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To Mess or Not Mess With the Mortgage Interest Deduction


That is the question…

I’ve been trying to avoid writing about this subject for a week or two now, mainly because it’s so controversial, so overanalyzed, and really hard to sum up in one neatly edited post on this website.

Aside from that, one’s opinion of the mortgage interest deduction will surely be swayed by whether or not they own a home, if they have a mortgage on said home, how much money they make, if they itemize deductions, if they’re a realtor or a homebuilder, and so on.

But first a little background on the mortgage interest deduction, known as the MID.

Currently, homeowners are able to deduct mortgage interest on both primary residences and second homes, just as they are real estate property taxes.

However, in order to take advantage of the MID, homeowners must itemize their deductions, and those deductions must exceed the standard deduction to actually benefit the homeowner.

Secondly, there are caps on the MID – only the first $1 million of home acquisition debt is deductible ($500,000 if married and filing separately).

And for home equity debt, only the first $100,000 is deductible. There are a lot of finer details, but I don’t want to derail the conversation into complicated tax topics. Save that for your CPA.

What the Mortgage Interest Deduction Costs

Now let’s talk about cost. The MID is reportedly the largest deduction in the tax code, accounting for $470.4 billion in tax deductions in 2008, per the Reason Foundation.

In 2008, itemized tax deductions totaled $1.26 trillion, with 36% of that total coming from the mortgage interest deduction.

Put simply, the MID costs the government billions upon billions each year, maybe even close to $100 billion in lost revenue annually.

For this reason, the MID has a giant target on its back, as the government scurries to balance their books before the impending fiscal cliff.

By the way, the Reason Foundation is decidedly against the MID, and actually believes it should be eliminated entirely.

Who Benefits and Who Doesn’t?


Not everyone enjoys the widely beloved tax break. In fact, only a small subset of the population can take advantage of it.

Obviously, those who rent apartments or homes see no benefit. And those who have already paid off their mortgages, but own, see no benefit, at least, not anymore.

Additionally, those who are close to paying off their mortgages see little benefit, as interest is front-loaded on mortgages, so savings are mainly experienced early on.

Interestingly enough, those who opt for interest-only mortgages or serially refinance their mortgages benefit the most from this deduction.

So one could argue that those who actually strive to pay off their mortgages don’t stand to benefit as much from the MID.

On top of that, only about 33% of taxpayers itemized their deductions in 2009, and of those, 20% did not take advantage of the mortgage interest deduction, per Reason.

As you can see from their tax table above, young wealthy homeowners stand to benefit the most from the MID.

In short, they’ve got the biggest mortgages, the highest tax bracket, and pay the most interest as a percentage of their total mortgage payment because their loans are so fresh.

Artificially Inflated Home Prices?

The Reason Foundation cites three main reasons why they are against MID, including the argument that it doesn’t increase homeownership, that it promotes the use of mortgage debt, and inflates homes prices.

Of course, their mid-2011 study is well-timed, considering the horrendous housing crisis that took flight just years earlier, effectively wiping out recent homeownership gains.

The Reason researchers also dispel the myth that getting rid of it would reduce home prices by as much as 15%, a claim made by the National Association of Realtors.

Instead, they believe it only props up prices by three to six percent. The disparity reflects including homes at all price points, not just higher priced homes.

But that’s still no incidental number.

There are a ton of figures and well-groomed stats out there, all of which serve different agendas.

If you look at the National Association of Realtor’s website, they’ll tell you that 65% of homeowners who claim the MID make less than $100,000.

They’ll also tell you that repealing the MID is a tax increase, which will hurt families with children the most.

And that homeownership leads to cleaner communities, better educated children, less crime, etc., etc.

For the record, NAR is one of the biggest supporters of the MID, largely because it makes home buying more attractive, which real estate agents tend to like…last I checked.

Or take the National Association of Home Builders, who argue that the MID has been in the tax code for nearly 100 years.

Why would it all of a sudden need to be purged from tax policy? Surely we’ve balanced budgets before.

Is Now the Time to Tinker?

Clearly there are some decent arguments for making changes to the mortgage interest deduction, which effectively subsidizes housing, but you have to wonder if right now is the time to meddle.

In case you hadn’t noticed, the housing recovery is far from “for real,” and just one wrong turn can set off a whole other downturn.

There have been several proposals for changes to the MID, including a lower cap at say $500,000 instead of $1 million and/or a tax credit, or the elimination of the deduction for second homes and HELOCs.

While all the plans may have merit, they all come with consequences as well, including near-term, unknown damage to the housing market.

In other words, the changes might be bad for home prices now, but ideally good for them later, especially if the economy is healthier.

The question is whether the housing market can stomach such a change at the moment, at a time when the government is doing all it can to prop up sagging prices.

Heck, the housing market isn’t exactly humming along, even with the intense manipulation of mortgage rates.

And if the MID is messed with now, and results in lower home prices, even if less severe than the doomsayers fear, the result could still be material.

We’re talking millions of homeowners who just got above water grabbing for their snorkels again, or just giving up and mailing in the keys.

Even if changes to the MID target the wealthy, they could have far-reaching unintended consequences that affect homeowners at all price points.

For example, a retiree with no mortgage would feel the brunt when it came time to list their home…for less.

And middle-class homeowners in pricier metros throughout the nation would have less incentive to buy than rent, despite everyone thinking, “they’re rich anyway.”

There’s also the emotional loss of the MID, which could scare away prospective buyers, even if they didn’t stand to lose anything at all.

To sum it up, the hope is that whatever changes do come are gradual and well conceived, as to not set off another firestorm in the housing market.

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