FIN351 - Section 14 - Mortgage Interest Payment Deduction and SALT

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California State University, Fullerton *

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351

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Finance

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Jan 9, 2024

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pptx

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FIN 351 Real Estate Principles Dr. Jia Xie • Mortgage Interest Payment Deduction • Impact of Marginal Income Tax Rate on Mortgage Cost • State and Local Tax (SALT) Deduction YouTube (56:48): https://youtu.be/9oz7USmlD68

2 Topics What is mortgage interest deduction New rule since 2018 Calculation of Tax deduction and actual mortgage payment Calculation of effective after-tax borrowing cost

3 Mortgage Interest Deduction and the New Rule since 2018 Interest payments are income deductible on mortgages up to a loan limit New limits since 2018  For single filers and married couple filing jointly: $750,000 (formerly $1,000,000)  For married couples filing separately: $375,000 each (formerly $500,000)  No deduction allowed for Home Equity Line Of Credit (HELOCs) and second mortgages (formerly $100,000) These new limits won't apply to mortgages/HELOCs originated before December 15, 2017

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4 Mortgage Interest Deduction and the New Rule since 2018 Interest payments are income deductible on mortgages up to a loan limit Limit on loan sizes Old rule: Before 12/15/2017 New rule: After 12/15/2017 Single filer & Married couples filing jointly $1m $750k Married couples filing separately $500k $375k Home Equity Line Of Credit (HELOCs) & Second mortgages $100k $0

5 Mortgage Interest Deduction and the New Rule since 2018 What if your mortgage size is over the limit? Answer: you're allowed to deduct the portion of interest paid on the amount of debt under the limit. For example, if mortgage balance is $1.2 million, and you paid $80,000 mortgage interest for the year. How much can you deduct from your income under the new and the old rules, respectively, if you file married jointly?  New rule: 750,000/1,200,000*80,000=$50,000  Old rule: 1,000,000/1,200,000*80,000=$66,667  Your income deduction is lower under the new rule!

6 Mortgage Interest Deduction and the New Rule since 2018 The mortgage balance changes during the year, which balance should you use in the above calculations?  You have two options:  The highest balance of the mortgage during the year , or  The average balance  Which one to use? And why?  You should use the average balance, to reduce the denominator.

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7 Calculation of Tax Deduction and Actual Mortgage Payment Assumptions: A 30-year FRM with loan amount $200,000 and interest rate 6%. The borrower’s marginal income tax rate is 28% Questions: 1. Can you fill out the table below? 2. What are tax deductions and actual mortgage payments in the first 5 months? Month Beginning Balance Payment Interest Principal Ending Balance Tax Deduction Actual payment 1 2 3 4 5

8 Calculation of Tax Deduction and Actual Mortgage Payment Assumptions: A 30-year FRM with loan amount $200,000 and interest rate 6%. The borrower’s marginal income tax rate is 28% Q1. Can you fill out the table below? Hint: Step 1: Fill out the first 5 columns for Month 1 (Learned in Week 10) Step 2: Repeat this for Months 2, 3, 4 and 5 Step 3: Tax deduction = Interest Payment * Marginal Tax Rate Month Beginning Balance Payment Interest Principal Ending Balance Tax Deduction Actual payment 1 2 3 4 5

9 Step 1: Calculate the payment, interest, principal and ending balance for Month 1 Assumptions: A 30-year FRM with loan amount $200,000 and interest rate 6%. The borrower’s marginal income tax rate is 28% Calculation: N=360; I=6/12; PV=200k; FV=0  PMT=-1,199.10 2 ND , AMORT, P1=1, P2=1  BAL=199,800.90, PRN=199.10, INT=1,000.00 Month Beginning Balance Payment Interest Principal Ending Balance Tax Deduction Actual payment 1 200,000.00 1,199.10 1000.00 199.10 199,800.90 2 199,800.90 3 4 5

