This is a quick follow-up to my email to subscribers yesterday. I said I wasn’t sure whether making the mortgage payment due on January 1 in December would save taxes when you will switch from itemizing deductions in 2017 to using the standard deduction in 2018 due to the new tax law. I did some research afterwards and the answer is yes.
This doesn’t affect you if you already take the standard deduction in 2017 no matter what or if you will continue to itemize in both 2017 and 2018 no matter what. It only works when you will switch from itemizing in 2017 to using the standard deduction in 2018.
For the mortgage interest to count as a 2017 deduction, two conditions must be met: (1) the interest must be already incurred; and (2) the interest is actually paid in 2017. A typical home mortgage charges interest in arrears. The December interest is due on January 1 and you typically have a 15-day grace period to pay.
If you paid your December 2016 interest in the first half of January 2017, that counts as a 2017 deduction. If you pay your December 2017 interest in December 2017, that also counts as a 2017 deduction. If you wait until January 2018 that would count as a 2018 deduction. With the new $10,000 limit on deducting state and local taxes and the expanded standard deduction in 2018, you may not get any additional deduction for your mortgage interest when you switch to the standard deduction in 2018. If that’s the case for you, making your mortgage payment due on January 1 in December will save you some money.
When you make the payment, make sure the bank takes it as a regular payment against the payment due to January 1, not as a one-time extra principal payment. My mortgage is with Chase. I had to first stop the auto pay scheduled on the 5th of each month and then schedule a payment on December 26. After the payment goes through, I will set up the auto pay again starting in February 2018.
It only works for this one payment. The January 2018 interest due on Feb. 1, 2018 hasn’t been incurred yet. Paying extra now to have your bank wait and apply it to the payment due on Feb. 1, 2018 doesn’t make it deductible in 2017.
Similarly, if the 2018 property tax bill hasn’t come out yet, prepaying now to just have the local government hang on to the money doesn’t make it deductible in 2017. If the property tax bill has already come out, paying it in 2017 may help, but it doesn’t work if you are on AMT in 2017. If you weren’t on AMT before, accelerating the property tax payment may also get you on AMT in 2017, which takes away part of the benefits of accelerating the payment.
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“This doesn’t affect you if you already take the standard deduction in 2017 or if you will continue to itemize in both 2017 and 2018. It only works when you will switch from itemizing in 2017 to using the standard deduction in 2018.”
It’s not nearly that simple. Let’s take the first part – just because you take the standard deduction in 2017 doesn’t mean you couldn’t benefit by accelerating your Jan 2018 mortgage payment.
Say that all your potential deductions, including 12 months of mortgage payments add up to $12,699 (for a couple). You’d normally take the standard deduction ($12,700) instead of itemizing. If instead you made your Jan payment early, you’d get nearly the full value of the interest payment (only a dollar less). But if you paid it in January as usual, you’d lose the full value of the deduction, because your itemized expenses would be well below the $24,000 standard deduction for 2018. So for 2018 your deduction would be $2400 whether or not you made the payment in December or January.
Now suppose that you have $25,000 worth of itemized deductions, including $2,000 of monthly mortgage interest. If you pay on schedule (the January payment in 2018) then you get only $1,000 worth of deductions on that $2,000 payment. (If you accelerate that payment into December, you still get a $24,000 deduction.)
In 2017, you’re already itemizing. So adding that $2000 deduction by paying early gives you the full $2,000 worth of extra deductions. Thus, even though you’re itemizing in both 2017 and 2018 it can still be better to accelerate that payment.
Finally, even if you’d get the full value of the deduction in either year (e.g. you’ve got $30,000 worth of itemized deductions aside from the monthly interest payment), you still come out ahead by accelerating payment. That’s because you’re going to be taxed at a lower rate in 2018, so it’s better to shift income into 2018, or equivalently, accelerate deductions into 2017. The only time this fails is if you wind up paying AMT in 2017.
Harry Sit says
In your first example you will itemize in 2017 after you pull in the payment due on Jan. 1. So by definition you are not taking the standard deduction in 2017.
In your second example after you pull in the payment due on January 1, you will take the standard deduction in 2018. So by definition you will no longer itemize.
Both cases fit the switching from itemizing to standard description.
“In your first example you will itemize in 2017 AFTER you pull in the payment due on Jan. 1. So by definition you are not taking the standard deduction in 2017.”
But you had written: “This doesn’t affect you if you ALREADY take the standard deduction in 2017”.
In my first example you are ALREADY taking the standard deduction. Watch your tenses. By definition you WILL not be taking the standard deduction AFTER you pull in the payment.
“Both cases fit the switching from itemized to standard description”. That description was: “switch FROM itemizing deductions IN 2017.”
