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No tax deduction is more misunderstood than the mortgage interest tax deduction. By law, taxpayers can deduct interest paid on their mortgage, but most middle-class taxpayers save little or nothing at all from the mortgage interest tax deduction.
In fact, the mortgage interest tax deduction is more for the benefit of millionaires than it is the average American.
How the mortgage interest deduction works
You can deduct all of your mortgage interest on up to $1 million in principal on the home in which you live. Thus, if you pay interest on a $100,000 mortgage, all of it is deductible. If you pay interest on a $1.5 million mortgage, only the interest on the first $1 million of principal is tax deductible.
But there are limitations. To qualify for the mortgage interest tax deduction, you have to itemize when you file your taxes. By itemizing, you forgo the standard deduction, which starts at $6,200 for singles and $12,400 for couples.
The standard deduction is a baseline. You can opt for the standard deduction, and not itemize, at your discretion. Thus, whether or not the mortgage interest deduction helps your financial being rests on whether or not it pushes you over the standard deduction.
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Consider this scenario
You and your spouse paid $10,000 of mortgage interest on your $200,000 home this year. You also had $3,000 in other tax deductions.
When you itemize, you'll be able to claim $13,000 in tax deductions. If instead you choose not to itemize, you'll get $12,400 just by virtue of being a married taxpayer.
Thus, the net effect is that only $600 of your mortgage interest is tax deductible, because your deductions exceed the standard deduction for your situation by only $600. If you end up in a marginal tax bracket of 25%, you'll save about $150 in taxes for paying $10,000 in mortgage interest -- not much more than a rounding error.
Tax savings for high earners
All in all, the mortgage tax deduction is a (small-f) fool's game for middle-class earners in low-cost areas, and a boon for high-income earners in high-cost areas.
Someone who owns a million-dollar home and who pays interest on a $1 million mortgage will inevitably be able to deduct more of their mortgage interest than someone who pays interest on a $100,000 mortgage.
So, while the mortgage interest tax deduction is touted as one of the best reasons to buy a home, it often provides little help to people who don't live in a modern day McMansion. Buyer beware.
The article Why Your Mortgage Interest Tax Deduction Doesn't Really Help Much originally appeared on Fool.com.
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