The Annoying "mortgage interest" write off

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Recently I've heard (or seen) some real estate guys preach and preach and preach about how keeping mortgage debt is good because you don't lose the mortgage interest deduction. This is very misleading to a new investor who may not have a grasp on taxes and tax deductions and how they work.

Let me explain why the mortgage interest deduction is not a good justification for not paying off debt:

The first reason is that 1. Mortgage interest is a DEDUCTION not a credit. A tax credit reduces the taxes due....after you've run your tax calculation if you owe $1000 and you have a $100 tax credit, the tax bill is reduced to $900. This is a direct $1 for $1 write off. Great. Too bad mortgage interest is not a credit, it is a deduction. This means it only reduces your taxable income. Assuming your tax rate is 20% and you pay in $1 of mortgage interest, the deduction would reduce your taxable income by $1. The $1 deduction in taxable income X 20% = $0.20 savings on your tax liability. You're still down $0.80 for that dollar, it's not a wash as some people make it sound.

This next part does not really apply to a properly run rental business because if you're treating it as a seperate business, the mortgage interest is an expense of doing business.

But when talking about your primary residence, I hear uneducated Realtors and bankers suggesting to keep a mortgage to keep the tax deduction. As seen above, you are only saving $0.20 on your taxes for every $1 you pay to the bank. To add insult to injury, the small benefit is only received if you itemize your deductions. If you claim the standard deduction ($11,600 for married couples) then you receive no tax benefit for your mortgage interest paid. What this means is your itemized deductions MUST be more than the default $11,600 deduction to receive any benefit (if married, $5800 if single). So, say your only itemized deduction is $12,000 in mortgage interest, you're good right?! All clear!....well, not really. Sure, you are itemizing, but are you really receiving $12,000 in true deduction? I vote no. I like to look at things incrementally. What i mean is without itemizing, you get $11,600 deduction by default, with itemizing you're getting $12,000 worth of deductions. The true felt benefit is only $400 INCREMENTAL deduction ($12,000 itemized - $11,600 standard) . Now take that $400 and multiply it by the above 20% tax rate and you only save an incremental $80 on your tax liability over the standard. Is that worth $12,000 in interest paid?

What I'm saying here is, the interest deduction is not that sweet and certainly not worth justifying keeping debt if you have the means to pay it off. Lets think of it in terms outside of real estate and taxes, people get in a la la land when they hear tax deduction (i think due to a lack of understanding). Lets think of this in terms of a pizza and a coupon. If I had a coupon that would save you $20 on your pizza, would you pay me $100 for it? The obvious answer is no, so why would you pay $1000 to the bank in the form of mortgage interest to save $200 on your tax liability? If you're going to be giving money away, donate the $1000 to charity instead and you will get the same $200 tax benefit.

That's it for my rant,

D Payne

[J Scott]

If the only benefit of holding a mortgage was the interest deduction, there is no argument that the benefit doesn't outweigh the cost (just like you shouldn't get married or have kids just to the tax benefits).

But, just like with marriage and kids, the benefits of mortgages extend well past the tax benefits.

These days, with interest rates so low, any decent investor should be able to earn more than the rate at which he can borrow. The opportunity for basic investing arbitrage is perhaps better than it's ever been or ever will be again in our lifetimes.

Additionally, the benefits of leverage to be able to buy property (or other assets) at the currently depressed rates gives the ability to both dollar cost average and increase cash flow long-term (with the obvious risks of leverage if you use too much of it).

Add these benefits to the benefit of the interest deduction (which is much higher than 20% if you're earning more money, btw), and the overall benefit can be extremely positive.

Again, it's easy to approach this topic with a very narrow and simplistic view, but good investors realize that most things are not simplistic in this world...