Tax Deductions and Common Sense

A tax deduction is not always a good thing.

Let me repeat this: Just because something is deductible, that does not mean you should spend the money.

Why in the world would I say this?

Because I think that many people have lost sight of what exactly a deduction is. First of all, a tax deduction is simply a REDUCTION of your income in the eyes of the IRS. So, if you are in the 30% tax bracket, and you can deduct $1,000, you will only receive $300 back. With a deduction, you only receive the amount by which you reduced your total tax burden back, not the (your) cost of the whole deduction.

We forget this, and go out and make a decision simply because it is tax-deductible. For example, you roll your capital gains deferral from your primary residence into a newer, bigger house because the interest is deductible. Your old house had a $180,000 mortgage at 5% for a payment of $966. The total yearly deductible interest from that note is about $9000. Now, this does not mean you get a check from the IRS for $9000 at the end of the year. Rather, you reduce your income by $9000, which if you are in the 30% tax bracket comes out to a $3000 check back from the IRS. Not nearly as cool.

Now, your new house has a mortgage of $240,000 over 30 years at 5%, and a payment of $1395. You can deduct $12,000 for the year from your income, but the check from the IRS will only be $3,600.

Wait a minute. You only get $600 more back from the IRS, and your cost of owning a home is $5,148 more per year. So, your decision has cost you a $4,548 reduction in your cashflow a year.

Not such a great deal, now is it?