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Post-Fiscal Cliff, Should We Reform the Mortgage Interest Deduction?

Jan. 28, 2013
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In an effort to reform the tax code, our congressmen are expected to look at the mortgage interest deduction. It’s the biggest tax break available to many Americans; most save about $600 a year. Critics, though, suggest that we do away with it, primarily because the deduction effectively subsidizes wealthier homeowners.

There’s been heavy resistance to such a change in the real estate industry. Realtors are, of course, anxious that the deduction’s elimination would also remove one of the greatest incentives to homeownership.

Not all realtors are vigilantly pro-deduction. Kenneth Clark, a realtor at GetYourPHX, is a vocal critic. “There are many ways to find a way to reduce the deficit and debt and the National Association of Realtors is not helping in any way. Every time they send me a note to call my member of congress to preserve the deduction, I email my member and tell them to reform it.”

Why, Clark wonders, should RVs count as second homes and qualify for a tax deduction? The answers aren’t simple, and, in the end, it’s a question of how much of the tax burden you think America’s top-earners should shoulder.

How the deduction works

When we pay interest on our mortgage, we are allowed to deduct a portion from our taxable income. For wealthier consumers, then, this deduction is a way of putting income directly in the four walls around them; it’s prudent to do so, because it protects that cash from the IRS.

At the moment, taxpayers can deduct as much as $1 million on their first and second homes and up to $100,000 on home-equity loans. Your income tax bracket also determines how much you save. The top bracket in 2012 was 35%, and those taxpayers can generally deduct 35% of mortgage interest from their taxable income. For 2013, the top tax rate jumps to 39.6%, a result of the fiscal cliff agreement. At the other end of the spectrum, those making less than $8,700 in 2012 or $8,925 in 2013 ($17,400 and $17,850 if you file jointly) will receive only a 10% benefit.

To benefit from the deduction at all, though, you must make a decision when you file your federal income tax return: do you take a standard deduction or itemize your deductions? The former returns a flat amount to you, which hinges on your marital status, age and a few other factors (i.e. if you’re single, or if you’re married filing separately, etc.). For example, in 2011 the standard deduction for single filers was $5,800.

Itemized deductions break down your tax return by item: you apply for deductions on income you spent on medical care, state and local taxes, charity and our focus here: mortgage interest payments. Itemizing your deductions means saving receipts and cataloging your expenses, but for the relatively wealthy, it’s worth the effort. If they have an enormous home and an enormous mortgage to match, then they save quite a bit of cash with itemized deductions.

Deduction privileges expensive homes

Perhaps the most vital critique of this deduction is that it effectively subsidizes the rich. As we explained above, only the wealthy, who itemize their deductions, will see a real cash benefit.

And benefit they do. High-earning families save over ten times as much on their mortgages than the poor, found economists James Poterba and Todd Sinai in a study. To be precise, families making over $250,000 in a year saved $5,000 and those in the $40,000-$75,000 bracket saved about a tenth of that.

The government can’t tax that $5,000, and so they look for that revenue elsewhere; the deduction redistributes the tax burden, and it follows that renters and small homeowners pay for the tax break, if indirectly.

It’s no surprise, then, that Americans aren’t up in arms about anti-deduction litigation. In an August 2012 survey of 1,719 people, the Texas Trust Credit Union found that a full 65% said the elimination of the deduction wouldn’t diminish their interest in homeownership. Only 8% said that it would.

Deduction encourages debt

The deduction also encourages people to take on larger mortgages than they might otherwise. The larger the mortgage, the larger the interest payments and, most importantly, the more income homeowners can protect from taxation.

Some critics have argued that, in light of last decade’s subprime crisis, this facet of the deduction is most troublesome. I’m not entirely sure if those arguments are apt. Too much debt will always be too much debt, but I doubt we can lump subprime borrowers with the borrowers who benefit from the deduction.

Subprime borrowers are high-risk borrowers: they’re the ones with poor credit, who often ask for an especially hefty mortgage loan to buy a home. Last decade, some borrowed more than they could truly afford, especially after interest rates spiked, and so they defaulted. These are not the same folks who itemize their deductions — they’re not relatively wealthy.

That said, the spirit of this argument is true. We shouldn’t encourage Americans to borrow more than they can afford.

Replace the deduction with a tax credit?

A tax credit could be more progressive, were all homeowners able to claim it, regardless of itemization. The Tax Policy Center proposes four different credits. One, for example, calls for a uniform 20% return of mortgage interest paid in a year.

Such a credit would redistribute the tax burden. It would help low- and middle-income groups, according to the Tax Policy Center. It might even allow for greater discretionary income when such a thing is scant for many Americans.

It would, however, hurt the wealthy, who can claim as much as 39.6% of mortgage interest this year — 39.6% minus something called the Pease phase-out. This addendum to the tax code was passed by Congress earlier this year, and it cuts back deductions for only the wealthiest of the wealthiest. A married couple filing jointly, for example, need only be concerned about Pease if they make over $300,000 a year in gross income.

If this couple does hit that threshold, then the federal government will no longer be quite as generous with deductions and exemptions. They subtract a so-called “phase-out” from the total deductions that couple claims. The math is complex — and it varies from tax filer to tax filer, depending on their wealth and their deductions — but, usually, this phase-out tacks on a 3% charge to the super-wealthy’s federal income tax. It effectively raises their marginal tax rate from 39.6% to 42.6%. And it does so by clamping down on all deductions and exemptions — not just mortgage interest.

The future of tax deductions is more tenuous still. Senate Budget Committee Chairwoman Patty Murray has suggested curtailing deductions further, particularly for the top 2%. It’s their tax burden that’s at the heart of this discussion. For more information on that point — and for more information about the tax burden as a whole — look out for our forthcoming study.