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The Mortgage Interest Tax Deduction

The federal tax law encourages homeownership in a big way by allowing homeowners to deduct from their income taxes the interest they pay on home mortgages.

The deduction may be used for mortgage debt totaling $1 million, and up to $100,000 in home-equity loans or lines of credit, for a principal and second home.

One study estimates that the mortgage interest deduction lowers the cost of capital for owner-occupied housing by 7 percent. Also, by allowing taxpayers to deduct mortgage interest from their taxable income, but not rental payments, the tax code creates a strong financial incentive to buy rather than rent a home.

In 2009, about 35 million households claimed the deduction, and more than 75 percent of homeowners have used the deduction at least once.

As you might expect, the mortgage interest deduction is expensive. Indeed, it’s one of the largest tax breaks in the tax code, costing about $80 billion per year. That’s why the so-called “Gang of Six,” a bipartisan group of six senators that has been drafting a deficit reduction plan, has called for changes in the deduction.

The six senators’ draft plan states Congress should “reform, not eliminate … tax expenditures for homeownership.”

The group has not provided any concrete proposals on how the home interest deduction should be changed, but many are already on the table.

For example, the Obama administration has proposed limiting the value of the deduction for taxpayers in the top two tax brackets: 33 percent and 35 percent. These taxpayers would not be allowed to use the deduction to reduce their income in the top two brackets.

In effect, this converts the deduction to a 28 percent tax credit for these upper-income homeowners. Homeowners with incomes below $250,000 would generally not be directly affected by this proposal.

Other proposals call for limiting the deduction to homes worth $500,000 or less, rather than the current $1 million limit, and eliminating it entirely for second homes. Others contend that the deduction should be phased out entirely in return for lower tax rates for everyone.

What happens if the mortgage interest deduction is “reformed”? The National Association of Realtors says eliminating the deduction entirely would cause a 15 percent decline in the value of homes across the nation.

In high-cost areas, that impact would be greater, while in lower-cost areas the effect would be less. Obviously, the impact would be less severe if reform short of total elimination of the deduction is enacted.

On the other hand, some claim that reforming the deduction wouldn’t be such a big deal. After all, the average home interest deduction is only about $2,000 per return. It’s primarily upper-income taxpayers who would be affected.

Households earning more than $200,000 a year account for less than 10 percent of all returns filed, but account for 30 percent of all the tax savings from the home interest deduction. Households earning more than $100,000 a year get 69 percent of all the tax benefits from the deduction.

The mortgage interest deduction was adopted more or less by accident back in the 1890s. Since that time it has become one of America’s best-loved tax breaks. Anyone looking to greatly change it will be in for a fight.