**Small Business Taxes & Management ^{TM}**

How much will my taxes go down when I buy that house? CPAs often get that question from first-time homebuyers. As always, there's no quick rule of thumb. If you live on Long Island real estate taxes for a modest home could be $7,000 a year; in many areas of Massachusetts for a similar home they could be $3,500. But chances are the biggest deduction will be mortgage interest. In fact, for many married taxpayers if their home is paid off or they're paying cash for a property, they may not have enough in deductions to itemize.

First Step--Mortgage Interest

You can't start the analysis without knowing what your mortgage interest will be. Unfortunately, calculating the exact amount will require a financial calculator, a formula and a scientific calculator, or generating an amortization schedule. Fortunately, you don't have to be exact and you can approximate your interest expense for the first year at least by simply multiplying the outstanding principal amount by the interest rate and adjusting for the number of months in the year.

Fred and Sue purchase a new home on April 1, 2008 for $400,000 with a $300,000 mortgage with interest at 6% for 30 years. The approximate interest for the full first year would be $18,000 ($300,000 X 0.06). Since the mortgage is in effect for only nine months, the tax deduction would be approximately $13,500 ($18,000/12 X 9).Example--

How far off will you be? We used $18,000 for the interest on a $300,000, 6%, 30-year mortgage. The actual amount is $17,899.80--$100.20 less interest expense. More than close enough for tax planning. If the principal amount was double ($600,000) the dollar error would be double. If the interest rate is higher the error actually decreases (slowly). If the mortgage were shorter, say a 20-year loan, the difference would be higher, about $218 using $300,000 and 6%. Still not a significant difference. Unfortunately, differences increase quickly as the years go on. In the second year of a $300,000, 6%, 20-year loan using the quickie approach overstates interest expense by $327; in the third year it's $569. The difference gets larger quicker the shorter the mortgage. On a 20-year loan it jumps from $218 in the first year to $712 in the second to $1,236 in the third.

**NOTE.** Don't try and use this quick computation for a car, equipment, or any other short-term loan. The shorter the term, the larger the error. On these short-term loans the error is too high to be acceptable.

For years two and three on a 30-year loan you could use the same quick approach to estimate interest expense if you reduce it by a couple of hundred dollars to be on the safe side. Or use the amount from your prior year's return and reduce it by a couple of hundred dollars. Remember, as the loan gets older principal repayments increase quickly and interest expense decreases quickly.

If you paid points to get the loan, they're deductible in the year paid. (Applies only to principal residence.) Only points designated on the settlement statement as loan origination fees, loan discount, discount points, or points qualify. In addition, they've got to meet several other requirements. Amounts paid in lieu of inspections, appraisals, etc. don't qualify. You can only deduct amounts associated with the purchase of the home. Points paid on refinancings can only be amortized over the life of the loan.

Finally, interest is deductible only on the first $1,000,000 of qualified mortgage debt. That includes a second or vacation home.

Other Deductions

Real estate taxes are deductible (both principal residence and vacation property) in the year paid. If you're making the payments to a bank or mortgage company, you can claim a deduction only when the lender pays the taxes.

You can deduct mortgage insurance premiums for contracts first issued after 2006. The deduction applies to premiums paid through December 31, 2010. The deduction is phased out for taxpayers with adjusted gross income in excess of $50,000 ($100,000, married filing joint).

You'll probably pay a number of fees on the purchase of the property. That can include attorney's fees, appraisals, mortgage recording fees, transfer taxes, etc. They're generally not deductible. However, you should save your closing statement because most can be added to your basis in the property, reducing your gain on the sale of the property.

Computing the Tax Savings

If you currently itemize, your tax savings will depend principally on your tax brackets with and without the deductions for the house. If you used computer software to prepare your return for last year, you can plug the interest and taxes into that program. Differences from tax rate changes for inflation won't have much of an effect. If you didn't use a program or don't have access to one, you'll have to work through the numbers by hand. Sorry, but there's no easy way. That's because your deduction for interest and real estate taxes could easily total $20,000 or more and there's a good chance you're savings will be in more than one bracket.

Things get slightly more complicated if you're taking the standard deduction currently. In order to achieve any savings, your itemized deductions have to exceed the standard deduction. That means that some of your house deductions may not save any taxes.In 2008 Fred and Sue have salary income of $90,000. Because they have high charitable contributions ($7,000) and income taxes ($5,000) they itemize. Their taxable income is $71,000 ($90,000 less $12,000 in itemized deductions less $7,000 for exemptions). They purchase a house early in the year and anticipate $18,000 in interest and $4,000 in real estate taxes, for a total of $22,000 in deductions. Because they file jointly, taxable income over $65,100 is taxed at 25%; income between $16,050 and $65,100 is taxed at 15%. Thus, the first $5,900 of the $22,000 in interest and taxes saves income tax at 25% ($1,475); the remaining $16,100 of the $22,000 saves taxes at 15% ($2,415). Thus, the total saving would be $3,890. If you owe state income taxes and the interest and real estate taxes are deductible there, you'd get an additional saving. But those state tax savings would reduce your deduction for state income taxes on your federal return.Example--

How much should you increase your withholdings? Some tax software programs have a withholding calculator. You can also find one at www.irs.gov/individuals/article/0,,id=96196,00.html.Fred and Sue normally take the standard deduction since their only other deduction is for state income taxes of $4,000. Since the standard deduction for 2008 is $10,900 for a married couple filing jointly, only the deductions that exceed $10,900 will actually save them taxes. Assuming their interest and real estate taxes total $22,000 that, combined with their income tax deduction is $26,000. However, they would have gotten a $10,900 standard deduction so the deduction that will reduce their taxes is $26,000 less $10,900 or $15,100. Apply the appropriate tax rates to this net deduction.Example--

Copyright 2008 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536

**--Last Update 05/21/08**