The possibility of eliminating the mortgage interest deduction on primary residences continues to draw interest in the nation’s capital. While most housing analysts believe the chances this will happen are remote, consumers have been interested in knowing the most popular alternative to the present plan.
Under present law, homeowners with a mortgage may deduct the amount of interest paid on a first or second home (interest allocable to up to $1 million in mortgage debt) plus interest paid on up to $100,000 of home equity loan debt. The proposed new plan offers a 12 percent mortgage interest tax credit.
With the help of the National Association of Home Builders, let’s look at the basics. The amount of the home mortgage interest deduction is added to other permitted itemized deductions, such as expenses for real estate taxes, charitable contributions, and state and local income/sales taxes.
However, if the sum of these itemized deductions is less than the permitted standard deduction, then the standard deduction is used in lieu of these itemized deductions because it offers a better deal. In 2010, those standard deductions were $11,400 for married taxpayers filing a joint return and $5,700 for single returns.
First, let’s assume that a married couple has sufficient non-mortgage-related itemized deductions such that they would itemize their taxes even without a deduction for mortgage interest. Hence, they would not claim the standard deduction. The couple owns a home and faces a 25 percent marginal tax rate. They paid $6,000 in mortgage interest in the year.
In general, the deduction for mortgage interest will reduce their final tax liability by $1,500 ($6,000 multiplied by 0.25). The actual amount would depend on other itemized deductions and how close they are to the next tax-rate bracket.
Alternatively, if the deduction for mortgage interest were converted into a 12 percent tax credit, the taxpayer would calculate the credit instead of claiming the deduction. The value of the tax credit would equal $720 ($6,000 multiplied by 0.12). This tax credit is then used to reduce final tax liability.
This example assumes all other tax rules are held constant. Obviously, if other tax provisions are changed so would a taxpayer’s overall picture.
The present mortgage interest deduction is not a dollar-for-dollar tax deduction; it reduces taxable income. The 12 percent credit proposal would be for mortgages only up to a certain limit, say $500,000. Under the 12 percent proposal, not only would interest on home equity loans no longer be tax-deductible but taxpayers would also lose deductions for state and local property and income taxes.
If the mortgage interest deduction goes on the chopping block, most analysts believe it would start with second homes. Now, consumers may deduct mortgage interest on two residences. Some consider that to be a luxury — something the nation cannot afford in these economic times.
Others believe any incentive — perceived or real — that would rekindle the housing market is dearly needed. Many second-home owners already rent out their homes for at least a few days a year, so making the conversion from a "qualified" residence to a rental would not be a major transition.
The National Association of Home Builders (NAHB) and the National Association of Realtors (NAR) are vehemently opposed to dropping the mortgage interest deduction. The two huge organizations employ influential lobbyists who have hounded legislators since word of an alternative surfaced.
"While we commend the hard work of the president’s deficit commission to improve the nation’s fiscal situation, this is simply the wrong approach to the problem," Bob Jones, chairman of NAHB, said in a press release.
"It would put a huge tax increase on millions of middle-class homeowners by eliminating or devaluing the mortgage interest deduction. The consequences would be devastating for housing and the economy. This would further depress home prices, putting countless more homeowners underwater and triggering a new wave of foreclosures."
Before 1987, mortgage interest on all residences could be deducted without limit. Since then, consumers with more than two residences are required to choose two "qualified" residences where mortgage interest could be deducted, but the selected residences are allowed to be juggled into the "qualified" category from year to year.