The Tax Benefits of Home Ownership Add Up

     When people compare the costs of renting versus buying a home, they don’t always realize that the true cost of owning a home is significantly lower than the monthly payment suggests, once you factor in the tax benefits. Let’s walk through the numbers.

Interest Deduction on Home Loan

     For most homeowners, the interest paid on a home loan is fully tax deductible. In the early years of the loan, the vast majority of your monthly payment is interest, which means the deduction is at its most powerful right when you need it most.

     Let’s say you're looking at a $450,000 home. You could rent a comparable place for around $2,000 a month. Or, if you chose to buy, 80% down would be a $360,000 loan. At 6.5% interest, you’d be looking at a monthly payment of about $2,275. On the surface, buying costs about $275 more per month. But that’s not the whole story.

     In your first month alone, roughly $1,950 of that home loan payment is interest. Annualized, that's about $23,400 in deductible interest. If you're in a typical tax bracket (state and federal combined), you'll save approximately a third of that, which is around $7,800 per year, or $650 a month.

     Add the property tax deduction. On a $450,000 home, you're likely paying around $5,400 annually in property taxes. That deduction saves you another $1,800 a year, or $150 a month. Now factor back in some costs: the cost of insurance (roughly $200/month) and the property tax payment itself ($450/month), and your true net monthly housing cost works out to about $2,175.

     Now you’re comparing home ownership costs of $2,175 to rent of $2,000. For an additional $175 a month you own your home, which allows you to build equity, and you have the freedom to live in a place that you can tailor to suit your needs. To be fair, there are maintenance and repair costs that belong to homeowners that don’t belong to renters, but overall, I think it’s a worthwhile trade if you can afford it.

You're Building Equity, Not Paying Someone Else's Home Loan

     Every loan payment reduces your loan balance. Meanwhile, if historical trends hold, your property appreciates (becomes worth more). Over time, that combination creates wealth.

     And when you eventually sell, the tax code rewards you again. Single filers can exclude taxes on up to $250,000 in profit from the sale. Married couples can exclude $500,000. At current capital gains rates, that full exclusion for a married couple represents roughly $150,000 in tax savings. That’s a lot.

A Word of Caution: Don't Overextend

     While the tax benefits of homeownership are real and substantial, you don’t want to buy more house than you can comfortably afford. Lenders will often approve you for more than you feel comfortable spending, and it can be tempting to stretch for the nicer home in the better neighborhood.

     Before you stretch, really think about how that will affect your day-to-day life. Being "house poor," where your loan payment consumes so much of your income that you have no financial flexibility, can have a major impact on your emotional well-being. A home should feel like a port in a storm, not an anchor dragging you down.

What About Investment Property?

     If you’re thinking beyond your primary residence to owning rental property, there are also plenty of tax benefits. As with your residence, you can deduct property taxes, interest. And, with investment property, you can also write off insurance, maintenance, and depreciation costs. Depreciation is a non-cash deduction, meaning you get a tax benefit without actually spending money. When you sell, you're taxed at capital gains rates, which are lower than ordinary income rates.

     The long-term earnings on rental property are compelling. Fifty years ago, a small apartment building might have sold for $50,000. That same property today could easily be worth $1 million. Rents rise with inflation over time, which means a property that initially breaks even gradually generates more cash flow as the years pass.

The Bottom Line

     If you've been holding back because the monthly payment for buying looks higher than your current rent, I'd encourage you to run the numbers. The tax system, equity growth, and long-term appreciation often make homeownership more affordable and far more valuable than it first appears.

     If you have questions about property management or real estate, please contact me at [email protected] or call (707) 462-4000. If you have an idea for a future column, share it with me and if I use it, I’ll send you a $25 gift certificate to Schat’s Bakery.

Dick Selzer is a real estate broker who has been in the business for more than 50 years. The opinions expressed here are his and do not necessarily represent his affiliated organizations.