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10 Step 3: Repeat this for Month 2 and so on… Assumptions: A 30-year FRM with loan amount $200,000 and interest rate 6%. The borrower’s marginal income tax rate is 28% Calculation: P1=2, P2=2  BAL=199,600.80, PRN=200.09, INT=999.00 P1=3, P2=3  BAL= 199,399.71, PRN=201.10, INT=998.00 P1=4, P2=4  BAL= 199,197.60, PRN=202.10, INT=997.00 P1=5, P2=5  BAL= 198,994.49, PRN=203.11, INT=995.99 Month Beginning Balance Payment Interest Principal Ending Balance Tax Deduction Actual payment 1 200,000.00 1,199.10 1000.00 199.10 199,800.90 2 199,800.90 1,199.10 999.00 200.09 199,600.8 0 3 199,600.80 1,199.10 998.00 201.10 199,399.71 4 199,399.71 1,199.10 997.00 202.10 199,197.60 5 199,197.60 1,199.10 995.99 203.11 198,994.49

11 Step 2: Calculate the tax deduction and Actual payment for all the months Assumptions: A 30-year FRM with loan amount $200,000 and interest rate 6%. The borrower’s marginal income tax rate is 28% Calculation: Tax deduction = Interest payment *Marginal Tax Rate Actual payment = Monthly Payment – Tax deduction Month Beginning Balance Payment Interest Principal Ending Balance Tax Deduction Actual payment 1 200,000.00 1,199.10 1000.00 199.10 199,800.90 280 919.10 2 199,800.90 1,199.10 999.00 200.09 199,600.8 0 279.72 919.38 3 199,600.80 1,199.10 998.00 201.10 199,399.71 279.44 919.66 4 199,399.71 1,199.10 997.00 202.10 199,197.60 279.16 919.94 5 199,197.60 1,199.10 995.99 203.11 198,994.49 278.88 920.22

12 Calculation of Tax Deduction and Actual Mortgage Payment Assumptions: A 30-year FRM with loan amount $200,000 and interest rate 6%. The borrower’s marginal income tax rate is 28% Q2. What are the borrower’s tax deductions and actual mortgage payments in the first 5 months?

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13 Calculation of Tax deduction and actual mortgage payment Assumptions: A 30-year FRM with loan amount $200,000 and interest rate 6%. The borrower’s marginal income tax rate is 28% Q2. What are the borrower’s tax deductions and actual mortgage payments in the first 5 months? Observation: tax deduction benefit is substantial! Month Beginning Balance Payment Interest Principal Ending Balance Tax Deduction Actual payment 1 200,000.00 1,199.10 1000.00 199.10 199,800.90 280 919.10 2 199,800.9 1,199.10 999.00 200.09 199,600.8 0 279.72 919.38 3 199,600.80 1,199.10 998.00 201.10 199,399.71 279.44 919.66 4 199,399.71 1,199.10 997.00 202.10 199,197.60 279.16 919.94 5 199,197.60 1,199.10 995.99 203.11 198,994.49 278.88 920.22 Total 5,995.51 1,397.20 4,598.31

14 Calculation of Tax Deduction and Actual Mortgage Payment Assumptions: A 30-year FRM with loan amount $200,000 and interest rate 6%. The borrower’s marginal income tax rate is 28% Q2. What are the borrower’s tax deductions and actual mortgage payments in the first 5 months? Do we have to fill out the whole table to answer this question? No! Just need to know the mortgage payment and interest payment in the first 5 months Step 1: N=360; I=6/12; PV=200k; FV=0  PMT=-1,199.10 2 ND , AMORT, P1=1, P2=5  INT=4,989.995 Step 2: Tax deduction = INT * Marginal Tax Rate= 4,989.995 * 28% = 1,397.20

15 Calculation of Effective After-Tax Borrowing Cost Assumptions: You bought a house with price of $250,000. LTV is 80%. You get a 30-year mortgage with interest rate 6%. Transaction cost is $10,000 and marginal income tax rate is 25%. Questions: 1. What is your actual mortgage payment in the 1st month? 2. What does your after-tax cash flow look like if your loan will be outstanding for only 1 month? 3. What is the annual effective cost of this loan after-tax if your loan will be outstanding for only 1 month?

