If desperate times call for desperate measures, the mortgage interest deduction — at least as we’ve known it since 1986 — could be in real trouble.
Everyone is looking for ways to cut the federal deficit and avoid the fiscal cliff. This will require both spending cuts and tax increases.
There are two main ways to raise taxes: raise the tax rates or reduce or eliminate tax deductions. The Republicans are dead set against raising tax rates for anybody, so reducing deductions may be the only option available to increase tax revenue.
One of the most expensive tax deductions is for home mortgage interest — the "MID" costs about $83 billion per year. There has been talk about cutting or eliminating the home mortgage deduction for years, but it has never gotten anywhere. Not only is the real estate and building industry staunchly opposed, the deduction also has broad support from the public.
There are two ways Congress could cut the home mortgage deduction: the direct way or the sneaky way.
The direct way would be to reduce the amount of the specific deduction. It could, for example, be limited to homes worth $500,000 or less, rather than the current $1 million limit. It could also be eliminated entirely for second homes. The most extreme measure would be to completely phase out the deduction entirely. Such direct attacks would be vigorously opposed by the real estate industry.
It’s more likely that Congress will go the sneaky route. Instead of specifically targeting the home mortgage deduction, a cap would be placed on all itemized tax deductions. The Obama Administration has already proposed capping such deductions at 28 percent for households earning more than $250,000. This would substantially reduce the value of the home mortgage deduction for high income taxpayers.
For example, under current law a taxpayer in the 35 percent bracket and deducting $25,000 in mortgage interest payments would receive $8,750 in tax savings. However, if the deduction was capped at 28 percent, the same taxpayer would save only $6,250.
Capping the home mortgage deduction — or reducing or even eliminating it — would not affect the great majority of taxpayers. Since the home mortgage deduction is an itemized personal deduction, it can’t be taken at all by the 70 percent of taxpayers who take the standard deduction instead of itemizing.
According to the Urban-Brookings Tax Policy Center, about two-thirds of the total tax savings from the home mortgage deduction go to households earning $100,000 to $500,000 per year.
Moreover, the deduction disproportionally benefits homeowners in wealthy cities and states where real estate prices are high. For example, the average per capita tax benefit for the 20,000 residents of Beverly Hills, Calif., amounts to $1,873, while the average benefit for the 20,000 residents of Clarksdale, Miss., is only $45.47.
Thus, reducing the deduction may come to be viewed as a way to reduce the deficit without harming the American middle class.