Many people have written me asking: “What is the difference between a tax deduction and a tax credit?” They are confused about this issue. There is also an important distinction based on the source of the tax deduction, as in your home mortgage interest vs. your rental property mortgage interest deductions which are treated differently.
Today I hope to clear up these issues so your taxes are more understandable. The most important thing to remember is where these deductions and credits are used on your tax forms. That makes all the difference in the world in their value and here is why.
Tax deductions lower the income that your taxes are calculated on. First you add up all your income to come up with your Adjusted Gross Income (AGI) found on form 1040 line 11. Then you subtract your deductions from this AGI on form 1040 lines 12 and 13. This leaves you with your Taxable Income on line 15.
Tax deductions are based on your tax rate. For example, if your effective tax rate was 24%, then your benefit will be 24% of your deduction. If someone had a $10,000 tax deduction, with an effective tax rate of 24%, they would save $2,400 in taxes, or 24% of the tax deduction.
Tax credits are directly subtracted from the tax bill. So, after calculating the tax you owe on form 1040 line 16, you subtract your tax credits to arrive at the net taxes owed. Different tax credits are deducted on various lines on form 1040. Since tax credits are deducted after the total taxes have been calculated, they provide a benefit of 100% of the credit. If you have a $10,000 tax credit, you will save $10,000 in taxes. This is about four times more powerful than a tax deduction of the same value, depending on your tax bracket. As you can see, tax credits are more powerful and valuable than tax deductions.
For those of you who are visual, here is a chart showing the difference a tax credit and deduction make for someone with an adjusted gross income of $250,000 using the actual federal tax tables. This assumes they did not have the deduction limited, which is a problem I will discuss below.
|Tax to pay||36,183||43,783||46,183|
The source of your deduction also contributes to its power. Your home mortgage is deducted on Schedule A line 8. Unfortunately, schedule A is not very powerful. Since the standard deduction is $24,800 for a married couple in 2020, only the amount of the deduction that exceeds the standard deduction actually has a benefit to you.
If the home mortgage interest and the other deductions you have do not total more than $24,800, you do not get any benefit at all from the deduction. This is the case for 90% of Americans. Since 90% of Americans take the standard deduction, they get absolutely no tax benefit from the interest paid on their home mortgage. Even though almost 100% of these people think they are gaining a benefit from that great home mortgage interest deduction their banker told them about. More than 60% of the population has a home mortgage, but only 10% of the total population gets a deduction for their home mortgage interest.
If you are a high earner, your deductions on Schedule A have even more limits placed on them. Married couples with new mortgages can only deduct the interest on the first $750,000 of the loan. In addition, if their Adjusted Gross Income is more than $313,800 then the deductions will be limited even more.
If the interest deduction is for a mortgage on a rental property, the deal is better. This interest, which is deducted on Schedule E line 12 and 13, is fully deducted from your rental income. If you do not have enough rental income to cover the deduction, the remaining deduction will be carried forward to be used against future rental income. So the interest deduction on your rental property will always be deducted in its entirety from your taxes.
This makes the decision easy as to which mortgage to pay off first when deciding between the home mortgage and the rental property mortgage. The rental is fully deductible, but the home mortgage deduction is limited and could even be zero. So pay off the home mortgage first when you are working to get out of debt. I wrote a blog about paying off the home mortgage vs. the rental mortgage in more detail that can be read here.
So remember, tax credits yield a better tax benefit than tax deductions. Your deductions might not be a deduction at all, merely the illusion of a deduction. Don’t be fooled.