For decades, homeowners have been allowed to deduct the cost of interest paid on their mortgage from their federal tax bill, reducing what they owe the U.S. government.
Reducing or even eliminating this deduction has certainly been in the news in recent months, but is there a real chance that it could actually happen? And if so, who might be hurt the most?
Here's a quick update on the issue for anyone thinking about buying a home and wondering what a cutback or elimination of mortgage interest deductions would mean financially.
Why Might the Mortgage Deduction Change?
Let's start with the basics. Congress and the White House are looking for ways to lower the federal deficit. And popular items like the mortgage interest deduction are high on the target list for one major reason: They cost a lot. The government estimates that homeowning taxpayers save about $70 billion a year by deducting the interest on their loans from the income taxes they'd otherwise pay. To homeowners, that's $70 billion they're happy to have in their pockets. To a revenue-hungry U.S. Treasury, it's $70 billion that "got away."
Some context here: There are hundreds of deductions and credits in the U.S. tax code, many inserted by special interest groups and designed to benefit relatively small numbers of private companies or industries. The mortgage interest deduction, by contrast, was never inserted into the code by any group. It's been part of the tax code from the day the code took effect.
More important, it's intended to benefit millions of families and individuals by making the bottom-line annual costs of owning a home a little less burdensome. It is restricted solely to taxpayers who own and occupy a principal residence with a mortgage balance and can also be used on a second residence that they live in part time.
In 1986, Congress set a limit on the maximum mortgage amounts that qualify for the deduction: $1 million in principal residence mortgage debt and $100,000 in home equity debt, such as a second mortgage or an equity credit line.
Who uses the mortgage interest deduction?
Overwhelmingly, it's homeowners in the middle and upper-middle income categories. According to statistics compiled by the Congressional Joint Committee on Taxation, 68 percent of annual mortgage interest deductions are claimed by families and individuals with incomes less than $200,000. Slightly more than 40 percent of these deductions go to taxpayers with incomes between $100,000 and $200,000. Roughly 12 percent of total deductions are claimed by taxpayers with incomes between $50,000 and $75,000.
Federal statistical studies also reveal that the mortgage interest deductions claimed by owners tend to increase as families have children and require more bedrooms and larger houses. Single homeowners - often young, first time purchasers - deducted an average of $1,300 per year for mortgage interest in one study, compared with $1,950 a year for a couple with two dependent children, and $2,010 for owners with three dependents.
In this sense, the mortgage interest deduction helps families with their life cycle financial needs. It helps them "move up" into houses with more square footage, bigger price tags and larger mortgage amounts. As the kids grow up and move out, statistics show that parents eventually either pay off their mortgages - disqualifying them from taking the deduction - or "downsize" into smaller homes with smaller mortgages. Either way, the size of deductions diminishes toward the end of the typical ownership life cycle.
The amounts claimed for mortgage interest deductions can vary dramatically state by state and even in different parts of the same state. A 2013 study by the Pew Charitable Trust found that the heaviest use of the mortgage interest deduction comes in states and communities that have relatively high median costs of housing. These tend to be along the Atlantic and Pacific coasts, but also include a handful of states that have resort areas containing large numbers of luxury homes.
What size deductions are we talking about?
Homeowners in Maryland took the largest average deductions per tax filer - $4,580 - during the 2010 tax season, the latest data available. Californians were next with an average $4,311, followed by Virginians ($4,179), Coloradans ($3,850) and Washington state homeowners ($3,811). States with the lowest average deductions, according to the Pew study, were Arkansas ($1,456), Mississippi ($1,314), West Virginia ($1,220), North Dakota ($1,192) and South Dakota ($1,134).
Homeowners in the high-deduction states also tend to have a higher rate of filings for mortgage interest deductions. Although on a national average basis, just 25.5 percent of all tax filers claim the mortgage interest deduction; in Maryland nearly 37 percent do. In Virginia, it's 33.2 percent and in Colorado 32.8 percent. By contrast, just 15 percent of North Dakota and West Virginia filers claim the deduction.
Within states, people who live in different metropolitan areas can differ significantly in their rate of claims. For example, in Texas, 28 percent of Austin tax filers claim the mortgage writeoff at an average annual amount of a little less than $3,000. In the Odessa area, by contrast, just 7.5 percent take the deduction for an average of $468. In California, residents of the San Jose metropolitan area take average mortgage interest deductions of $7,700 - almost double the statewide average.
The key point here: Different families, in widely differing economic and housing cost situations, make different uses of the mortgage interest deduction as a financial benefit. There is no nationally uniform "mortgage interest deduction," no typical taxpayer, no standard rate of claims.
Will Congress reduce or eliminate this deduction to decrease the federal deficit? What would be the consequences?
Start with the consequences. A number of academic studies have been published in the past two decades using statistical models to simulate what would happen if the mortgage deduction were abruptly ended. Researchers have come up with somewhat different numbers, but they all pretty much agree: Home prices would drop because the value of the mortgage deduction is baked into the value of the underlying real estate. Some studies project a real estate devaluation of around 15 percent. Others have predicted 18 percent on average, with much higher percentage losses in those states and metropolitan areas where use of the deduction traditionally has been high.
Withdrawing the deduction would have immediate impacts on the affordability of houses for first-time buyers and would probably prevent large numbers of them from being able to purchase. The housing market would fall back into recession, large numbers of workers in construction and housing-dependent industries would lose their jobs and defaults and foreclosures would almost certainly increase.
What's the Most Likely Outcome?
Under these circumstances, it is not likely that the mortgage interest deduction is going away anytime soon or will even be sharply reduced. There is a possibility, however, that in the event of a broad-ranging, bipartisan budget deficit package being hammered out on Capitol Hill, Congress might lower the current $1.1 million limit on eligible mortgage amounts, say to $500,000 or $700,000. That would have a negative impact on homeowners with the biggest houses and biggest mortgages, but have a less dramatic effect on owners of homes with mortgages below those amounts.
But don't hold your breath for this outcome either. The current Congress can barely agree on small issues, much less on massive tax and spending changes, especially ones that could trigger an economic downturn.
Even if a modest cutback occurs, it would be phased in over a minimum of 10 years to minimize the impact on buyers and sellers.