Eliminating the Mortgage Interest
Deduction Now Would Be a Disaster

Losing the Mortgage Interest Deduction

Most homeowners take for granted the ability to deduct mortgage interest paid from their taxes, but they shouldn't. At the federal level, the idea of eliminating this deduction has been in discussion on-and-off for years. When California's state legislature began formal consideration of eliminating the mortgage interest deduction at the state level earlier this year, it sparked anew the debate.  Now, President Obama's Deficit Reduction Commission has brought it up again at the federal level.

What is it?

The Mortgage Interest Deduction is a tax break that homeowners get from the IRS. There are three basic types of interest you can claim as a deduction on your tax return.
 

• Mortgage Interest paid on first or second homes with loan amounts of up to $1 million
• “Points” paid to get the loan in the first place (some are deductible in the year you pay them, some are deductible over time)
• Home Equity Loan (or Line of Credit) Interest paid on first or second homes – up to $100,000 so long as the total debt (mortgage + home equity) does not exceed the fair market value of the home

[Note on “second” homes: Even if you have more than one “second” home, you can only claim one of them as your second home for purposes of this deduction. Also, you must use your “second” home at least part of the year to qualify for the deduction. If you rent it out 100% of the year, you cannot claim the deduction.]

Other deductible payments under this law:

• Pre-payment and late penalties

Payments you cannot deduct

• Service fees such as for appraisals & inspections

How Does It Work?

For most homeowners, this deduction is fairly straightforward. Generally, you should receive a Form 1098 from your lender. That form should arrive by January 31st for the previous year, and a copy is sent to the IRS too. It will show you all of the points and interest paid that you can deduct. However, it might not show all possible deductions and there are many “exceptions” and “special circumstances” that may apply to you. Therefore, you should talk to your accountant and read the IRS publication here: http://www.irs.gov/pub/irs-pdf/p936.pdf

How It Works At The State Level

If your state has a home-mortgage interest deduction, the way it likely works is that your income for tax purposes is lowered based on the federal deduction. If your state does not have this deduction, then your income for state tax purposes is higher.

Why Do We Have It?

The mortgage interest deduction is something like a legend in America. The commonly accepted explanation is that it was created to help make homes more affordable for more people. That, however, may be a bit of a myth.

What seems to be closer to the truth is that homeowners can thank business interests for the home mortgage interest deduction. In the early days of our tax code, all interest was deductible by those who paid it because it was considered an “expense” of doing business, and it was pure income to someone else, namely the lender.  In fact, the policy of allowing the deduction of interest was a benefit almost exclusively of business interests, since, until the 1950s, most homes were purchased without loans.

Despite questions about its original purpose, the reality is that the home mortgage interest deduction is now very important to millions of homeowners in America. Not only do we rely on it (and even look forward to it at tax time) but it helps us afford more expensive homes than we otherwise could.
Will It Be Here Forever?

Maybe and maybe not. Economists and lawmakers (both Republicans and Democrats) at the federal as well as the state level have suggested more than once that we should either eliminate or reduce this deduction. Those in favor of changing the laws regarding this deduction are considering the following possible scenarios:

1. Eliminate the deduction altogether (either all at once or gradually)
2. Reduce the amount of the deduction to focus on the “middle class” more and the “wealthy” less. This could take different forms:
   a. A national “cap” that is lower than the current $1,000,000 plus the $100,000 in home equity debt and/or
   b. Regional caps based on FHA conventional loan limits, where more expensive areas such as California have higher limits than lower-priced ones.

Arguments To Eliminate Or Reduce It

1. Despite the myth, it does not have a significant impact on home ownership rates.
2. Allowing the deduction for home equity loans (which people can spend on anything) means taxpayers can avoid the tax on personal interest loans.
3. It disproportionately favors high-income taxpayers.
   a. While a middle-class person certainly enjoys a savings of $2,000 or so, a wealthy homeowner really enjoys a deduction of $20,000.
   b. Most taxpayers don’t benefit at all – especially those with modest incomes. Renters don’t take it (of course) and lower-income homeowners don’t benefit because their standard deduction is higher.
4. The increased income to the federal government would offset losses in other areas (such as revisions to the problematic Alternative Minimum Tax).
5. The deduction inflates home prices (because with the deduction, people know they won’t really pay 100% of the interest) so eliminating it or reducing it would make homes more affordable.

