Mortgage Tax Break Faces Extinction

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What would happen to homeowners if the mortgage-interest tax deduction were eliminated?

It’s not likely to happen tomorrow, but the idea has some advocates as Washington ponders reforms to the mortgage market after the catastrophes of the past few years. Scrapping the time-honored deduction would hurt many homeowners, but many people think the deduction is worth more than it is.

Regulators, academics and mortgage-industry executives recently met in a conference to discuss the future of the mortgage market, and the Obama administration plans to have detailed proposals in January. The administration has previously proposed limiting the mortgage-interest deduction for wealthy taxpayers, and some experts think a broader attack on the tax break could help reduce the federal budget deficit.

Some economists argue the deduction isn’t necessary to encourage home ownership. Canada, for example, has about the same homeownership rate as the U.S. but offers no deduction.

And critics of the deduction say it’s unfair for tax policy to favor homeowners over renters, or to favor those with mortgages over others, such as many elderly homeowners, who paid their mortgages off. The deduction is also more valuable to wealthier homeowners because they are in higher tax brackets, while it provides no value to homeowners, many of modest means, who do not itemize their federal tax returns.

So many factors affect an individual’s tax bill that it’s difficult to say just how valuable the break is for the typical homeowner, if there is such a person. But it is easy to overestimate the break’s value. (Check your situation with the Mortgage Tax Savings Calculator.

A home buyer taking out a new 30-year fixed-rate mortgage at today’s rate would pay $4,667 in interest for every $100,000 borrowed. At a 25% tax rate, the interest deduction would save the homeowner $1,167 in taxes.

That’s just the first year. As monthly payments gradually reduce the loan balance, the interest portion of the payment shrinks and the principal portion gets larger. In the 20th year, the homeowner would have the same $519 monthly payment, but the year’s interest would be just $2,428, and the deduction would be worth only $607, not $1,167. Over 30 years, interest would total $86,709, producing $21,667 in tax savings if the homeowner stayed in the 25% tax bracket.

But any savings must also be seen in the context of the standard deduction, which is available to taxpayers who do not itemize deductions. For 2010, the standard deduction is $5,700 for an individual taxpayer and $11,400 for a couple filing a joint return. Any taxpayer can claim the standard deduction, but those who do can’t usually itemize mortgage interest or other deductions.

Itemized deductions are valuable only if they exceed the amount of the standard deduction. This is why most taxpayers don’t itemize.

If a married couple took out a $200,000 loan, interest would total $9,334, producing a $2,334 tax saving as an itemized deduction. But by not itemizing, the couple could get the $11,400 standard deduction, saving $2,850. For this couple, the mortgage interest deduction is worthless.

If the husband and wife had no other deductions, they would benefit from the mortgage only to the extent that the year’s interest charges exceeded the standard deduction. A couple that took out a $300,000 loan would pay $14,000 in interest the first year. Subtracting the $11,400 the couple could get from the standard deduction would leave $2,600, a tax saving of just $650 from claiming the interest payments as an itemized deduction.

In real life, many homeowners have other itemized deductions, including expenses like real estate taxes, state taxes, medical expenses, gifts to charity and unreimbursed business expenses. If all of those exceed the standard deduction, the homeowner does get the full benefit of the mortgage-interest deduction. (Figure itemized deductions with Schedule A.

There’s no doubt that an interest deduction can be valuable to many homeowners. But it’s not so valuable that you should take out a bigger loan than you really need. And many homeowners, especially those with lower incomes and few other deductions, would find loss of the mortgage-interest deduction painless, as they’re not benefiting anyway.

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