Q: I have cash on hand to buy a house. I’ve been told that I should finance the property specifically for tax purposes. But, I would think that I would be paying more in interest than I would save on taxes. Can you help?
A: A lot of people think that they’ll do better by getting a bigger mortgage because they can write off the interest they pay on their federal income taxes.
But that kind of thinking only works if (1) you actually itemize on your federal income tax form (more than half of all homeowners do not itemize) and (2) you have a better place to put your cash than in your property.
For example, if your mortgage is at 6 percent, and you itemize, and you’re in the 28 percent tax bracket, the net interest you’re paying on your mortgage balance is about 4 percent interest.
Now you have to find an investment that pays more than what you’re paying to borrow the money. If you stick the cash in a bank account earning 1 percent, you’d be losing cash each month. If you found an investment that paid 6 percent, you might think you’re making money, because you’re paying interest at a net rate of 4 percent and your investment is earning two percent more than that.
But then there are the taxes you’d pay on the investment. For short-term capital gains, which is what you’d have if you held those investments for less than a year, you’d pay taxes at your marginal tax rate. If you hold the investment for a year, your maximum tax rate would be 15 percent.
What you’d really need is an investment that would return 8 to 10 percent, or about double your net investment rate, to make it really worthwhile. And, those are hard to come by.
Just looking at your cash flow, a bigger mortgage means bigger monthly payments, which could be difficult to swing if you, or your spouse, lose a job.
I wouldn’t use all of my available cash to buy a property, however. I’d want to keep enough on hand to pay my expenses for at least 6 months, in case of an emergency. Once you’ve set aside cash with your emergency fund, you’ll have to decide what feels right to you.
It might help to run the numbers by your tax preparer or accountant, who can show you what your true cost and tax savings might be.
March 20, 2005.