As we are approaching year end, a number of tax advice articles have appeared. One of the most discussed year-end tax saving strategy is to prepay January 2004 mortgage bill in late December so one may deduct 13 months' interest on mortgage payments instead of 12 months', provided the other circumstance of the household allows for itemized deduction. (See stories from BankRate.)
Here is how to quantify the baseline benefit of this strategy:
For example, if your January 2004 mortgage bill is $300 in principal and $1,000 in mortgage interest, by prepaying the January 1, 2004 bill on December 20, 2003, you only pay the opportunity cost of 10 days' worth of interest on the $1,300, but you can claim $1,000 more in deductions in the 2003 tax return, and that's worth $250 if you are in the 25% tax bracket. Note: You don't actually get an extra $250 out of the strategy; the strategy only helps you to move $250 worth of tax from tax year 2003 to tax year 2004, so the benefit is one year's interest of $250.
In summary, in this normal situation, you pay 10 days interest on $1,300 and you get one year's interest on $250. With an interest rate of 2% (you can get this saving rate from most Internet banks), it's about $5. It is small money indeed.
However, everyone's tax situation is different, and this strategy may mean substantial savings for someone or will backfire for another.
Scenario #1. You may reap substantial benefit if this year you file as itemized deduction and you knows for sure that next year you will file with standard deduction.
In this situation, if you pay your January mortgage bill in January, the $250 is your net benefit out of the strategy. Considering you only pay less than $1 in opportunity cost of interest, the return is massive.
Scenario #2. The strategy may backfire if you just bought your house. This scenario actually applies to me: I bought the house in August 2003 and I'll never have enough mortgage interest and property tax bill for 2003 to qualify for itemized deduction (that is, have more than $9,500 household deduction) no matter I prepay the January 2004 bill or not.
In this scenario, if I prepay the January 2004 bill without considering the consequences, I will actually lose $1,000 worth of deduction in the next tax year, which means the strategy will cost me $250.
BTW, the BankRate story also correctly pointed out that people need to consider exposure to AMT before adopting this strategy.