Honey, I Shrunk The Mortgage Interest Deduction – Plan 1

Proposed Tax Reform and the Mortgage Interest Deduction

This year’s political landscape has been marked by intense debate, particularly over the proposed tax reform that threatens the mortgage interest deduction. Here’s a closer look at the potential implications of these changes:

1. The Political Divide: Tax Reform vs. Raising Taxes

• Historical Context: Traditionally, Democrats are associated with raising taxes, while Republicans are seen as proponents of tax reform. However, in both scenarios, taxpayers often end up facing higher costs.

• Current Proposal: A bipartisan committee, in response to President Bush’s directive to simplify the tax code, is considering significant changes that could affect homeowners, specifically targeting the mortgage interest deduction.

2. The Mortgage Interest Deduction

• Current Status: The mortgage interest deduction has long been a significant tax benefit for homeowners, allowing them to deduct interest paid on their mortgage from their taxable income.

• Proposed Change: The committee’s proposal includes reducing or eliminating this deduction. The plan suggests tying the deduction to the loan amount backed by the Federal Housing Administration (FHA). The FHA aims to assist low-income individuals with home ownership, which implies a lower cap on deductible mortgage interest.

3. Potential Impact of the Proposed Plan

• Reduction of Deduction: In areas with high real estate prices, such as San Diego, where the average single-family home exceeds $600,000, the FHA cap is around $315,000. This could lead to a significant reduction in the mortgage interest deduction for many homeowners.

• Consequences:

  • Increased Financial Strain: Homeowners in high-cost areas may lose a substantial portion of their tax deduction, potentially leading to financial strain.

  • Impact on Homeownership: Reduced deductions could make homeownership more expensive, possibly leading to higher default rates as some homeowners may struggle to meet mortgage payments.

  • Housing Market Effects: An increase in defaults could disrupt the housing market, leading to a drop in home values and causing many homeowners to face negative equity (owing more than their home is worth).

4. Political and Economic Uncertainty

• Political Challenges: Implementing a cap on the mortgage interest deduction could lead to significant backlash from both homeowners and real estate professionals. The political feasibility of such a plan remains uncertain.

• Economic Ramifications: The proposed changes could create widespread economic disruption, particularly in high-cost real estate markets. The potential for increased defaults and declining home values could have broader implications for the economy.

5. Conclusion

The proposed tax reform targeting the mortgage interest deduction represents a major shift in tax policy with potentially far-reaching consequences. While aimed at simplifying the tax code, the impact on homeowners, particularly in high-cost areas, could be profound. It remains to be seen how these proposals will evolve and what measures, if any, will be taken to mitigate the potential negative effects on the housing market and homeowners.