Tinker with the mortgage interest deduction?
As lawmakers continue to debate how to handle the nation's debt and aim to do "something big" rather than simply patch the problem, it seems probable that many broader tax reform issues may resurface during the course of negotiations.
One such issue is the mortgage interest deduction; one of the largest tax drains.
According to estimates, the deduction cost Treasury somewhere between $80 and $103 billion in 2010, and its value over the 10-year budget window is expected to exceed $1 trillion.
Let's examine arguments for and against reforming the deduction, reform proposals, and the projected effect of any changes on both taxpayers and the budget.
Background. Itemizing taxpayers can deduct mortgage interest on up to $1 million of qualifying acquisition debt on a qualified principal and second home.
This deduction reduces the after-tax cost of financing a home. In contrast, no deduction is permitted for renting a home.
Itemizers can also deduct interest on up to $100,000 ($50,000 for marrieds filing separately) of home equity debt, i.e., debt secured by a taxpayer's qualified residence, up to the fair market value of the home net of the amount of any acquisition debt.
Arguments for and against reforming the deduction. Proponents of the deduction argue that it encourages home ownership and makes it affordable for taxpayers who could otherwise not own a home.
Critics claim, in response that, rather than encouraging home ownership, the deduction actually encourages middle-class and wealthy taxpayers to take on more debt and buy larger homes than they otherwise would.
Further, critics argue that the deduction tends to benefit taxpayers with larger incomes who likely would have purchased a home anyway.
Critics also claim that the deduction artificially drives up home prices. However, this same argument is cited by proponents, who observe that eliminating the deduction could further impact home prices in an already depressed market.
It occurs to me that the effect of driving up prices, which both sides seem to agree occurs, may have contributed to the problem of "underwater" mortgages, where taxpayers owe more on their homes than the home is actually worth.
Proposals. A number of different proposals, including repeal, have been advanced regarding the mortgage interest deduction.
In general, the proposals tend to focus on converting the deduction to a credit, capping the maximum mortgage amount, or limiting the credit to a primary residence.
The President's Fiscal Commission proposed a 12% nonrefundable credit on up to a $500,000 mortgage, with no credit for a second residence or for home equity.
The Debt Reduction Task Force would have a 15% refundable tax credit capped at $25,000.
Other proposals suggest a 20% credit, whereas another is to simply have a fixed credit for owning a home, as opposed to having a mortgage.
President Obama's budget proposals suggested capping all itemized deductions, including mortgage interest, for taxpayers in the top two tax brackets (33% and 35%). Under the proposal, these taxpayers would only be able to reduce their tax liability by a maximum of 28%.
Economic effect. Given the amount of lost revenue, the effects of reforming or repealing the provision could be significant.
If repealed, the Urban-Brookings Tax Policy Center (TPC) estimates that the average tax bill of those claiming the deduction would increase by $710.
This increase would vary widely among taxpayers. Those with $30,000 to $40,000 incomes would face an average increase of $70, whereas taxpayers making over $1 million would face an average increase of $4,000.
However, given the popularity of the deduction and the strength of the real estate lobby, its outright repeal seems unlikely.
According to the TPC, replacing the current mortgage interest deduction with a 20% nonrefundable credit, limiting mortgages eligible for the credit to $500,000, and limiting the credit to primary residences would only have a nominal or positive effect on the majority of the tax bills of those who claim the deduction.
Again, those who would face the largest increase are taxpayers in the top tax brackets with the largest mortgages.
The economic effect of replacing the deduction with a flat credit for homeowners, mortgaged or not, would obviously depend on the amount of the credit.
In general, credits are considered more progressive than deductions, and the benefit of a flat credit to higher-income taxpayers would presumably be less than that under the current regime. However, the incentive towards home ownership would remain intact.
The Joint Committee on Taxation estimates that President Obama's proposal to limit upper-income taxpayers' itemized deductions to 28% would yield $293,261 million over the 2011 through 2021 period.
This increased revenue would be largely attributable to the limits on mortgage interest and charitable contribution deductions.
Conclusion. While it seems unlikely that the deduction will be repealed outright, it is possible that this popular tax benefit could be somehow reformed or curtailed.
The looming debt crisis may well provide the necessary push for lawmakers to take action.
What choices will be made and when remains to be seen—stay tuned!
