Mortgage interest deduction seen as vulnerable in budget negotiations

Peter Eavis / New York Times News Service /

A tax break that has long been untouchable could soon be in for some serious manhandling.

Many home buyers deduct their mortgage interest when assessing their tax bill, a perk that has helped bolster the income of millions of families — and the broader housing market.

But as President Barack Obama and Congress try to hash out a deal to reduce the budget deficit, the mortgage interest deduction looks vulnerable. Limits on a broad array of deductions could emerge in any budget deal.

It is likely that any caps would be structured to aim at high-income households and would diminish or end the mortgage tax break for many of those taxpayers.

“This is definitely a chance worth jumping for,” said Amir Sufi, a professor at the Booth School of Business at the University of Chicago. “For a fixed amount of revenue, it’s better to remove deductions than increase marginal tax rates.”

Such a move would be fiercely opposed by the real estate industry. The industry has played a crucial role in defending the tax break, even as other countries with high homeownership have phased it out.

One of the reasons the mortgage tax break is so vulnerable is that both Democrats and Republicans have recently favored capping deductions, including both Obama and the recent Republican presidential nominee, Mitt Romney.

What is more, deductions could be used to grease a compromise in the budget negotiations. High earners would be hit most by deduction limits, something that might make Republicans recoil. But the party may tolerate such a policy in return for a deal that limits how much actual tax rates go up for high-income households.

Tax numbers suggest it may not be hard to structure deduction limits in a way that leaves most middle-income households untouched.

With the mortgage interest deduction, households realized tax savings of $83 billion in 2010, according to figures from the Reason Foundation. Nearly $65 billion, or 78 percent of those savings, went to households earning $100,000 or more.

There is a range of ways to increase tax revenue by aiming at higher earners, some less comprehensive than others. For instance, the interest deduction relating to second homes could be ended. Also, the cap on mortgage debt eligible for the interest rate deduction — currently $1 million — could be reduced. There are broader approaches, too. In its proposed budget, the Obama administration plans to focus on top earners. The administration suggests capping deductions at 28 percent for high-income households, those earning more than $250,000.

Under the current rules, a high-earning household deducting $20,000 in interest payments would probably apply a 35 percent rate to that amount and receive $7,000 in tax savings. The Obama budget aims to limit that tax saving by capping that rate at 28 percent. If that rate were applied to $20,000 of interest payments, the saving would fall to $5,800.

The United States would capture the difference. Over the next 10 years, that 28 percent cap could increase tax revenue by $584 billion, according to the Treasury Department.

Separately, the Obama administration also wants to limit high earners’ deductions by letting certain Bush-era exemptions expire. Altogether, the Treasury Department thinks it could raise $749 billion over 10 years by limiting deductions for higher earners. That is substantially more than the $684 billion it thinks it could raise from increasing their tax rates.

One argument against curtailing the mortgage deduction is that it could reduce demand for housing, depressing home prices when the housing market is still somewhat weak. The National Association of Realtors believes a removal of the deduction could reduce property values by 15 percent, according to a presentation last year from its chief economist, Lawrence Yun.

Other analysts say they believe the housing industry overstates the potential impact. With several forms of government subsidy also supporting housing, it is hard to single out the effect of the mortgage deduction. At the most, the Reason Foundation estimates, the deduction may bolster house prices by 3 percent.

Since any deduction cap is likely to aim at higher earners, expensive houses would be most affected. But big-ticket homes appear much more resilient to shocks than lower-cost dwellings.

CoreLogic, a housing data company, tracks data that effectively divides the market into higher- and lower-cost houses, grouping them based on the size of the mortgages. The prices of the higher-cost houses are up 5.9 percent since the start of 2005, before the housing crash. In contrast, the houses at the lower end have fallen 13.5 percent in price since the beginning of 2005.

Given the apparent sturdiness of the higher end of the housing market, politicians may decide there are few risks in effectively capping mortgage deductions for high earners. Limiting tax breaks in a way that could reduce mortgage relief would be a change for Washington, which has done so much to support housing.

Nick Kasprak, an analyst at the Tax Foundation, said that up until recently he didn’t expect to see a cap on deductions.

“But now,” he said, “it seems both parties are open to pursuing this strategy.”