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Proposed Mortgage Deduction Changes

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I wrote about the Presidential Tax Reform Panel Recommendations a few days ago and briefly touched on one of the most important things that affects homeowners such as myself, proposed changes to the mortgage deduction rules. Taken at face value the proposals appear to be bad for all homeowners but it’s actually only worse for rich and about the same for the rest of us.

The current system lets anyone with a mortgage under $1M to deduct interest from your income and keep $250k gains tax-free ($500k if married). The new system, specifics still unknown until Nov. 1, would reduce the $1M cap to a flexible one based on local home prices, replace the deduction with a credit, reduce what part of your income is reduced by the interest, reduce the $250k capital gains cap, or a combination of all of them.

Note: Fundamentally I’m perfectly happy with the wealthy carrying a heavier portion of the tax burden when compared with other economic classes. Bill Gates pays the same as I do for a gallon of milk and other necessities.

1. Lowering the $1M Bar – Most folks who carry $1M mortgages probably aren’t going to miss the mortgage deduction… I mean they live in a $1M+ house after all. Now, moving the bar to one that’s regionally based makes more sense anyway (compare San Diego prices to Iowa prices and what a million can get you) but this effectively takes money out of the pockets of the wealthy (who can get $1M+ homes) and into the bank account of the government. The panel did research and found that 22% of all the economic benefits from mortgage interest deduction came from the top 2.2% of returns, so lowering this cap, though, will not affect most Americans.

2. Replace the deduction with a credit – I didn’t realize that in 2002, only 35% filed an itemized deduction, the only way you can deduct mortgage interest. (Take that number with a grain of salt because we don’t know how many people who own a home filed a standard deduction) By making it a credit, it only helps lower income families because it lets them take the standard deduction plus whatever they would get from owning a home. Again, this doesn’t hurt most Americans.

3. Change in how the deduction affects income – Right now when you deduct interest, it’s taken off your income and thus your most heavily taxed dollar. The panel suggested that perhaps it be deducted from a dollar taxed in a lower bracket such as the 15% or 25%. This won’t affect most Americans but it effectively takes money out of the pockets of the wealthy and into the coffers of the state, presumably to help fund the other changes (such as the deduction credit).

4. Reducing the capital gains exempt cap – This is the only idea I’m not entirely thrilled about because there are many folks who live in hot housing markets where their home equity has skyrocketed. The only problem is so have all the areas they would’ve considered moving to and so they are “stuck” in their existing homes. If the cap was lowered and they were to move to somewhere else, a huge chunk of their equity would be eaten away by taxes.

Some, all or none of these suggestions may be implemented but the panel has been clear that any accepted proposals would be phased in (or some owners would be grandfathered into the past). One problem I see is that by implementing some of the proposals you would make the tax code more complex than it is right now, but at least you are transferring a little bit of the tax burden from the poor to the rich.

{ 4 comments, please add your thoughts now! }

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4 Responses to “Proposed Mortgage Deduction Changes”

  1. Amit says:

    From what I understand, regarding (1), the $1M limit is not on the interest, but rather on the mortgage amount. So reducing that will defeinitely have an effect even on “middle-class” families on the coasts. In CA/NY, starter homes can easily cost $500k+

  2. jim says:

    Amit, you are correct, I initially misread the report and have fixed the post. Thanks!

  3. Matt says:

    If the maximum cap is cut, as has been discussed, to $300k and change, that will affect a LOT more people than the current $1M cap. It does little good to adjust for geography if you have a maximum that’s so low it doesn’t even cover the cost of a tear-down in a lot of markets. Adjusting for geography, given that, doesn’t so much mean that Californians, New Yorkers, Floridians, et al get a break as that Iowans and Michiganders also get punished.

    “Living in a million-dollar house” may still mean something…but “living in a $300,000 house” is simply a synonym for “not renting”.

  4. jim says:

    Where have you seen $300k and change discussed? That’s ludicriously low.

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