The Mortgage Interest Deduction: Is It Under Attack?

The Pease limitation was reinstated in 2013 which will reduce itemized deductions for some high income homeowners.

The federal tax law encourages home ownership in a big way by allowing homeowners to deduct the interest they pay on home mortgages from their income taxes. The deduction may be used for mortgage debt on a principal or second home totaling $1 million or up to $100,000 in home-equity loans or lines of credit.

One study estimates that the mortgage interest deduction lowers the cost of capital for owner-occupied housing by seven percent. Also, by allowing taxpayers to deduct mortgage interest from their taxable income, but not rental payments, the tax code creates a strong financial incentive to buy rather than rent a home. In 2009, about 35 million households claimed the deduction and more than 75% of homeowners used the deduction at least some time.

As you might expect, the mortgage interest deduction is expensive. Indeed, it’s one of the largest tax breaks in the Tax Code, costing about $80 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.

However, desperate times call for desperate measures. Everyone is looking for ways to cut the federal deficit. 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.

Thus, it is possible that this deduction, as we have known it in its current form since 1986, could be in real trouble.

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--for example, it could be limited to homes worth $500,000 or less, rather than the current $1 million dollar limit. It could also be eliminated entirely for second homes. The most extreme measure would be to phase out the deduction entirely. Such direct attacks would be vigorously opposed by the real estate industry.

Alternatively, Congress could 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% 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% bracket and deducting $25,000 in mortgage interest payments would receive $8,750 in tax savings. However, if the deduction was capped at 28%, such a taxpayer would save only $6,250.

Many feared that one of these measures would be included in the fiscal cliff tax deal passed by Congress in early January. To the relief of the real estate industry, this did not happen. However, many high-income taxpayers will see some reduction in the value of the home mortgage interest deductions as well as their other itemized deductions. This is because the fiscal cliff law brought back the "Pease limitation," which had expired in 2009. This provision reduces a taxpayer's itemized deductions by 3% of the amount his or her AGI exceeds a threshold amount.

Under the new law, the Pease thresholds are $300,000 for married taxpayers filing jointly, and $250,000 for single taxpayers. Thus, for example, a married couple with an AGI of $400,000 and $50,000 in itemized deductions (including home mortgage interest) would be $100,000 over the threshold. Three percent of $100,000 = $3,000; so their itemized deductions would be reduced from $50,000 to $47,000. The couple ends up with $3,000 more in taxable income, which at their income level is taxed at a 33% rate. They end up paying $999 in extra taxes.

However, no matter how high a taxpayer's AGI, the Pease reduction cannot exceed 80% of the amount of itemized deductions otherwise allowable for the year. But this still means that a very high-income homeowner could still lose up to 80% of his or her itemized deductions for home mortgage interest, state and local income and property taxes, and charitable contributions.

January 2013

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