The United States government has granted us the privilege of deducting our mortgage interest expenses from our income, thereby reducing our tax liability. The extent of the maximum mortgage tax deduction is contingent on income, a subject I’ll delve into below.
In the past, you could deduct mortgage interest on up to $1 million in mortgage debt. However, this is no longer the case. The limit was lowered to $750,000 following the passage of the Tax Cut & Jobs Act in 2017, which applies to 2018 and subsequent years.
While this reduction is unfortunate for property owners with substantial mortgages, it’s still a benefit to have. Unlike countries such as Canada, Australia, Asia, and Europe, where there’s no comparable mortgage tax deduction, at least we can appreciate the availability of this deduction. Nevertheless, it’s worth noting their advantage of affordable healthcare.
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To grasp the maximum mortgage tax deduction, let’s first review the marginal income tax rates in the United States.
Marginal Income Tax Rates
Given the progressive nature of the US tax system, the higher your income, the more valuable the mortgage interest income deduction becomes. For regular individuals, homeownership with a mortgage serves as an excellent shield against taxes.
Moreover, owning rental properties stands out as one of the best strategies to generate tax-efficient semi-passive income. Rental properties have captured my attention since 2022, as the significance of cash flow has significantly increased.
Now, let’s examine the most recent marginal tax rates for singles and married couples.
Single Filing Status for 2022:
- 10% on taxable income from $0 to $9,875, plus
- 12% on taxable income from $9,876 to $40,125, plus
- 22% on taxable income from $40,126 to $85,525, plus
- 24% on taxable income from $85,526 to $163,300, plus
- 32% on taxable income from $163,301 to $207,350, plus
- 35% on taxable income from $207,351 to $518,400, plus
- 37% on taxable income over $518,400.
Married Filing Jointly or Qualifying Widow(er) Filing Status for 2022:
- 10% on taxable income from $0 to $19,750, plus
- 12% on taxable income from $19,751 to $80,250, plus
- 22% on taxable income from $80,251 to $171,050, plus
- 24% on taxable income from $171,051 to $326,600, plus
- 32% on taxable income from $326,601 to $414,700, plus
- 35% on taxable income from $414,701 to $622,050, plus
- 37% on taxable income over $622,051.
As your income increases, your marginal tax rate also rises. It’s vital to know your top marginal tax rate, as earning over approximately $200,000 as an individual or $400,000 as a couple leads to a reduction in your mortgage tax deduction due to the Alternative Minimum Tax (AMT).
The AMT exists to prevent higher-income individuals from reaping all tax benefits.
Additionally, be aware that Joe Biden aims to raise taxes for individuals or households earning more than $400,000 annually. Hopefully, he will also increase the maximum mortgage tax deduction to $1,000,000, although this remains uncertain for now.
The Maximum Mortgage Tax Deduction Can Yield Savings
Crucially, for those in the highest tax bracket, you get 37 cents back for every dollar of interest paid on your mortgage.
If you’re also subject to State income tax, your marginal tax rate could easily reach 50% on your final dollar of earned income. The advantage of the mortgage interest deduction lies in its applicability to your marginal income and thus your highest marginal tax rate.
Even if your mortgage isn’t substantial enough to fully exploit the maximum mortgage tax deduction, that’s perfectly fine. Utilize as much of the eligible mortgage interest tax deduction as possible to save on taxes.
For individuals in the 12% Federal tax bracket or below, a mortgage tax deduction provides limited benefits. To reap any advantages, you’d need a massive mortgage at a 12% Federal marginal tax rate, given that the standard deduction stands at $12,000 for singles and $24,000 for married couples.
When you’re in the 24% marginal tax bracket, homeownership becomes more advantageous, provided you adhere to the 30/30 rule for home buying.
The Value of Homeownership for Higher Income Earners
Example #1
Imagine you earned $518,400 in 2020 as a single taxpayer. Your income from $207,351 to $518,400 is taxed at a 35% Federal Tax rate.
Assuming you paid $50,000 in mortgage interest for 2020, you can lower your taxable income from $518,400 to $468,400. As a result, your tax liability reduces by $50,000 X 35% = $17,500!
Unfortunately, AMT will likely curtail the mortgage interest tax deduction by approximately 30% to 50%, given your high income. Nonetheless, receiving a tax deduction of $8,750 to $12,250 is a significant benefit.
Example #2
Suppose you earned $136,000 in 2020. Roughly $50,000 of your income would be subject to a 24% federal tax rate.
If you managed to pay $50,000 in mortgage interest for 2020, your taxable income would be only $86,000. This would lead to $50,000 X 24% = $12,000 less in Federal taxes.
