Uncommon Cents

Many people are confused about the term “tax deductible”. We often here that in reference to donations to charitable organizations or for the interest on the mortgage payments for a primary residence. Here’s how all of this comes into play:

For federal (and, at least in Hawai’i, state) income tax, there is a “standard deduction”–an amount that the folks who collect and calculate taxes on income say you can deduct no matter what. However, if you have tax deductions that are in excess of the standard deduction, it would reduce your taxable income to use those instead. The interest on primary residence mortgages and charitable donations fall into that category.

Despite common belief, you don’t get a one to one benefit on your deductions. Instead, what you are getting is a benefit equivalent to your marginal tax rate on deductions, and in the case of interest on mortgages, it’s a benefit on paid interest. Let’s look at an example:

Say you’re in the 25% federal tax bracket, as I am. Let’s say you have a $1200 a month mortgage payment, and $1000 of that is interest. At the end of the year, you can deduct that $1000 from your adjusted gross income; given that you’re in the 25% bracket, 25% of that $1000, meaning $250, is the amount you are actually reducing your tax bill by. Let’s say you’re in the 5% state bracket; that would be another $50 off your state tax bill. So while you are getting a hefty $300 in tax benefit, it’s not the whole $1000. Keep this in mind when considering whether or not you can afford your mortgage!

It works similarly for tax deductible charitable contributions as well. While the tax benefits are great, just remember that you’re not getting a one to one benefit, rather a benefit based on your marginal tax brackets.

Tags: Mortgages, Taxes

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