Michael on July 16th, 2007
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You: When someone tells me that they don’t care about an expense because it’s tax-deductible for them, does that mean that the expense is basically free?

Although a tax-deductible charge reduces your taxes, the expense is not free. The tax savings provided by the deduction means the true cost is less than if the item were not tax-deductible. Still, it is always more financially advantageous to avoid the expense entirely.

You: Huh?

Yeah, exactly.

You: Okay, so let’s move away from the hypothetical. My show-off boss tells me he recently finished building a vacation home in the mountains. However, he just learned that the property tax on his nice, new, and expensive home is very high. But boss man says he doesn’t care about the property tax because he just writes it off. Whoa! Does that mean he basically pays no property tax since he gets it all back as a deduction on his tax return? That’s not fair.

I agree—it’s not fair. Also, it’s not true.

It’s a common misconception that a deduction, such as the one for property tax, reduces your income tax by the amount of the deduction. False! Take your boss’s tax situation:

Property tax on mountain home: $10,000
Top income tax rate: 28 percent
Taxable income prior to new mountain home: $150,000

Let’s see what changes as a result of his new property tax deduction. To determine his new taxable income of $140,000, subtract the $10,000 property tax write-off from his $150,000 of taxable income. Make sense?

You: So far.

Let’s keep going. Before the home, he and his wife’s tax bill was $30,992.50. Afterwards, his tax bill will be $2,800 less or $28,192.50.

Next, compare your boss’s combined expenses for income tax and property tax:

Before the purchase:

$30,992.50 Income tax
After the purchase:

$28,192.50 Income tax

+ $10,000.00 Property tax
——————————-

$38,192.50 Total tax

His total tax expenses increased by $7,200. If he thought his write-off made his new property tax expense essentially free, he was wrong. There are definite savings from tax-deductible expenses—in this case $2,800—but they are not dollar-for-dollar savings. A write-off does not make an expense free.

Clearer now?

You: Wow, I don’t think my boss realizes that.

Perhaps not. He wouldn’t be alone.

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