Every year a plethora of financial articles come out telling people how to save money on their taxes at the end of the year. It’s a fine idea, and frankly, no stone should go unturned. However, the best tax planning takes happens year round. That being said, there are numerous last-minute ways to cut income taxes by making last minute moves in December. Today, we examine one of the most common end of year tax moves, paying your mortgage early.
Check here to learn how to deduct mortgage interest on your taxes.
Make Mortgage Payment Early to Deduct More
One of the biggest tax deductions that is available to ordinary taxpayers is the mortgage interest deduction. Simply put, the mortgage interest deduction is the ability to deduct whatever amount you pay in mortgage interest from your income taxes. There are several rules and exclusions, but they don’t apply to most taxpayers unless you have more than $1 million in mortgages or several houses. This is one of those tax deductions with no income limits. You do need to itemize your deductions in order to claim the mortgage interest deduction. For many people, the amount of their mortgage interest deduction determines whether it is best to itemize or claim the standard deduction amount.
In a normal year, you make 12 mortgage payments. Add up the total amount of interest paid, and that is how much you get to deduct. Your mortgage company will actually do it for you because they are required to submit a 1099-INT to both you and the IRS. This means the IRS knows how much money you actually paid on your mortgage, so this isn’t a good place to get creative. You can find the 1099-INT forms on the IRS website.
However, as with most tax deductions, you get to claim the amount amount you pay during the year regardless of when it is actually due. Thus, if you pay your January mortgage payment in December, you get to deduct it on this year’s taxes. That means you get to deduct the amount of interest paid on 13 payments instead of just 12.
For example, let’s assume for the ease of math that you pay $1,000 per month in interest on your mortgage. (Keep in mind that only the interest part of your payment is deductible. The amount that goes to principal and the escrow payment is NOT deductible.) If you made all the payments at the regular time during 2011, then your 2011 mortgage interest deduction would be $12,000.
That’s not too shabby. But, if you pay your January payment during December, then you have made 13 payments during the current tax year instead of 12. That means that on your 2015 taxes, you can deduct $13,000 instead of just $12,000. That extra $1,000 deduction can be very valuable especially at higher tax brackets. In the 30 percent tax bracket, making your payment just a few days early saves $300 on your taxes.
The Catch to Paying Your Mortgage Early
There is, of course, a catch to using the tax trick of paying off your mortgage early.
By making your January payment in December, you have eliminated one of the payments you would normally make during following year. That means that you can only deduct 11 mortgage payments worth of interest in 2016 because the January payment was not made during 2016, it was paid in 2015.
In our example above, by paying the January 2016 payment early, you got to deduct $13,000 in 2015. But, that means you will only be able to deduct $1,000 less, or only $11,000 on your 2016 taxes. There is a way around this. If you make your January 2017 payment during December 2016, then you can deduct the full-year of interest of $12,000. However, there is no way to get that extra deduction again until you bite the bullet and take only 11 months worth of interest payments as your mortgage deduction in some year.
Mortgage Interest Deduction Audits
Here is the mistake that many taxpayers accidentally make.
In 2015, they read about this really great idea to make their January mortgage payment early in order to get a bigger interest deduction. So, they pay 13 months worth of payments during 2015 and they deduct 13 months worth of interest. So far, so good.
However, in 2016, they forget that they did that. The mortgage company sends them a 1099-INT that shows a full 12 months of interest payments for 2016 and they deduct the full 12 months of interest, even though they can only legally deduct 11.
The other mistake belongs to those who try and use the trick a second time in 2016 by paying their mortgage early and deducting 13 months of interest when they only qualify for 12 months of interest payments because they did the early pay the year before.
Remember those 1099-INT forms that the mortgage company sends to both you and the IRS?
That is how you get caught. The IRS computers run the numbers on the forms against the numbers you claim and then a letter shows up in the mail saying that a routine examination of your return has discovered a possible error. If you are really unlucky, your return will get flagged for a full-scale audit. Typically, however, you’ll just be subject to an “information audit” where the IRS will require you to provide documents to support your deductions.
It won’t take long for cancelled checks and mortgage statements to reveal that you claimed too many deductions owe back taxes and interest on the amount. Theoretically, if the IRS can prove you did it on purpose, you can also be on the hook for fraud and additional penalties, but this kind of mistake happens all the time and non-accountants routinely fall victim so they probably won’t go after you for that.
How To Maximize Tax Deductions by Paying Mortgage Early
Paying your mortgage early to increase your mortgage deduction amount works best for people who either have income that varies from year to year, or people who know that they are going to get hit with a big tax bill and will adjust for it on next year’s taxes.
If your income varies because you earn commissions, own your own business, or you get bonuses that are different sizes each year, then you want to pay your mortgage early in a year where your income will be high. Even if it is high the next year, you can pay early again and keep your full-year interest deduction. Eventually, when you have an off year or your bonus is smaller than usual, you can not pay early and only deduct 11 months of payments. This “reloads” this tax deduction increase trick for another year when your income is higher.
For people who get an unexpected windfall during the year that may result in a higher tax bill, that extra $300 deduction will give you some extra room when filing your current year taxes. Just be sure to adjust your withholding for next year so that you don’t come up short again.
Paying your mortgage early is a good end of year tax tip. However, be sure you fully understand what you are doing and how it affects your future taxes. If you pay early this year, you have to pay early for every other year until you are ready to take the smaller 11-month size deduction.