If you're considering switching from renting to owning a home or buying a bigger house, you could be in for a larger tax break because of the tax deductions for property taxes and mortgage interest. However, the effect on your income taxes isn't always as simple as a dollar for dollar reduction in your taxable income. Understanding how the deductions affect your adjusted gross income and your taxable income helps you better estimate your true tax savings.
No Change to AGI
Your adjusted gross income is not affected by the property tax deduction or the mortgage interest deduction. You calculate your AGI by subtracting your adjustments to income, but not your itemized deductions, from your gross income. Both the property tax deduction and the mortgage interest deduction are itemized deductions that are subtracted from your adjusted gross income to figure your taxable income. The difference is more than mere semantics, because your eligibility for some deductions and credits depends on your adjusted gross income, not your taxable income. If your adjusted gross income is too high, even if your mortgage interest deduction would decrease it to below the limit, you don't qualify.
The IRS does not limit the size of the deduction for property taxes paid. To be deductible, the property taxes must be assessed based on the value of the property and charged uniformly. The mortgage interest deduction is limited, however, but the limits are very high. If you aren't married filing separately, you can deduct the interest paid on the first $1 million of mortgage interest. If you are married filing separately, the limit is the interest on the first $500,000 of mortgage interest each.
Minimal Other Itemized Deduction
You have to forgo the standard deduction to claim any itemized deductions, including the property tax deduction or the mortgage interest deduction. The value of the standard deduction varies depending on your filing status. If you wouldn't otherwise itemize, your taxable income won't decrease dollar for dollar. For example, if your standard deduction is $10,000 and your itemized deductions besides the mortgage interest deductions total $3,000, the first $7,000 of your mortgage interest and property taxes merely offsets the remainder of your standard deduction. If the total of your itemized deductions doesn't exceed the value of your standard deduction, you won't benefit at all. Alternatively, if the total of your itemized deductions, including mortgage interest and property taxes, is $11,000, your taxable income only decreases by $1,000 compared to if you had taken the $10,000 standard deduction.
Significant Other Itemized Deductions
If you have other itemized deductions that exceed your standard deduction, your property taxes and mortgage interest can reduce your taxable income on a dollar for dollar basis. For example, if you made $8,000 in charitable donations during the year, paid $7,000 in state and local income taxes and your standard deduction is $10,000, your other itemized deductions total more than your standard deduction, so the mortgage interest and property tax deductions further reduce your taxable income without having to offset the difference between your other itemized deductions and the standard deduction.
- house image by Brett Bouwer from Fotolia.com