Optimizing Your Itemized Deductions

So back to pumping up your Itemized Deductions or making an itemizer out of you if you are not already itemizing your deductions.  The single event that will make an itemizer out of you is home ownership.  Later in this book, we will study in detail the necessary financial planning incident to home ownership.  Here and elsewhere in this Tax Planning section, we will explore the tax advantages of home ownership.

Look at Exhibit 1 again.  Remember that in order to be an itemizing taxpayer, all of your Itemized Deductions for the year must exceed the standard deduction amount.  To the extent your total Itemized Deductions exceed your standard deduction amount, you will reduce your Taxable Income number.  Under our "Keep It Simple Stupid" (KISS) philosophy, we are trying to optimize our Itemized Deductions in the simplest manner.  Home ownership gets us there.

Two of the most common Itemized Deductions are interest expense on a home mortgage and the property taxes paid on the home.  We will discuss these two Itemized Deductions, as well as others, in detail later on.  These two items alone, even on a fairly modestly priced home, will frequently push us over the standard deduction threshold and make an itemizer out of us.  Here is an example of how this would work and also how we can use the leverage of home ownership to catapult us from a renter to a homeowner at little or no additional after-tax cost.

Example:  In 2003, John and Jane Smith rent their apartment at a cost of $850 per month.  Their utilities cost $100 per month but are paid for by the landlord.  Additionally, the Smiths pay $3,000 in state income taxes, $1,500 in local income taxes and donate $500 a year to their church.  In the tax year being analyzed, the Smiths are in a marginal tax bracket of 28%.  They purchase a new home and mortgage finance $100,000 of the purchase price.  Their monthly mortgage payment is $700 a month or $8,400 for the year.  Additionally, they will pay $200 a month ($2,400 for the year) in property taxes.  Their utility expense, which they will now pay after the home purchase, is a non-deductible personal expense and will remain at $100 per month ($1,200 for the year).

Before the purchase of their home, the Smiths had $5,000 in Itemized Deductions (the state and local income taxes and the church donations) but were not itemizers since their basic standard deduction of $7,950 exceeded their Itemized Deductions.  After the home purchase, they are able to add to their pre-existing $5,000 of Itemized Deductions the property taxes ($2,400 per year) and their mortgage interest expense.  As I will explain in great detail later in this section and in the Home Ownership and Financing section of the book, in the early years of a mortgage, almost all the mortgage payment is interest.  In our Example, say $650 per month of the $700 monthly mortgage payment or $7,800 for the year is mortgage interest expense.  Because of their home ownership, the Smiths have increased their Itemized Deductions by $10,200 to $15,200.

The Smiths have generated $7,250 of new deductions (the $15,200 of new Itemized Deductions minus their $7,950 standard deduction that they had before owning the home).  How much does the additional $7,250 of deductions save the Smiths on their tax return?  As we noted under the Exhibit 2 analysis, we would multiply $7,250 by their marginal tax rate of 28% and find that they will reduce their federal income tax liability by $2,030.

Now let's do a reconciliation to see how the Smith's transition to home ownership and the leverage from the additional tax deductions will actually put them in a better cash position than they were in before (let alone the fact that they now own a home that is hopefully appreciating in value each year):

            Pre-ownership housing cost $850 x 12 = $10,200

            After-ownership housing costs:

            Housing mortgage payments $700 x 12 = $8,400

            Property taxes = $2,400

            Utilities = $1,200

            Minus Additional tax savings from increased Itemized Deductions = ($2,030)

            After-tax cost of their home = $9,970 ($8,400 + $2,400 + $1,200 - $2,030).

Thus, in our Example we see that the Smiths are actually better off after purchasing the home in terms of after-tax cash outlay.  Although there are many incidental expenses of home ownership, hopefully these are more than outweighed by the pride of ownership and the increase in the home's net value over the years as the mortgage is repaid and the home otherwise appreciates in value.  Also, there is the down payment and other closing costs incurred when purchasing a home.  In the Home Ownership and Financing section of this book I will talk about all the elements of making home ownership work – selecting the best and cheapest mortgage, selecting a good city to live in, and purchasing the home with an optimum amount of cash down.