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16 Calculation of effective after-tax borrowing cost Assumptions: You bought a house with price of $250,000. LTV is 80%. You get a 30-year mortgage with interest rate 6%. Transaction cost is $10,000 and marginal income tax rate is 25%. Q1. What is your actual mortgage payment in the 1st month? Answer: N=30*12; I=6/12; PV=200k; FV=0  PMT=-1,199.10 2 ND , AMORT, P1=1, P2=1  BAL= 199,800.90, INT=1,000 Tax deduction = INT * Marginal Tax Rate = 1,000*25% = 250 Actual payment = Payment – Tax deduction = 1,199.10-250 = 949.10

17 Calculation of effective after-tax borrowing cost Assumptions: You bought a house with price of $250,000. LTV is 80%. You get a 30-year mortgage with interest rate 6%. Transaction cost is $10,000 and marginal income tax rate is 25%. Q2. What does your after-tax cash flow look like if your loan will be outstanding for only 1 month? Answer: Time 0: $200,000-$10,000= $190,000 Time 1: - Actual payment – BAL = -949.10 - 199,800.90 = -$200,750.00

18 Calculation of effective after-tax borrowing cost Assumptions: You bought a house with price of $250,000. LTV is 80%. You get a 30-year mortgage with interest rate 6%. Transaction cost is $10,000 and marginal income tax rate is 25%. Q3. What is the annual effective cost of this loan after- tax if your loan will be outstanding for only 1 month? A: N=1; PV=190,000; PMT=0; FV=-200,750.00  I=5.66 Cost= 5.66*12%= 67.89%

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19 2018 Federal Income Tax Rate 2018 Tax Rates Schedule X - Single If taxable income is over But not overThe tax is $0 $9,525 10% of the taxable amount $9,525 $38,700 $952.50 plus 12% of the excess over $9,525 $38,700 $82,500 $4,453.50 plus 22% of the excess over $38,700 $82,500 $157,500 $14,089.50 plus 24% of the excess over $82,500 $157,500 $200,000 $32,089.50 plus 32% of the excess over $157,500 $200,000 $500,000 $45,689.50 plus 35% of the excess over $200,000 Over $500,000 no limit $150,689.50 plus 37% of the excess over $500,000 2018 Tax Rates Schedule Y-1 - Married Filing Jointly or Qualifying Widow(er) If taxable income is over But not overThe tax is $0 $19,050 10% of the taxable amount $19,050 $77,400 $1,905 plus 12% of the excess over $19,050 $77,400 $165,000 $8,907 plus 22% of the excess over $77,400 $165,000 $315,000 $28,179 plus 24% of the excess over $165,000 $315,000 $400,000 $64,179 plus 32% of the excess over $315,000 $400,000 $600,000 $91,379 plus 35% of the excess over $400,000 $600,000 no limit $161,379 plus 37% of the excess over $600,000

20 State and Local Tax (SALT) Deduction The State And Local Tax (SALT) deduction allows taxpayers to deduct the following from taxable income in their federal tax returns • Local (city and county) property tax • Local (city and state) income tax Before 2018, all of the local property and income tax payments can be deducted. Since 2018, the maximum SALT deduction is $10,000 To do SALT deduction, taxpayers need to file itemize their deduction; they can not take the standard deduction Residents of states with high income taxes (California, New York, New Jersey …) generally opt to deduct their state and local income taxes

State and Local Tax (SALT) Deduction THE STATES WITH THE HIGHEST AVERAGE SALT DEDUCTION State Percent of Filers Who Deduct State and Local Taxes Average Size of Deduction for State and Local Taxes New York 34.14% $21,038.02 Connecticut 41.04% $18,939.72 New Jersey 41.00% $17,183.33 California 33.86% $17,148.35 Washington, D.C. 39.19% $15,452.40 Massachusetts 36.73% $14,760.99 Illinois 32.34% $12,877.51 Maryland 45.04% $12,442.78 Rhode Island 32.83% $12,138.75 Vermont 27.41% $11,843.95 21

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22 Summary • In this class, we have learned that homeowners can deduct the following three items from federal tax returns o Mortgage interest payment o Local property tax payment o Local income tax payment • These are all incentives given by the federal government to American households to promote the American Dream of Homeownership

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