What are the tax benefits of owning a home instead of renting?

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First-time home buyers face multiple challenges in today’s market, especially in the seller’s market of Silicon Valley. Houses routinely sell for 15% to 30% over asking price, with multiple cash offers. It is hard to find properties under a million dollars, and many homes sell for prices closer to $2 million. It seems that every sale involves a bidding frenzy.

The short answer is that the tax benefit is less than most people realize, but it is still worthwhile, if you have the need for a place to live that is more comfortable than most apartments.

We have discussed elsewhere the benefits of home ownership:

• Protection against inflation. With a 30-year fixed mortgage, the principal plus interest payment is flat, and although homeowners insurance has become more costly due to the mismanagement of California’s lands and infrastructure, property taxes are, for now, limited to a 2% annual increase under Proposition 13. In comparison, rent typically increases every year; and the renter does not benefit when home values increase.
• Diversification out of the stock market. With equities scaling new heights, and historically high valuations, real estate is perceived as a relative safe haven. Real estate prices behave differently than equities. Here in Silicon Valley, homeowners must be careful to avoid having too many of their eggs in the real estate basket.
• Borrowing against the home at low rates and over an extended period, keeps payments low, allowing the owners to save for retirement, education, and other goals.
• There is the intangible benefit of having “our own place,” and there is no place like home.

For all these reasons, long-time homeowners generally think of owning their own home as the best investment they ever make. In many cases, it is the only one they ever make and keep for the long term.

In this post, I will briefly discuss the tax benefits of owning a home. I will not go into corner cases or details. While these benefits are not as much as they used to be, there is still a meaningful tax savings that comes from home ownership.

For most people, benefits come in two main forms:

• Deductibility of mortgage interest and real estate taxes.
• Exclusion of sale on the sale of Principal Residence.

Deduction for mortgage interest and real estate taxes.

In the past, most homeowners were able to deduct all of the home mortgage interest and real estate taxes on their principal residence. Two things changed to limit this:

• The Tax Cuts and Jobs Act (TCJA), effective beginning in 2018 and through 2025, reduced the amount of mortgage interest to amounts on the first $750,000 borrowed. Prior to 2018, this amount was limited to the first $1 million borrowed, and there were ways to expand the benefit further using home equity loans.
• Home prices in Silicon Valley have increased steadily. With a mortgage of under $1 million, almost every home would qualify to have all deductible interest; as prices rose and the limit was decreased, most homes sold to first-time buyers here have mortgages that are not fully deductible.
• Prior to TCJA, ALL real estate taxes were deductible. Now, only $10,000 of state and local (including real estate) taxes are deductible. This is the “SALT Cap.”

When considering buying a home before these changes, it was easy to calculate the tax deduction in the first year. Just multiply the mortgage payment by twelve; most of that would be interest in the first year. Add the property taxes, and that is the deduction.

Today, the calculation is more complicated. In fact, to do it correctly, tax planning software must be used. All the particulars of the taxpayer’s situation must be considered. And the benefits are reduced by around 50% in many cases, in comparison to what people have been brought up to think they are.

Here is an example calculation:

First, the setup:

• Buy a home for $1.4M, finance 80% with 30-year fixed mortgage at 3.00%.
  • Loan amount = $1,120,000
  • Principal and Interest payment = $4,722
  • Monthly Property Tax = $1,120, or $13,440 annually.
  • First year interest payments total = $33,280
  • No points.
  • Assuming $2400 homeowner’s insurance cost, PITI = $4,722 + $1,120 + $200 = $6,042 (pre-tax)

Now, suppose you were renting an apartment for $3,000 per month, and were considering buying the home with a mortgage as shown above.  How much would your housing costs increase? And what would your tax savings be?  Let us run the tax model, assuming a taxable income of $250,000, and Married Filing Jointly:

Housing costs when renting: $36,000  (omits renter’s insurance which is usually minimal).

Total Housing costs when owning (before tax savings): $72,504

But after considering tax savings, the cost is $64,690 ($5,391 monthly).

This comparison is simplified. Apartments are usually smaller than single family homes, and do not come with land. Here we are isolating the effect of being able to deduct part of the mortgage interest and part of the real estate tax. The comparison assumes no other tax deductions, such as for charitable contributions, no children (tax credits for children and childcare exist), and no foreign tax credits.  Even with these limitations, annually, taxes are reduced by $7,814. This taxpayer would be in the 24% Federal and 9.3% California brackets.

Many people consider the tax deduction benefits to be more than they are. If all the mortgage and property tax were deductible in this example, the tax deductions would total $46,720, and would result in a tax savings of about $15.4K (nearly twice what they actually are under the TCJA).

Returning to our example, now the door is open to having deductible charitable contributions, and in some cases, medical expenses can become deductible if they are high enough. Otherwise, these deductions may not result in any tax savings, because today, the Standard Deduction is much higher than it was before TCJA. By adding mortgage interest to the deductions, usually it is possible to itemize other expenses and save even more on taxes. And these tax savings continue as long as you own the home.

Now, remember the second tax benefit mentioned earlier: the possibility to exclude the capital gain on the sale of a principal residence. A married couple can exclude up to $500,000 from the gain, when selling a home, if conditions are met.

Section 121 of the Internal Revenue Code lays out the rules:

• The home must be your principal residence for two out of the last 5 years.
• At least one person of the married couple must have owned the home for two out of the last 5 years.

In the example above, if the home purchased for $1.4M in 2021 is sold in 2025 for $1.82M (a 30% increase, not at all unusual today), then the entire gain of $420,000 is excluded from Federal and California income taxes. This is a huge tax benefit. No other investment has this benefit.  Section 121 has many complex rules. This mentions only the key provisions.

If you are considering buying a home and are wondering whether you can afford it, analyze how much it will cost, and whether you can truly afford (or need) the home.  Even with the reduced benefits available today, the ability to save on income taxes and to avoid paying tax on the gain, still make home ownership one of the very best investments we can make.  The tax benefits can be tricky to calculate, so a tax or accounting professional can help you evaluate your situation. Most importantly, it is too easy to get in over your head with a house that is more than you can afford and end up “house poor.”  Banks will be happy to lend you enough that you will not be able to save enough for retirement or education. Making these personal tradeoffs for your particular situation is where a fee-only financial planner can help the most.