The Impact of Losing a Second-Home Mortgage Deduction

NEW YORK (MainStreet) -- In a candid moment overheard by reporters, Republican presidential candidate Mitt Romney recently said he might target the mortgage interest deduction long available to owners of second homes.

So, if you have been thinking of picking up a vacation or investment property, should you abandon the idea?

Probably not, unless the deduction is a make-or-break factor in your purchase decision.

At first glance, an interest deduction for second homes is harder to justify than the deduction long available for first homes.

Homeownership is generally a good financial move, and the first-home deduction encourages people to own rather than rent. But not many people really need a second home, so why should other taxpayers subsidize what is primarily a luxury?

Because many people see it that way, the second-home deduction probably is more vulnerable to elimination than the one on primary homes. But it is far from a done deal. Romney might not be elected and he might not follow through on the idea if he is president. Some Democrats could push it, as President Obama’s budget commission did last year, but they might get a lot of resistance from lawmakers who think the second-home deduction spurs investment to help the sick housing market recover.

So it is way too soon to count out the second-home deduction.

And even if the deduction is eliminated, many owners of second homes would find the pain less severe than they might expect since it is easy to overestimate the long-term value of mortgage interest deductions.

Since a taxpayer must claim itemized deductions to get the interest deduction, it has no value to those who don’t itemize. Itemizing pays off only if itemized deductions exceed the value of the standard deduction available to those who don’t itemize — $11,900 for a married couple filing a joint return,  $5,950 for singles. Even if a second-home owner does itemize, the interest deduction has value only to the extent it pushes itemized deductions above the levels of the standard deductions.

Also, mortgage interest payments shrink over time. As the loan balance gets smaller, less of each month’s payment goes to interest, reducing the interest deduction. In the first year of a 30-year $200,000 mortgage at 4%, the borrower would pay nearly $8,000 in interest, producing a $2,000 tax savings, assuming a 25% tax bracket. In the 15th year, interest payments would total about $5,300, and in the 20th year less than $4,000. Of course, in 20 years the dollar will be worth a lot less due to inflation, so a $1,000 tax cut then might be worth only $500 in today’s dollars.

Moreover, the interest deduction is far less valuable when rates are low, as they are today. At a 7% rate, common just a few years ago, the borrower would pay nearly $14,000 in interest during the first year of a $200,000 loan, for a tax saving of $3,500 at a 25% rate. That’s 75% more than the same borrower would save with a 4% mortgage rate.

So the interest deduction on a second home may not be terribly valuable. Any thoughts of scrapping the deduction are a long way from being enacted. Even if they were, a grandfather clause could preserve the deduction for mortgages before the law changed.

If a second home seems like a good idea, worries about the mortgage deduction probably shouldn’t get in the way.