Should I Take a Mortgage For the Tax Deduction?
August 9, 1999, Revised December 2, 2006

"My husband and I would like to find or build a home with a complete suite for my mother. Her CPA has told her she needs a mortgage to offset her income from my dad's retirement and her rental property. We also need a mortgage for our tax purposes. Is there a way to have separate mortgages?"

Your mother cannot have a mortgage on your property unless she shares in the ownership-of your home. If she is a co-owner, she could also be a co-borrower, sharing responsibility for the mortgage according to a formula that your agree on beforehand. On your mother's rental property, she could take out her own first mortgage.

Let me now turn to the question you didn't ask, but should have because it is more important than the question you did ask. Does it make sense to take out a mortgage for the sole purpose of sheltering other income from taxes? The answer depends on how the mortgage proceeds are invested. If the rate paid on the mortgage is higher than the rate earned on the investments, taking out a mortgage is a loser, regardless of what tax bracket you are in.

Suppose, for example, your mother borrows $100,000 at 6% to invest the proceeds at 5%, and she is in the 40% tax bracket. Then her interest cost in year 1 is about $6,000 less the tax saving of $2,400, or $3,600. Her interest income is $5,000 less the tax liability of $2,000, or $3,000. Net she is $600 in the hole.

A more refined analysis would take account of mortgage costs other than the rate, including points (which are deductible) and other settlement costs that are not. It would also take account of the risk of loss on other investments. The conclusion would not change, however, because both of these factors would add to the net loss.

The moral is very clear. It is never sensible take out a home mortgage for tax reasons alone unless you have investment opportunities that provide risk-adjusted yields that are higher than the cost of the mortgage.
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