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How The Mortgage Interest Deduction Can Be Cut, Sliced & Diced

Is it time to end the mortgage interest deduction? For the first time in years the question is a matter of serious debate in Washington.

Right now residential mortgage interest deduction (MID) is generally allowed on first- and second- home debt worth as much as $1 million plus an additional $100,000 for a home equity line of credit (HELOC) or a second loan in general.

For instance, if you have a 3.5 percent mortgage rate and $1 million in qualified borrowing you could reduce your taxable income by $35,000 ($1 million x 3.5 percent). If you’re in the 40 percent bracket for combined federal and state income taxes you would save $14,000.

One idea is to simply lower the allowable deduction. Two years ago the Simpson-Bowles report (a report from the bi-partisan National Commission on Fiscal Responsibility and Reform) suggested a $500,000 cap on qualifying residential debt with no write-offs for second homes or HELOCs.

And, indeed, allowing deductions on residential debt of as much as $500,000 would work for most borrowers if only because the typical home sells for $178,700 according to the National Association of Realtors.

At this point you will hear shouts of pain and outrage by those who believe the mortgage interest deduction is sacred, something left to us by Washington and Jefferson.

It wasn’t. We only started income taxes — and deductions — in 1913 with the passage of the 16th Amendment.


Balance 

It is now possible to seriously talk about an MID reduction for two reasons. First, the government is starving for money — a condition which actually elates some voters and politicians who worry that government is “too” big. Second, with mortgage rates now at or near historic lows there is less to write off and thus less taxpayer pain if the deduction is reduced.

So, how might we revise the mortgage interest deduction?

We don’t want to make it too low — say zero or $100,000 — because too many homeowners would be impacted. That would be politically impossible.

But, we want to do “something” that will show public resolve — without destroying home values in high-cost metro areas and with them the rest of the economy.

What we need is some magical arrangement that allows a smaller write-off than today but a reduction which does not impact too many people. In the spirit of such a quest I would suggest a new MID that looks like this:

  • Financing on first and second homes would be allowed (remember, if you get rid of the second home deduction you hurt many local economies along beaches and mountains as well as in resort areas).
  • An interest deduction would be allowed on total financing worth as much as the FHA loan limit for a single-family home in most areas — that’s currently $417,000.
  • Write-offs in the future would only be allowed for new FHA loans, VA mortgages, conventional loans and portfolio mortgages which were originated with a fully-documented loan application and where the cost of all points and fees is less than 3 percent of the mortgage amount. This would make toxic lending with no-doc loans virtually impossible.
  • Also, we should allow a write-off for an additional $100,000 for HELOCs and second trusts — this is money often used to pay for tuition, home repairs and business start-ups — all things we want to encourage.

In considering this issue let’s not forget that the tax revenue raised by lowering the MID has consequences to the extent that buying, selling and home repair are impacted. This is especially true in high-cost areas. What we gain in new MID revenues we might lose in the form of less construction, fewer jobs, etc. It’s hard to know where the balance is, except to say that a $517,000 cap seems financially, politically and practically possible at this time.

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