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Is Your Mortgage Interest Deduction Doomed?

Sharply limiting the size and scope of the mortgage interest deduction made it onto the short list -- okay, not so short -- of deficit reduction proposals floated this week by Erskine Bowles and Alan Simpson. One of the three tax plans offered up by the co-chairs of President Obama's fiscal deficit commission would end the mortgage interest deduction on primary-home mortgages above $500,000, down from the current limit of $1 million. The deficit-cutting duo also proposed to completely eliminate the deductibility on second homes and home equity loans and lines; currently up to $100,000 of interest on such loans and lines qualify for the tax break.

There is no question that tinkering with the mortgage interest deduction would be controversial, to say the least, but it's also a mistake to think this idea has no chance of gaining any traction in Washington. It's long been on the radar as an inequitable tax break for the wealthy, just the sort of line item that sticks out like a sore thumb if you're serious about reducing the federal deficit. "It's really just a gift to the owners of very expensive homes," says Duke professor of public policy Jacob Vigdor. "This sacred cow has been targeted for slaughter many times in the past, and one of these days a reform effort will finally succeed."

So is now the time? Here's what's at play:

It's a $131 billion break for the wealthy. That's the White House's official estimate of the 2012 revenue cost of the mortgage interest deduction. A study that looked at proposals to reform the mortgage deduction put out by the Tax Policy Center at the Urban Institute points out that sum is "much more than the total of all outlays by the Department of Housing and Urban Development ($48 billion)." And studies show that most of the benefit goes to taxpayers in the top 20 percent of the income distribution ladder. Significantly, you need to itemize your deductions to claim the break, a step that only about one-third of Americans take. According to the Tax Foundation, for the 2008 tax year, just 26.8 percent of tax returns claimed the mortgage interest deduction. Among the returns that claimed the deduction, the average amount was $12,221.

Slashing the mortgage interest deduction is not a new idea. A 2005 tax reform panel convened by President George W. Bush recommended scaling back the deduction and partially offsetting it through a tax credit. So this isn't some sort of out-of-left-field idea. (Side note: It's hard not to wonder what might have happened if that reform ever saw the light of day in 2005. Maybe it would have provided some counterweight to the then-burgeoning housing bubble.)

It's not like we haven't chipped away at consumer-interest tax breaks before. The sweeping 1986 Reagan tax reform bill eliminated the deductibility of credit card and other consumer-loan interest, so don't think there's not precedent for this sort of thing. Back then, President Reagan was loud and clear that the mortgage interest deduction was an untouchable sacred cow. But when you've got a $1.29 trillion federal deficit that is growing as we speak, you'd think anyone serious about deficit reduction would have to think about winnowing down the herd of sacred cows.

Most homeowners would still reap a full benefit. Last I checked, the median price of a new home was hovering around $200,000. The Bowles-Simpson proposal would retain the deduction on mortgages below $500,000. Assuming a 10 percent down payment, we're essentially talking about the proposal hitting only folks who buy homes for more than about $550,000; that's more than double the median home price these days. Now as someone who lives (and owns) in a high cost area where the median price is well above $500,000, I am already hearing the NIMBY yowls. But when we've got such a huge federal deficit, is subsidizing expensive homes really all that defensible? (Yes, the comments field is open below).

The hit to home values likely wouldn't be catastrophic. My MoneyWatch blogging colleague John Keefe has an informative analysis of earlier proposals to reduce the mortgage interest deduction. He cites a study that posits "at the extreme, [researchers] estimate an upper-bound estimate of the effect on prices at 10 percent." Moreover, if there were some kind of offsetting credit for homeowners, that would reduce the pocketbook hit. (Howard Gleckman, at the Tax Policy Center has more detail on the impact of a credit along with a cut in the mortgage interest deduction.)

It's time to talk. Of course, as Michael Berman, chairman of the Mortgage Bankers Association dutifully pointed out after the Bowles-Simpson proposal went public: "Given the fragile state of the nation's housing market, now is not the time to be scaling back incentives for homeownership." No argument there. But that doesn't mean now is a bad time to start having the discussion about making hard choices today that can be implemented later, an approach Mark Zandi, chief economist at Moody's Analytics, recommends. After all, that's how we handle most change -- just look at health care reform, which passed this year, but most of the provisions of which don't kick in until 2014.

Photo courtesy of Flickr user Svadilfari
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