The two largest assets that are found in most households today across our nations is a Qualified Retirement savings account and the family’s home. Unfortunately, they are also the two most misunderstood assets when it comes to understanding the tax advantages and the tax liabilities each holds. Thus this makes these two assets the most mismanaged of all that we own.
By better understanding and properly managing just both the Qualified Retirement Savings account and the home mortgage, the average American household could increase their total net worth at retirement age by a million dollars. I know that may be very hard to believe, but I’ve seen it happen over and over again, and with people who aren’t millionaires.
When you look at most families’ assets and liabilities, the family’s home is usually the number one asset—and liability. I’m more concerned with the liability part of that equation.
For many of us, our mortgage deduction is the biggest tax break we get every year. If your mortgage qualifies according to IRS publication 936, you can offset the income you have to pay taxes on by claiming the interest rate on your mortgage.1
When we’re in our high earning years, most of us come to rely on that tax deduction to ensure a tax refund. A friend of mine told me that her dad was a teacher, and the only time her large family (5 kids), got to go out for dinner at a restaurant was when the tax-refund check came in the mail—a refund largely fueled by the mortgage tax deduction.
But this mortgage deduction is only as good as long as you have a mortgage loan. One of the other sacred cows of American society is the idea that paying off your home early is a sound financial decision. When that happens you don’t have that awful mortgage payment; you own all the equity in your home, which you can borrow against by taking out a home equity loan or a “second mortgage.” That interest is deductible, but not nearly as much as it is with the original loan (you can deduct up to $100,000 of a home equity line of credit but you can deduct up to $1,00,000 (or $500,000 is married and filling separately) off the original mortgage.2
You can’t have both—a paid off house and that sweet mortgage deduction every year.
It’s actually the difference between “tax evasion,” and “tax avoidance.” When I talk to my clients about this and they want to know the difference between the two, I say (and this is without joking) “about ten years in jail.”
Tax evasion is what finally cornered Al Capone. He didn’t pay his taxes and the dreaded IRS agents finally caught up with him.
However, “tax avoidance,” is something that more people should know about. The IRS provides so many efficient and effective ways to avoid taxes. These are legal exceptions, yet too many Americans don’t take advantage of all that they can. So the majority of our accumulated wealth, as well as our yearly income, is deteriorated unnecessarily through taxation.
I’ve read that only half of Americans take advantage of their mortgage deduction. I find that hard to believe, but that’s what the American Tax Foundation reported in 2007 when it talked about the paltry number of people who actually itemize their tax returns—and that’s the only way you can take the mortgage deduction.3
Let me give you just one example of how most people mismanage their home mortgage. IRS code 163(h) is the tax code that regulates the amount of mortgage interest that can be deducted from your earned income.4
There are two terms in the code that are very important and ones you should be familiar with if you own a home with a mortgage: 1) acquisition indebtedness and 2) equity indebtedness.
The definition of these terms are:
Acquisition indebtedness – Any indebtedness that is incurred in acquiring, constructing, or substantially improving a qualified residence and is secured by the residence.5
Equity indebtedness –Indebtedness secured by a qualified residence that is $100,000 above the acquisition indebtedness.6
When purchasing a home, acquisition indebtedness is your best friend when it comes to reducing taxation, because the interest on this debt is total deductible from your earned income. (In other words, this is what gives you the mortgage deduction.)
When you pay a principal payment towards your homes mortgage, you reduce the acquisition indebtedness dollar for dollar. In other words you kill your largest tax deduction.
Once you reduce the value of your acquisition indebtedness, it is gone forever, never to be regained on your primary residence. This is a very expensive activity for most home owners, and they don’t even know it.
There is a way to manage a residential home mortgage that will allow you to keep that all-important acquisition indebtedness as high as possible which keeps your mortgage deduction going as long as possible.
Because it requires a fairly lengthy explanation, I’m going to cover it in another blog. So stay tuned…I won’t keep you waiting!
2 See note #1
6 see note #3 and #4.