Investors often get excited for anything that may reduce their tax liability, including deductions and write-offs. Tax deductions, however, in many cases can be like a hairy lollipop. From a distance the lollipop looks delicious, but as you get closer you start to see that appearances can be misleading.
There’s a funny episode of Seinfeld where Kramer explains “write-offs” to Jerry but as he attempts to explain how business works, Jerry fails to grasp any of the details. A write-off is another way of saying a tax deduction. Although write-offs can be very beneficial for most people, they are not always a benefit to every situation.
A misconception about tax deductions
I am not suggesting that you avoid tax deductions altogether, because they can be an everyday part of most people’s financial spending or their businesses. If you qualify for deductions, then the correct course of action is to take them. You never want to leave money on the table. Even the staunchest supporters of raising tax rates still pay the absolute minimum they are required to pay.
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What I am suggesting is this: Don’t go out of your way to accumulate tax deductions.
A few years back a couple in their 40s requested a meeting with me to review their financial situation. When going through the client discovery process they were excited to tell me that they had paid off their house.
This was extremely impressive, because their home was a single-family house in a pleasant neighborhood that happened to be in the top half of home values in the area. They informed me that they took out a 15-year mortgage while purchasing the house and consistently overpaid the mortgage payments.
Whether that was a good idea or not is a topic for another day, but the couple were ecstatic. A sense of pride shone through as they told me that they bought another home “for the tax deductions.” Both nodded their heads in approval as the sentence came out of their mouths.
I asked them, “You celebrated paying off your house by buying another house?”
“Yea, you know… for the tax deduction.”
As they once again nodded their heads in approval, I was shaking my head in disappointment. That’s like celebrating your child’s college graduation by having another baby! They were overly joyed about the tax deduction but neglected to take a look at what a deduction really meant for them.
What exactly are tax deductions?
A tax deduction is an expense that you can use to offset income in some way. The issue is that you will always pay more in expenses than you receive in tax savings.
The celebratory house had a new mortgage attached to it. Based on mortgage amortization schedules, most of their payment went toward interest.
To keep numbers simple, let’s say the monthly interest on the mortgage is $1,000 and they are in a 24% tax bracket. The couple pays the bank $1,000 in interest and the IRS lets them save $240 in taxes. That’s a bad deal. Pay $1,000 to get $240 back.
Bad decisions with good intentions
As I explained this to them, they shifted to saying the new house was an investment. It was in a resort town, and they planned to rent it out. They then complained about how high the rental management company fees were, how much the renters trashed the place and how little time they had to use the property themselves. To make matters worse, the housing bubble burst and their $300,000 second home dropped to a value of $200,000.
But now if the couple sold the property for the new lower value, they would get one heck of a tax deduction! This is because you can claim deductions on rental properties but not on primary residences.
It is extremely important to clear this myth up of how great tax deductions are, because there are plenty of people who will make bad decisions with good intentions. They are ill-informed and do not think through the progression.
If you want to buy a second home, a big, fancy truck for your plumbing business or any other large purchase (especially one that’s unnecessarily large) that’s one thing, however, do not justify this expense to others by saying it’s for the tax deduction. I have helped with too many people who have made mistakes based on bad information.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through SFG Wealth Management, a registered investment advisor. SFG Wealth Management and Harford Retirement Planners are separate entities from LPL Financial.
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