3 reasons why the mortgage tax break isn't a break

December 3, 2010: 12:13 PM ET

The plan to eliminate the mortgage tax deduction was widely criticized, but the industry overreacted to the proposal. Turns out it's not that great for most of us.

mortgage deductionPresident Obama's deficit commission came up short of votes to command quick action in Congress of a bipartisan plan that recommended eliminating or reducing long-standing credits, including the popular home mortgage interest deduction. This isn't much of a surprise. While lawmakers acknowledge that the nation faces an incredibly worrisome debt problem and that a dramatic slash in spending needs to happen, the plan was politically unpopular from the start.

Real estate and mortgage industry experts argued the elimination of the mortgage deduction would put more pressure on an already fragile housing market. That might be the case, but if we look deeper, many of their arguments are exaggerated. If anything, once the housing market gains some strength three or so years from now, slimming the deduction down some might actually not be such a bad thing and it could save the US government billions of dollars. Here are three reasons why:

It doesn't benefit the vast majority of American homeowners anyway.

Under the current program, taxpayers who itemize their deductions can deduct the interest on mortgages of up to $1 million for their primary and second homes, as well as on home equity loans of up to $100,000. This overwhelmingly benefits relatively wealthier households since they're more likely to itemize their tax deductions. Middle to lower income households tend to go with standard deductions.

The deficit commission's proposal recommended scaling the mortgage interest deduction to $500,000 from $1 million and limiting it to only primary residences and not second homes. The deficit commission also proposed eliminating the mortgage interest deduction and turning it into a 12% nonrefundable tax credit available to everyone – a pitch that some experts including Steve Ott, director the University of North Carolina at Charlotte's Center for Real Estate says could benefit more homeowners including lower to middle-income households.

"A credit is always a benefit but the deduction is only a benefit to the extent that you itemize," Ott says.

What's more, even though mortgage industry leaders say doing away with the deduction could make homeownership less appealing, Chris Mayer, real estate professor at Columbia University, says the program hasn't proven to encourage home buying. Since the deduction mostly benefits relatively wealthier households, they would own homes with or without the deduction.

Years from now, it's anyone's guess what could come next of the mortgage tax deduction. Efforts to change the structure have been under way before. A panel in 2005 appointed by then-President Bush proposed allowing homeowners to claim a mortgage interest credit of 15% on loans of up to $412,000. The proposal never really took off.

It doesn't help home prices much.

In a way, the timing of the panel's latest proposals was just bad. Because of the fragility of home prices and record foreclosures, the housing market is an incredibly touchy topic, and a very political one at that.

Nationally, home prices for the third quarter fell 1.5% from the same time last year and were down 2% from the previous three months, according to data released earlier this week by the S&P/Case-Shiller index. At least for now, doing away with the deduction or scaling it down would likely push home prices even lower, especially in areas along the East Coast where home prices are higher relative to the rest of the country, says Mayer of Columbia University's Graduate School of Business. This might help make homes relatively more affordable to a wider spectrum of potential buyers but it could also increase foreclosures since far too many homeowners already owe more on their mortgages than their properties are valued.

Mayer adds that while winding down the tax deduction would add further pressure to the soft housing market in the short-term, it wouldn't have much of an impact on prices in the long-run. Enacting legislation that would start phasing out the program three or so years from now could be an option.

It encourages borrowers to take on more debt.

At a time when consumption has trended down and debt-ridden American consumers are trying to save more and spend less, it's not such a bad idea to tack on policies that could get homeowners to take on a little less debt.

One aspect often overlooked in the deduction is that it actually encourages homeowners to take on more debt than they perhaps would have without the subsidy, Mayer says. Anyone who pays off their home debt doesn't benefit from it.

With many homes under water and unemployment still at nearly 10%, many homeowners can barely pay their existing mortgages. So it's hard not to wonder why the government should spend so much on a tax policy that could further weaken the American consumer, especially since the subsidy steers them toward spending more of their income on homes as opposed to other goods and services that just might help the broader economy.

Also on Fortune.com:

Corporate America shrugs off deficit plan

Deficit reduction pleas fall on deaf ears

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About This Author
Nin-Hai Tseng
Nin-Hai Tseng
Writer, Fortune

Nin-Hai Tseng covers economics and finance. Before joining Fortune, Tseng was a reporter at The Orlando Sentinel and a public affairs associate at GE. She holds an MPA from Columbia University and a BS in Journalism from the University of Florida. She lives in New York City.

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