My example switched from STANDARD to ITEMIZED in 2017, as you observed. Just the reverse.
Harry Sit says
It’s unproductive to debate what ‘already’ means on Christmas Eve. For clarity I added the phrase ‘no matter what.’ In our context switching means going from itemizing in 2017 to using the standard deduction in 2018. That’s the description. You can only choose either itemizing or the standard deduction in any year after the year ends. There is no switching within the same year.
Okay, at least after several readings and notes, I think I finally see what you’re getting at. Let me try a clearer wording (or at least one that seems clearer to me):
=> Making your January mortgage payment in December 2017 helps reduce your taxes only if, by making that early payment, you itemize in 2017 and do not itemize in 2018. <=
But I would be wary of saying "no matter what".
Here's an example of a situation where one shifts that payment to December, itemizes in 2017 AND 2018, yet still benefits from shifting payments to December:
Consider a taxpayer subject to AMT in 2017, where his AMT exemption amount is partially reduced due to somewhat high income. (The way AMT works is that for every dollar of taxable income above $160,900 [married] until a certain point, the taxable income is increased by $1.25, effectively a 25% surtax; see the instructions for Form 6251, line 29.)
We can assume that this taxpayer won't see a surtax in 2018. That's because the new law sets the surtax start point at $1M income (for a couple). So this example is a direct consequence of the change in tax regimens.
To make matters concrete, let's assume a $2K monthly mortgage interest payment.
By paying in December instead of January, this taxpayer increases his 2018 taxable income by $2K. But in 2017, the surtax magnifies the value of that increased 2017 deduction, so that his 2017 taxable income is reduced by $2.5K. A net win.
Note that this trick doesn't work for SaLT. That's because AMT ignores SaLT deductions.
So even if one itemizes in both 2017 and 2018, shifting the mortgage payment from January 2018 to December 2017 MAY reduce taxes. I started by saying that things are hardly so simple. I think this example shows that, no matter what 🙂
Enjoy the holidays.
Harry Sit says
Or you simply have enough deductions to itemize in 2017 without making the early payment. You don’t need ‘by making that early payment.’ You will still itemize after making the early payment. The surtax you are talking about is just the difference in marginal tax brackets. It can also go the other way if you will have a higher income in 2018. It’s a different consideration than going from itemizing in 2017 to using the standard in 2018.
Let’s cut to the chase. It is always better to take deductions when they are more valuable than when they are less valuable. That’s independent of the deduction (whether it’s a mortgage interest deduction, a charitable contribution deduction, or anything else). This much has got nothing to do with tax law changes.
That’s the only necessary condition. It’s not necessary that you switch from itemizing in 2017 to a standard deduction in 2018. It’s only necessary that the deduction (here, the first monthly 2018 mortgage interest payment) be more valuable in 2017 than 2018, regardless of whether you itemize in 2018 without it. And regardless of whether without that extra deduction, you’d be itemizing in 2017.
Now let’s talk about what’s special with this tax law change. Here are three relevant changes that affect whether a deduction is more valuable in 2017 than in 2018 (the condition necessary for one to profit from accelerating deductions):
1) Lower tax rates in 2018. For someone with similar income in 2017 and 2018, a deduction (if one itemizes) in 2017 is worth more than a deduction (if one itemizes) in 2018. This is true even if one itemizes in 2018 after moving the the deduction to 2017.
2) Higher standard deduction in 2018. This increases the likelihood that one won’t benefit more from a potential deduction in 2018 than in 2017. This is because one is more likely to take a standard deduction (and thus lose all value of the potential deduction) in 2018. Even if one itemizes, one may not get the full benefit of the deduction. For example, a $2K interest deduction when one has $23K of other items to deduct is only worth $1K in 2018. That’s because one would get $24K standard deduction without this $2K item, and just $25K with it.
3) Virtual elimination of AMT in 2018 (with an exemption of $1M for couples, very few people will be subject to AMT). AMT brackets (26% and 28%) are pretty close to “regular” income tax brackets. What makes AMT onerous is its surtax of 6.5% or 7% as its exemption is phased out. This relates back to item #1 – the AMT surtax (for people subject to it) makes the tax rate in 2017 much higher than the tax rate in 2018.
Of course that extra tax is a surtax, and not simply a difference in statutory marginal rates (which for AMT are 26% and 28%):
“When you are in the [AMT exemption] phaseout range, your marginal tax rate under AMT is 6.5-7% higher than the statutory 26% and 28% rates.” ” … every additional $1 of income … phases out $0.25 of the exemption, which …is actually the equivalent of a 6.5% – 7.0% ‘surtax’.”
Harry knows the first quote well, he wrote it. The second is by Kitces.
