Mortgage Interest Deduction: Housing Boon or Boondoggle?

mortgage interest deductionWith Congress expecting to slash more than $2 trillion in long-term spending as part of the debt-ceiling compromise, nothing is safe from the chopping block -- not least of all, that housing industry darling, the mortgage interest tax deduction.

Often hailed as a boon to the middle-class by its defenders, the MID has been around in some form or another for as long as Americans have itemized their tax deductions. But with an anticipated price tag of nearly $100 billion in 2012 and mounting criticism that the provision disproportionately benefits the rich, the controversial deduction may be on its last legs.

Just what that will mean for the homebuying public, however, depends greatly on whom you ask. From the perspective of real estate trade organizations that claim the MID encourages homeownership, nothing could be worse.

"This has been in the rules of the game for the last 100 years," said Lawrence Yun, chief economist of the National Association of Realtors. "This is the worst time to make another obstacle for the housing recovery."

But the findings in recent studies paint a different picture. While almost 35 million households claimed the MID in 2009, the benefits skew sharply toward homeowners with higher incomes, according to a report from the Joint Committee on Taxation. Nearly 60 percent of those returns came from homeowners making $75,000 or more, with the largest number coming from the $100,000 to $200,000 income class. (See the chart below.)

mortgage interest deductionAnother fundamental problem with the MID is that the deduction incentivizes people to buy bigger -- but those who benefit most from the deduction are the least likely to need it. "The bigger the house, the more subsidy you get," said Roberton Williams, a senior fellow at the Urban-Brookings Tax Policy Center, during a phone interview. "It doesn't make any sense." Further, the MID is only available to those who itemize their tax deductions, and only about one-third of taxpayers do so, Williams said.

Even so, defenders of the MID claim that weakening the deduction will only serve to stifle the housing recovery by detracting from the value of homeownership. And, in at least one substantial way, experts on both sides of the debate agree.

The problem, said Williams, is that many middle-class homeowners who do take advantage of the MID are now reliant on the tax benefit to make their monthly payments.

"Had we never had this in the first place, it would be easier to say we shouldn't start it," he said. "But we're stuck with it, and it's already built into calculations."

The stakes are especially high in today's market, Williams says, because of the huge overhang of inventory. Anything that might disrupt the already-tenuous housing market could have a major impact on the recovery.

Possible Alternatives

As the largest subsidy to homeowners and one of the most expensive in the tax code, it's unlikely that the MID will go completely unscathed in budget talks. One compromise currently being touted in political circles is to put a stricter dollar cap on the size of qualifying mortgages. The deduction is currently capped at $1 million. Though, as Williams points out, depending on where you live, such a cap might alienate homeowners in more expensive housing markets, like New York and Los Angeles.

Another option might be to prohibit the use of the MID on second home purchases, which tends to benefit wealthier homeowners. In this scenario, however, critics like Lawrence Yun of the NAR would claim that this would stifle the job market in popular vacation home destinations, like Vail, Colo., where workers depend on luxury construction.

The third and least likely scenario, says Williams, is to turn the deduction into a flat tax benefit, in which homeowners across all tax brackets would benefit from a fixed percentage rate. But this would set an uncomfortable precedent, Williams says, which Congress is unlikely to back.

Ultimately, homeowners are wedged firmly between a rock and a hard truth. If the MID is repealed, homeowners who rely on the tax deduction to help offset their mortgage payments will feel the squeeze, putting more families at risk of foreclosure. If the MID is left intact, the most expensive housing tax incentive will continue to disproportionately benefit the wealthiest homeowners, throwing into question the very purpose of the deduction in the first place.

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