What is the Mortgage Interest Deduction?

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One of America’s most beloved tax breaks is teetering on the edge of the fiscal cliff. The mortgage interest deduction, which allows homeowners to deduct mortgage interest from their tax bill, may be taking a nasty tumble come 2013.

The past

The MID in the United States was born in 1913 with the introduction of tax deductions. At the time, few Americans regularly paid interest on debts. There were no credit cards or student loans, and most people actually owned their houses. Business owners accounted for the bulk of interest paid throughout the States. Tax deductions were initially applied to all interest in order to curb business expenses and to bolster economic growth.

Over the past century, the landscape of our nation’s debt has changed drastically. Personal debt has become a simple fact of life. We are encouraged to live beyond our means and make up the difference when we can afford it. Few can claim to be free from credit card debt, student loans and mortgages. Paying interest has become both normative and necessary.

As debt evolved, so did tax deductions. The Tax Reform Act of 1986 greatly limited deductions on personal loan interest (including interest on credit card debt). With so many Americans now paying through debts, restrictions had to be placed on interest-based tax deductions. However, the Reform Act actually increased the MID in hopes of encouraging home ownership.

The present

Fast forward to 2012 and the looming “fiscal cliff.” At midnight on December 31, the terms of the Budget Control Act of 2011 are scheduled to take effect. A combination a tax increases and spending cuts, which aim to cut the deficit in half, could hinder economic growth and drag the nation back into a deep recession. The Budget Control Act includes items like the end of tax cuts from 2001 – 2003, the end of last year’s temporary payroll tax cuts and the beginning of taxes related to new health care legislation.

However, if the changes are canceled, the deficit will continue to grow, and the United States could find itself facing a very similar situation to the financial crisis in Europe. Neither outcome is particularly appetizing.

In search of alternatives for alleviating the nation’s tremendous debt, legislators are looking at potentially eliminating certain tax breaks. And, by the looks of it, the MID is a prime target.

The future

There are a number of ways to diminish the MID and thereby increase tax revenue. The changes being kicked around would primarily affect high-earners. For example, the MID could be eliminated for second homes or the cap on eligible mortgage debt could be reduced (currently $1 million). The Obama administration suggests capping deductions at 28% (down from 35%) for households that earn more than $250,000. The Treasury Department estimates such a cap would generate $584 billion in tax revenue over the next 10 years.

Not surprisingly, the real estate industry is staunchly opposed to lessening the MID. Realtors are concerned such a change would reduce the demand for housing in an already weak market. The National Association of Realtors propounds that knocking down the MID could reduce property value up to 15%. Others argue that MID cuts would only really affect top earners, who would buy homes regardless of the deduction.

Despite opposition from the passionate and persuasive real estate contingency, MID cuts are likely. Both Democrats and Republicans have shown recent support for lowering the caps on tax deductions. Though the change would disproportionately affect the wealthy, Republicans favor cutting deductions over raising taxes. Lessening the MID may very well become part of a compromise to avoid the devastation of the fast-approaching fiscal cliff.

Of course, tweaking the MID is far from a panacea for mending the nation’s finances. It could help, but it wouldn’t be a singular deus-ex-machina to save the US economy from certain destruction. At the very least, the willingness of both parties to consider MID cuts demonstrates a readiness to make the necessary sacrifices.