The Finance Buff, 2013 and 2014 AMT Tax Brackets
Kitces.com, Evaluating Exposure To The Alternative Minimum Tax
Don’t like Kitces? How about the Tax Foundation? In describing the Pease limitation, a similarly structured phaseout, it wrote: “Due to its structure, Pease is … a stealth surtax on high-income individuals.”
The Pease Limitation on Itemized Deductions Is Really a Surtax
Harry Sit says
It’s all true. I chose to focus on (2) because the difference between being able to deduct and not being able to deduct is much larger than being able to deduct in both years but at different rates. I wouldn’t have bothered to make a change to just one monthly payment if I’m still able to deduct but just at a rate 3% or even 8.5% lower. Now I realize different people choose to optimize to different levels.
On the tangential topic of ‘surtax’ I choose to reserve that term for a separate line item, such as the Net Investment Income Tax or the Additional Medicare Tax. Due to all kinds of phaseout and interactions, the marginal tax rates are often not the rates listed in the tax schedules. Being in the 25% bracket while having large long-term capital gains can mean a 30% marginal tax rate on additional income. Having child tax credit phased out can mean a higher marginal tax rate too. Having more income while receiving Social Security benefits would be another one. Examples are numerous. Therefore I’d rather say they are all part of the marginal tax rates, to make it clear that the marginal tax rates are not the same as the so called tax brackets in a table. Again that’s just me. To me a surtax would be an additional tax, not just how the same tax is calculated.
Thanks Harry! I think, I hope, we’re both clear now on what each of us is saying.
One other side comment on terminology: The 30% marginal rate you’re referring to happens when ordinary income (IRS terminology) is in the 15% bracket, but total taxable income (including qualified divs and long term gains) exceeds the 25% bracket threshold.
I suspect most people (myself included) would say that this taxpayer is in the 15% bracket (based on the amount of ordinary income). You say that this person is in the 25% bracket. I know what you’re talking about because I’m familiar with the issue. Otherwise I might be confused.
Harry Sit says
We can agree whatever bracket it may be, 15% or 25%, it doesn’t count, because it’s not the true marginal tax rate.
Am I correct that there is a benefit for someone who is going to itemize both years to pull the payment into December, because you’ll save ~3% more in taxes in 2017 than you will in 2018 due to lower tax rates in 2018?
Harry Sit says
Yes, unless you expect a much higher income in 2018. The benefit is very small though. Maybe worth $50.
Ah, yes its only 3% of the interest portion of a single mortgage payment … i see
Frugal Professor says
Thanks! You saved me $350 or so with this post. Thank you!!!!
“If the property tax bill has already come out, paying it in 2017 may help, but it doesn’t work if you are on AMT in 2017. If you weren’t on AMT before, accelerating the property tax payment may also get you on AMT in 2017, which takes away part of the benefits of accelerating the payment.”
But… if you are NOT affected by AMT and your locality DOES accept pre-payments, this could be a pretty large deduction in 2017 that you wouldn’t get in 2018, so it pays to check. I bought TurboTax already and have entered what I expect everything to be for W-2, other income, other deductions, etc., then trying with the pre-paid property tax and am saving about $1200 by pre-paying a property tax bill of about $5000–and it does not change my AMT status. I would get nothing if I waited until 2018 because my state taxes are over $10,000 by themselves. Luckily, the county I live in (Hennepin, MN) allows pre-payment based on the proposed 2018 property tax they already sent out, and the web site specifically notes “Your tax payment is considered paid the date you submit it online.” I’m sure a lot of people won’t have this option, but I’d say it’s definitely worth checking.
Thanks Harry! Timely post!
Loan balance before we made extra mortgage payment was 162000. Total extra payment for a whole year was about 10k. Our original loan amount was 201750 with 5.875 in interest. We were only able to save $73 in interest for that one year. Why do I feel like I’m being scammed by my mortgage company?
Rohit Gupta says
So I am making 13 payments in 2017 instead of 12. Can’t I do the same in 2018 and still save, given that I will most likely itemize in 2018 as well?
Harry Sit says
See the second paragraph and comments from msf.
I took the prepayment route for the Jan. 1 payment and my mortgage company (Chase) has already sent me my statement for the Feb. 1st payment. Could I pay that as well to get 14 payments in 2017?
Harry Sit says
You can pay but it isn’t deductible in 2017.
I made my February 2018 mortgage payment in December 2017 and the interest was not included on my 2017 1099. Will it be included on my 2018 1099 or did I lose the deduction for that month?
You could only have prepaid your January payment and have it count toward 2017 because the interest was accrued in 2017 (i.e., month of December). Your February payment interest didn’t accrue until January 2018. So, it should be included on your 2018 1099, but that really only matters if you will still itemize deductions in 2018.