Arguments to Keep It

1. It’s VERY popular.  Once you are a homeowner, if you take the mortgage interest deduction, it likely is your biggest one and often puts you over the threshold allowing you to claim other deductions (as opposed to just taking the standard deduction allowed to all).
2. If businesses can deduct interest as an “expense” why not homeowners?
3. Taking the deduction away from homeowners may lead to MORE real estate speculation by investors who would continue to enjoy the interest deduction as a business.
4. Even for very modest incomes & mortgage levels, the money saved can be important.
5. It could hurt the second home market.
6. It makes real estate agents and mortgage brokers happy.

What Happens If It Goes Away?

Many economists say that if the deduction were to disappear, home prices would adjust downward to absorb the difference. Lower prices means more homes are more affordable to more people. So, it’s a good idea, right? Well, maybe, but eliminating it “cold turkey” would mean many homeowners will be hurt in the process. Consider this example: if you have a home that today is worth $200,000 and you have a loan of $160,000, you are fine because you have 20% equity. Now if home prices were to drop by 15% (which is what some economists estimate) due to the elimination of the mortgage interest deduction, your home is now worth $170,000 and your debt level is 94% and you only have 6% equity. That’s a problem. Therefore, repealing it suddenly would not make sense. If the deduction is repealed, it is likely to happen gradually over a period of many years.

Who Benefits From The Deduction (And Who Would Lose If It Disappeared)?

At some level, all homeowners with mortgages benefit.  How much depends on the size of their mortgage and its cost relative to their income and other expense. Others who don’t want to lose it include:

• Homebuilders – because it helps them sell bigger, more expensive homes
• Retailers – from lost consumer debt-based spending
• Over-extended homeowners (thus the need to remove it gradually if at all)

How Much Does It Cost The Country In Lost Tax Revenue?

Estimates range from $76 billion to over $400 billion (lower end if just counting US Treasury (federal level), higher end if including costs to state governments).


Has Anyone Actually Proposed Changing Or Ending It?

Yes – Proposals have been made recently at both the federal and state level:

• President George W Bush assembled a bipartisan Tax Reform Panel in 2005. In their report they suggested getting rid of the mortgage interest deduction as we know it and replacing it with a smaller tax credit for all homeowners (not just those who earn enough to itemize). The deduction would be limited to 15% of interest paid, it would apply to primary residences only and it would have a cap based on average regional home prices. For the full report, click here: http://www.taxreformpanel.gov/final-report/
• Now, President Obama's deficit reduction commission has also proposed elimnating the mortgage interest deduction under some circumstances.  Although that commission's proposal is still in formation at this time, the subject will be very contentious in the new session of Congress.

• In California, Governor Schwarzenegger as well as Democratic leaders in the legislature have indicated that they are willing to “close tax-loopholes” in order to balance the budget. However, they have not been very specific about which loopholes. Republican legislators in Sacramento, for their part, have vowed that ending any loophole is really a tax-hike and they will oppose it. The state’s nonpartisan Legislative Analyst’s Office supports changes – though not necessarily eliminating – the mortgage interest deduction. The two main arguments they make are: 1) at $5 Billion (yes, with a “b”) lost to state revenue each year it is more than some other states collect in total, and 2) nearly 50% of the benefit goes to the richest 10% of Californians. They suggest that there are better ways to make homeownership more affordable. Also, they note that the legislature could offset any reduction in the Mortgage Interest Deduction by reducing state income tax rates. This, of course, would not help the budget picture for the state. To read this section of the LAO report, click here: http://www.lao.ca.gov/2007/tax_expenditures/tax_expenditures_1107.aspx.  For the LAO’s homepage, go to: www.lao.ca.gov

   

Do Other Countries Use It?

Some, but not all, industrialized countries have some version of the tax. In addition to the US, Sweden, The Netherlands and Switzerland have some form of home mortgage interest deduction. However, Britain, Canada and Australia don’t, and they have homeownership rates about the same as in the US.

The Bottom Line

The Mortgage Interest Deduction is not only very popular, but it is genuinely financially important to many American homeowners. Therefore, most of the serious discussion is centering around the following ideas, if the deduction is to be altered or eliminated, at either the federal or state level:

• It should be replaced by an alternative homeownership credit that does a better job of increasing homeownership rates;
• It must be done gradually and/or with a “grandfather” clause so that current homeowners are not hurt;

• Any “caps” based on home prices must be realistic and accurate.