This is one secret that needs to be revealed for first-time homebuyers. A mortgage credit certificate is an assistance program that saves a homeowner some serious money over the life of their mortgage loan, starting the very first year.
Mortgage originators can use this program to help first-time homebuyers take advantage of a special federal income-tax credit based on mortgage interest paid annually. This tax credit can reduce potential federal income-tax liability, creating additional net-spendable income — which borrowers may use toward their monthly mortgage payment.
Once a mortgage credit certificate (MCC) is issued, the homeowner can file for credit on their federal income taxes equal to a portion of the annual mortgage interest paid. An MCC offers a dollar-for-dollar reduction in federal income tax liability.
These tax credits can help put extra cash in the borrower’s pocket each month so the borrower can more easily afford the housing payment. Although alike in theory, a tax credit is not the same as a tax deduction. A tax credit reduces the tax owed while a tax deduction reduces taxable income.
An MCC provides a tax credit, based on a percentage (as determined by the program guidelines) of the mortgage interest paid annually. The tax-credit rate is set by the MCC provider (usually the local city, county or state housing-finance agency), and the MCC benefit can equal 10 percent to 50 percent of the annual first-mortgage loan interest paid.
The MCC remains in effect for the life of the mortgage loan, so long as the home remains as the borrower’s principal residence. The amount of the annual mortgage credit is calculated on the basis of the tax-credit rate (i.e., 20 percent) of the total interest paid on the mortgage loan for that year. The mortgage interest credit is a non-refundable tax credit, so the homebuyer must have tax liability in order to take advantage of the tax credit.
Buyer benefits
Let’s look at some of the benefits. In this example, assume the first mortgage is a 30-year fixed-rate mortgage with a loan amount of $300,000 at a 5 percent interest rate. The borrower would pay $15,000 in mortgage interest the first year of ownership. If the MCC tax-credit rate were 20 percent, then the credit for the first year would equal $3,000 (20 percent of $15,000).
If the MCC tax-credit rate is above 20 percent (as it is in some areas nationally), then the maximum annual credit allowed by the IRS is set at $2,000. If the MCC tax-credit rate for the program is at or below 20 percent, there is no maximum dollar amount.
In this case, if the MCC was 30 percent at the time of purchase, then the borrower would be subject to the maximum of $2,000 each year. Since, the tax-credit rate is at 20 percent, the borrower could utilize the full amount of $3,000.
That $3,000 can directly reduce the overall amount due to the IRS. If the borrower owes $5,000 in taxes, they would be able to reduce it to only $2,000 owed by applying the $3,000 MCC tax credit. The borrower does not receive $3,000 as a rebate. They must owe the IRS in order to apply the $3,000 credit at the end of the year.
In this example, the tax credit converts to $250 per month ($3,000/12 months) which can be used in mortgage qualification. For Federal Housing Administration (FHA) and conventional loans, the underwriter can add $250 per month in additional disposable income, which helps reduce the borrower’s debt-to-income ratio. For Veteran Affairs (VA) loans, the $250 can be added to the residual income to meet the VA minimum residual-income requirement. For U.S. Department of Agriculture (USDA) loans, $250 would be treated as a deduction from the monthly payment, which is underwritten as a reduction in principal, interest, taxes and insurance.
While the tax credit is redeemed annually on the borrower’s federal taxes, the borrower can realize the benefit much sooner by increasing their withholdings on their paycheck. The borrower will want to adjust it so that they will owe the IRS at the end of year, thus taking home an extra $250 per month (as in the example provided above).
In this scenario, the borrower will need to owe the IRS $3,000 at the end of the year to get the full benefit of the available MCC credit. In California, the savings could be as high as $500 per month in high cost areas such as Orange and Los Angeles counties. (This MCC calculation is an estimate only, and is not intended to be tax advice as savings may differ from an individual’s final MCC credit.)
Because after-credit interest paid on the mortgage is reduced, the MCC effectively reduces the interest rate in the first year. Without an MCC, the annual interest of 5 percent on $300,000 would be $15,000. With the MCC, the annual interest amount would be $12,000, which in effect corresponds to a 4 percent interest rate on the same $300,000 mortgage in the first year.
Rules vary
Various cities and counties as well as certain state housing agencies can apply for authority to issue MCCs to low- and moderate-income homeowners. Each MCC provider determines the percentage of their MCC program based on their needs and any caps set forth by their governing state authority.
The MCC benefit in California can equal 15 percent to 20 percent. As mentioned, if the MCC tax-credit rate is above 20 percent (as it is in some areas nationally), then the maximum annual credit allowed by the IRS is set at $2,000. If the MCC tax-credit rate for the program is at or below 20 percent, there is no maximum dollar amount, and because of this, many MCC providers offer a tax-credit rate of 20 percent for their programs.
Some other MCC providers include Colorado Housing and Finance Authority, Golden State Finance Authority and the City of Los Angeles MCC — all of which offer a 20 percent tax-credit rate. The Texas Department of Housing and Community Affairs offers a 40 percent tax-credit rate, which is capped at $2,000 annually.
Some housing-finance agencies that offer first mortgages may have differing mortgage-qualification overlays or restrictions. The California Housing Finance agency, for example, allows MCCs to be issued with first mortgages; however, an MCC may not be used for qualifying purposes on California Housing Finance Agency first mortgages.
Among the MCC eligibility requirements, applicants must be first-time homebuyers, which means they have not had ownership interest in a home in the last three years. Three years of federal tax returns are typically required to verify this. There are exceptions to the first-time homebuyer requirement for veterans and homes located in targeted areas.
Borrowers also must be within the MCC program’s income limits, and they must live in the home as their primary residence for the entire term of the loan. The income limits are based on household size at or below a certain percentage of the area median income (AMI). In California, for example, the MCCs are typically available for up to 115 percent of the AMI or up to 140 percent of the AMI in federally designated target areas and/or high-cost areas. The MCC provider also will have sales-price limits, usually established by the county in which the property is located.
Plan carefully
If the amount of MCC credit exceeds the homebuyer’s tax liability or the annual limit of $2,000 (for MCC rates above 20 percent), the unused portion of the credit may be carried forward for up to the next three years, or until used, whichever comes first. The borrower may want to consider amending their W-4 withholding form on file with their employer to allow for the maximum benefit of the
MCC tax credit.
The effective interest rate assumes the borrower is able to take advantage of their full MCC credit the first year. If the borrower does not owe the IRS at the end of the tax year, they do not receive the credit.
Homebuyers are encouraged to consult with a tax adviser and employer to help them with the necessary tax forms and, if they so choose, to properly adjust their tax withholding via the W-4 form. There are application fees for the MCC program, which may vary by the MCC administrator; however, the potential tax savings over the course of a 30-year mortgage far surpasses the fee.
Although uncommon, recapture tax may apply under certain conditions within the first nine years of homeownership. The recapture tax is designed to “recapture” some of the financial benefit of the MCC if three separate conditions all occur. Those are the following: the home is sold within nine years, the recipient’s household income rises significantly and the value of the purchased house rises significantly.
A borrower will not lose the ability to use the annual MCC if they refinance their first-mortgage loan. They can still receive the benefits of the MCC and refinance their loan at any time without the potential for recapture tax.
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MCCs shouldn’t be a secret. The program should be a necessary part of the education process for first-time homebuyers, if they qualify. These homebuyers only have the opportunity at the time of purchase to apply for the MCC. Once approved, they will get a long-term benefit to use the tax credit each year based on the mortgage interest paid for the life of the loan. This is huge savings for the borrower and will help the originator in maintaining their relationship as they can remind their borrowers annually.
