Mortgage interest deduction: Can US debt panel keep it on the chopping block?

The mortgage interest tax deduction is cherished by many Americans as the path to homeownership. But the co-chairmen of the US debt panel say it should be rolled back.

By , Staff writer

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    Debt Commission co-chairmen Erskine Bowles (l.) and former Wyoming Sen. Alan Simpson, speak to the media on Capitol Hill in Washington, Wednesday. The two chairmen said Thursday that the mortgage interest tax deduction should be rolled back.
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Most people getting ready to buy a home have done the drill, totaling their monthly payments to see if they could afford to borrow enough money to buy the house they want.

But, while doing that calculation they often are reminded by their real estate broker: you can probably afford more than you think because the tax law gives you a mortgage interest deduction. That might allow you to adjust your income tax exemptions, giving you more take-home pay.

However, on Wednesday, as part of a broad effort to rein in the nation’s ballooning debt, the co-chairmen of the National Commission on Fiscal Responsibility and Reform, a bipartisan panel appointed by President Obama, proposed rolling back that deduction. The proposal would give homeowners a flat 12 percent deduction for mortgage interest, as opposed to a deduction defined by their income tax bracket.

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In addition, the co-chairs, Alan Simpson and Erskine Bowles, proposed capping the size of the mortgages eligible for the subsidy at $500,000 instead of the current $1.1 million. And, they would completely eliminate second homes from mortgage interest deductibility.

The current deduction is now the second most expensive tax subsidy, expected to cost the US Treasury $104 billion in 2011. Many economists and budget watchers have long viewed it as a form of wealth transfer to the rich, since they benefit the most.

But the deduction also resonates with many people as one of the ways to make the so-called American dream of homeownership come true.

The real estate industry is quick to respond whenever the subject of making any changes in the deduction comes up.

Immediately after the co-chairmen’s report came out, Michael Berman, the chairman of the Mortgage Bankers Association, said the proposal “would have a devastating impact on both present and future homeowners in this country.”

The National Association of Realtors (NAR) said the proposed changes would lower real estate values by 15 percent, possibly increasing the number of foreclosures as home prices sink.

“It will effectively close the door on the American dream,” said Ron Phipps, the president of NAR in a statement. NAR called on the 1.1 million realtors to write or call Congress using such words as “I have been on the front lines of the housing crisis.”

When Congress first passed the interest deduction in 1913, it was very rarely used for mortgages. It wasn’t until after World War II when American veterans came home, took out loans, and started paying taxes, that the deduction became more important.

“Over the course of fifty years, however, politicians and the housing industry transformed the subsidy into a sacred cow,” writes Dennis Ventry, a law professor at the University of California, Davis in an analysis with the title: “The Accidental Deduction: A History and Critique of the Tax Subsidy for Mortgage Interest.”

Despite the industry’s dire warnings, some economists and housing industry experts don’t see the proposed change as a death knell for the industry.

“It would not kill off the housing industry,” says Anthony Sanders, a real estate finance expert at the Mercatus Center at George Mason University in Arlington, Va.

In fact, Mr. Sanders thinks, the current law encourages households to take on additional risk.

“This is a positive when the housing market is increasing in price, but deadly on the downturn,” he says. “So we should not be encouraging risk-taking, particularly if taxpayers foot the bill on the downside.”

The subsidy has been particularly advantageous for the wealthy, says Sanders, who says most of the benefit mainly goes to such East Coast and West Coast communities as New York, Washington, San Francisco, Los Angeles, and San Diego, where housing is more expensive relative to the rest of the nation.

In those markets, he thinks a change in the tax code could have an adverse impact since the ability to deduct mortgage interest inflates housing prices since buyers can afford to pay more.

“That is why you won’t find much support for implementing any kind of lowering of the use of the mortgage interest rate deduction from legislators in those areas,” says Sanders. “It is almost like an entitlement and trying to take away those is very, very dangerous for the politician.”

This would not be the first time the real estate industry has confronted attempts to change the mortgage interest deduction. In 1995, then-Representative Dick Armey (R) of Texas proposed a flat-income tax with no deductions. Then, in 2005, President Bush’s tax reform panel suggested replacing the deduction with a 15 percent tax credit.

The real estate industry complained that the change would send a chill through the real estate market, which was leading the economy.

“Nothing happened with that proposal, it got shelved,” says Chuck Marr, director of federal tax policy at the Center on Budget and Policy Priorities in Washington. “But, it may have paved the way for the next one (proposal) to do it.”

Mr. Marr expects any changes will be part of a larger effort. But, he says even conservatives are starting to come on board, preferring to reduce a subsidy instead of a direct increase in taxes.

“We’re starting to see where this is becoming more palatable for elected officials,” he says.

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