However, you would need a substantial mortgage to pay $50,000 in mortgage interest annually. For instance, a $2 million mortgage at a 2.5% interest rate would achieve that. Nevertheless, lenders wouldn’t likely grant a $2 million loan based on a $136,000 income. With excellent credit, you might secure a mortgage of $650,000 (5 times your income).
A 2.5% mortgage rate on a $650,000 mortgage equates to $16,250 in mortgage interest. Hence, you would save at most $16,250 X 24% = $3,900 in income tax.
This illustrates that homeownership with a mortgage is more advantageous for those with higher incomes. Moreover, an asymmetric benefit exists for those with higher incomes.
Income Phaseout
Taxes are intricate. There’s an income threshold beyond which each additional $100 minimizes your mortgage interest deduction. This threshold is approximately $200,000 per individual and $400,000 per couple for 2021.
Here’s how the income phaseout functions with the previous individual income threshold of $166,800.
Know that once an individual’s adjusted gross income surpasses $166,800, the mortgage interest deduction starts to phase out. For each $100 of income over $200,000, you lose $
3 of itemized deduction multiplied by 33.3%, up to a maximum reduction of 80% of your itemized deductions. The complexity of this rule reflects another instance of IRS/government regulations.
Example: Earning $266,800 with $50,000 in mortgage interest deductions. Calculate $266,800 – $166,800 = $100,000. Compute $100,000 X 3% = $3,000. Finally, compute $3,000 X 33.3% = $999. Thus, you can only deduct $49,001 ($50,000 – $999) from your income, rather than the initial $50,000.
For the person earning $518,000 and paying $50,000 in mortgage interest annually, the homeowner can only deduct about $45,800 due to the phaseout. Consequently, the homeowner owes an extra $2,000 in taxes.
Note on the Alternative Minimum Tax (AMT)
The A.M.T. disallows any deduction for interest payments on a home equity loan if the proceeds are used for purposes other than home improvements. Nonetheless, you can deduct the mortgage interest regardless of your income.
However, deductions for property taxes, state and local income taxes, and exemptions for the taxpayer and dependents must be added back to determine the taxpayer’s alternative minimum taxable income. If the tax calculated using this method surpasses the tax from the regular computation, the higher amount must be paid.
In essence, if your individual income exceeds $200,000, you won’t receive the full mortgage interest tax deduction. So, expect this when tax season arrives.
Optimal Income to Leverage the Ideal Mortgage Amount
Given the income phaseout and AMT, I propose that an ideal income for homeowners to aim for is roughly $300,000 for couples and $250,000 for individuals. This range provides a comfortable standard of living, regardless of your location in the United States.
With the mortgage interest deduction and other deductions, you can reduce your AGI to $200,000 to $250,000, slipping just under the government’s income threshold for increased taxes.
$300,000 is essentially the household income required to maintain a middle-class lifestyle in today’s major cities. After taxes, $300,000 translates to roughly $210,000.
For the maximum mortgage interest deduction, the ideal mortgage amount is $750,000. Consequently, for pricier homes, you’ll need to make a larger down payment.
A Review of the Maximum Mortgage Tax Deduction
Homeownership is more advantageous for those with higher incomes, up to a certain point.
The phaseout of mortgage interest begins at around $200,000 of income, with a maximum phaseout of 80%.
The optimal income for homeowners is approximately $250,000 for singles and $300,000 for couples.
Earning more than $250,000 to $300,000 doesn’t substantially enhance happiness and could result in frustration due to higher taxes.
For the ideal income range, the recommended maximum mortgage amount is $750,000, equivalent to three times a household income of $250,000. This aligns well with my 30/30/3 rule for home purchasing.
The US government encourages homeownership, so capitalize on the benefits.
Single sellers can profit by up to $250,000 in tax-free gains, while married couples can double that amount.
Individual filers have a standard deduction of $12,400 for 2020 ($24,800 for married filers). You’re permitted to opt for either standardized or itemized deductions, choosing the higher of the two. Given we’re discussing ideal mortgage amounts of $750,000, itemized deductions are always the wiser choice.
Note: I’m not a real estate lawyer or accountant, but I possess a diverse property portfolio valued at over $3 million. I’ve also engaged in discussions with numerous accountants and real estate lawyers on this topic. As an active tax management and long-term wealth-building enthusiast, I offer insights based on my experiences.
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The Maximum Mortgage Tax Deduction Benefit Hinges on Income is an original post by Financial Samurai. Figures are subject to annual fluctuations. Overall, the higher your marginal income tax rate and income, the greater the benefit of the mortgage tax deduction. However, once individual income surpasses approximately $200,000, the benefit starts diminishing due to the AMT.