These Two Rights Could Be Nixed for Homeowners

NEW YORK (MainStreet) — Among the cherished rights of homeowners, two stand out: the tax deduction on mortgage interest payments and the tax exemption for profits on a home sale. If a Washington-based coalition has its way, both would be cut for wealthier homeowners.

At the same time, the coalition proposes an IRA-like savings account to allow prospective homeowners tax exemption on savings for a down payment. That begs the question: Under today's conditions, what is the best way to save for a down payment?

The coalition's proposals may never go anywhere, but they do show that anything could be on the table as Congress and the administration look for tax reforms.

Membership in the group Smart Growth for America includes environmental organizations, developers and investors and others focused on sustainable development, largely with a focus on making cities more livable. Its housing proposals would leave long-standing government support in place for homeowners of low and moderate incomes, but reduce benefits for wealthier property owners.

The coalition, for instance, recommends eliminating the mortgage interest deduction on second homes. For primary residences it would reduce the maximum debt to which the deduction could be applied to $500,000 from the current $1 million. It also recommends limiting real estate tax deductions for households making more than $100,000 a year.

And it would cut in half the tax exemption for profits on a home sale, setting a $125,000 limit for individuals, $250,000 for couples filing joint returns.

The group also wants Congress to establish Mortgage Savings Accounts that, like tax-deductible IRAs or 401(k)s, would provide a tax exemption on income set aside for the down payment on a first home. Withdrawals would be tax free if used for a down payment within 10 years of the account's establishment. Unused money would be taxed as income. The coalition estimates the program would cost the government about $10 billion in tax revenue over the first 10 years.

In the wake of the financial crisis, lenders typically require 20% down payments, creating a high hurdle for first-time buyers. Of course, that requirement may ease as the housing market and economy get healthier, and as lenders get hungrier for loan applications.

Since the coalition's proposals may never be enacted, prospective homeowners would be wise to look for the smartest options under current rules for building down payment funds.

The key issue is how soon the money will be needed. If the time horizon is only two or three years, the money can go into bank savings or money-market funds. Interest earnings will be very low, but the money will be safe. There's currently no way to get a tax exemption on your initial savings, and interest earnings will be taxed every year as income. But since the earnings would be small, the tax bite would be minor.

Savers with a longer horizon — say, five, seven or 10 years — can consider a more aggressive and risky program emphasizing stocks or stock mutual funds. Though there is a risk of loss, the potential investment returns could be much larger than in bank savings. And because you have the option of renting, you could postpone your home purchase if the account was down due to a weak stock market.

As with the bank savings, there would be no tax exemption on your initial deposits to the account. But investment gains would benefit from the lower tax rate on long-term capital gains and dividends — a maximum of 15% rather than the higher income tax rate.

Yes, stocks are risky. So another option is to divide your down-payment savings, putting half into a safe bank account, half into a riskier investment account.

Then cross your fingers and hope your investments do well, or that a few years down the road lenders settle for smaller down payments. In the past, they often required 5%, or even less.

--Written by Jeff Brown for MainStreet

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