itemize your deductions. However, you only benefit from the amount of mortgage deduction greater than the standard deduction.
Tax deduction value of your mortgage interest = ($15,000 – $12,600) * 25% = $600. You paid $15,000 in interest on your loan to save $600 on taxes, which amounts to (600/15,000) = 4% of your mortgage payments
Example 3: You are single and own a house. Your mortgage interest in 2016 is $25,000 and you have no other itemized deductions. You are in the 25% tax bracket. Since the value of your itemized deductions is more than the standard deduction ($6,300 for singles), you itemize your deductions. However, you only benefit from the amount of mortgage deduction greater than the standard deduction.
Tax deduction value of your mortgage interest = ($25,000 – $6,300) * 25% = $4,675. You paid $25,000 in interest on your loan to save $4,675 on taxes, which amounts to (4675/15,000) = 18.7% of your mortgage payments
As you can see, the value of the home mortgage deduction is minimal for most people with average sized mortgages. The following things REDUCE the value of your home mortgage:
- Increasing the standard deduction
- Reducing tax rates
- Getting married (because you have a higher standard deduction)
The following things INCREASE the value of your home mortgage
- Other itemized deductions (charitable contributions, etc.)
- Decreasing the standard deduction
- Increasing tax rates
How this impacts you
Here’s where the coming tax changes affect you. The proposed tax changes will increase the standard deduction and decrease tax rates. If the standard deduction for married couples is increased to $30,000 then you’ll gain no benefit from any amount of mortgage interest below $30k/year.
I did some quick calculations with various loan amounts and interest rates. All of these assume that you are in the 25% tax bracket, you get a standard loan with 20% down and property taxes (which are also deductible) are 1% of the property value per year. The total tax value is calculated as ((total itemized deductions – standard deduction) * tax rate) = total tax value.
Example 4: $600,000 house, $480,000 loan @ 4.5%.
- Mortgage interest in year 1 = $21,441.59
- Property taxes = $6,000
- Total itemized deductions = $27,442.59
- Total tax value = $0
Example 5: $600,000 house, $480,000 loan @ 5.5%.
- Mortgage interest in year 1 = $26,238.62
- Property taxes = $6,000
- Total itemized deductions = $32,238.62
- Total tax value = $559.66
Example 6: $800,000 house, $640,000 loan @ 4.5%
- Mortgage interest in year 1 = $28,588.78
- Property taxes = $8,000
- Total itemized deductions = $36,588.78
- Total tax value = $1,647.20
Note: These numbers are for the first year of your mortgage. For each successive year the mortgage interest decreases. For Example 6 the total itemized deductions drop below the standard deduction by year 12.
The impact of the proposed changes are pretty obvious – your home mortgage is about to become significantly less valuable from a tax deduction standpoint. Unless you have a large mortgage that results in you paying a lot of interest, it’s unlikely that you’ll see any tax benefit from the mortgage deduction.
What you should do
First, you should prepay any interest before the end of 2016. Make your January payment in December (and be sure to tell your mortgage company that the payment should be applied against your January bill. Otherwise they’ll likely credit the payment as towards your principle, which will have no benefit tax-wise).
Second, you should seriously look at paying off your entire mortgage as soon as possible. Given that the market is significantly overvalued today you’re probably looking at where to put your money other than the stock market. I’d recommend 2 things:
- Build a significant cash reserve. Some people call this “dry powder” – the idea is to have money on hand so you can take advantage of deals if and when they become available. Remember that just because you have money doesn’t mean you need to invest it immediately. Cash provides stability and strengthens your personal financial statement.
- Pay off your mortgage. As shown above, your mortgage is about to become much less valuable. It might be the case that your mortgage produces a tax savings today, but the combination of lower taxes, higher standard deductions, and the inevitable reduction in your loan value might mean there’s no tax savings next year. If your interest rate is 4% that means you’ll be earning a guaranteed 4% on your money – that is significantly higher than Treasuries, corporate bonds, CDs, or savings accounts.
A big caveat here – all of this applies to your personal residence. It does NOT apply to mortgages held on investment properties. There’s no standard deduction equivalent for investment properties, which means all mortgage interest is deductible for your investments. As a result, I do not plan on prepaying the mortgages on my investment properties at this time.
Questions for you
Have you considered this effect on the value of your home loan? Do you plan on paying off your home loan? What are you doing with your money today?
I like to make decisions about taxes when I know what the rules are. We will have to wait awhile to see what the new rules are. I might prepay the January 1st mortgage payment to take the deduction this year, however.
If they eliminate the MID for owner occupied residences, something I have also heard, I might turn my Silly Valley house into a rental. Pull out the equity first and use it to pay off higher rate investment loans on other properties.
We will cross that proverbial bridge when it’s directly in our path…
I thankfully paid off my mortgage 4 years ago. So I am fortunate that I will be able to really gain the benefits of the higher standard deduction. It will be fascinating to see how the final tax policy is implemented.
Thanks for your detail breakdown!!!
Yeah, it’s looking like paying off your mortgage is the best use of money right now, especially with the coming changes.
I can only imagine what a great sense of accomplishment it must be to not have a mortgage payment every month.
Hi moneycommando, I’m confused about the caveat you mentioned: “all mortgage interest is deductible for your investments.” I thought mortgage interest for rental properties was considered “passive activity” and therefore cannot be deducted. What am I missing here?
You can deduct the mortgage interest expenses up to the limit of your passive income. However, you are correct that if you have a passive loss you can’t deduct that loss from your income or capital gains.
Example 1: You own a rental property. You receive $12,000 in rent, pay $3,000 in mortgage interest, and take $5,000 in depreciation on the property.
Expenses = $3,000 + $5,000 = $8,000
Income = $12,000
Total passive profit/loss = $12,000 – $8,000 = $4,000
You would then list this $4,000 in income on your 1040, Schedule E and pay regular income taxes on it. You were allowed to fully deduct your mortgage interest from your rental income.
Example 2: You own a rental property. You receive $12,000 in rent, pay $5,000 in mortgage interest, and take $8,000 in depreciation on the property.
Expenses = $5,000 + $8,000 = $13,000
Income = $12,000
Total passive profit/loss = $12,000 – $13,000 = ($1,000)
Because this is a passive loss you would not use the $1,000 loss to offset income for this year. Instead, you would carry this loss over to the following tax year. In effect, you’re not allowed to use $1,000 of your deductions for this year, but they aren’t lost. Instead, you’ll be able to use them in a future year to offset future rental income.
Honestly with our refinanced rate of 3 percent the itemized deductions has a minimum impact on the equations since we can invest in fixed income at greater then 3. Still we have put some additional money into the mortgage recently simply to keep to our overall payoff schedule in line with other plans.
Good point – one unforeseen consequence of low interest rates is that the interest rate deduction is almost useless.
How about this? Im going to get a cashiers check make it out to internal revenue service in the amount of 200,000 and put my social then under my social put 1040es, and then Drawren sign my corporation name in all caps of course and have my mortgage paid in full? Because we all know everytime we sign frn notes money is created… then they aka IRS can just tax me on it?
I’m sorry – I don’t quite understand what you’re saying.