WASHINGTON — Fifteen years ago, Carol Nietmann and her husband bought a spacious house in Maryland near Chesapeake Bay. And thanks to the time-honored tax deduction for mortgage interest, she said, their new place was a little bigger and a little nicer than they would otherwise have thought they could afford.
Much the same has been true for millions of Americans up and down the income scale. Perhaps the most sacred of all the sacred cows in the tax code, the home mortgage deduction has long been seen as crucial to a major element of the American dream — owning your own home.
It has also been a boon to homebuilders, construction workers, the financial services industry and local governments that benefited from fatter real estate tax revenue.
But nearly a century after coming into existence, the mortgage deduction may face a day of reckoning. Although out of the spotlight as the lame-duck Congress ended, the mortgage deduction issue is likely to resurface next year when the new Congress — including a lot more deficit-hawk Republicans — takes over.
In part, the hoary deduction has a target on its back as a result of policymakers rethinking the whole issue of home ownership. After the havoc that followed the latest housing bust — a calamity that still shadows the U.S. economy and will for years to come — it's no longer so clear that near-universal home ownership should be a paramount goal.
Scholars have long argued that the mortgage deduction and other tax subsidies supporting housing, including a deduction for property taxes and tax exemptions for profits on home sales, are neither equitable nor economically efficient. Some say they've helped skew the economy's reliance on an industry that has little export potential and often encourages over-consumption.
"It's fair to ask whether (government money) is best spent on housing or plants and equipment or other investments," said Richard K. Green, director of the Lusk Center for Real Estate at the University of Southern California.
More important, despite the deduction's grip on the public and politicians, changing it as part of a package of other revisions offers Washington a chance to do something meaningful about the surging federal deficit: generate billions of dollars more in federal revenues that could be used to cut the deficit while inflicting surprisingly little pain on most middle-class homeowners.
Who uses deduction?
The National Association of Realtors already is running ads warning that tampering with the deduction would hurt "hard-working American families." The ads point out that 65 percent of the taxpayers who took the deduction made less than $100,000.
What the group doesn't say is that about 75 percent of the entire $85.5 billion that people saved in taxes from the mortgage interest deduction in 2008 went to individuals or couples making $100,000 or more, according to an analysis by the congressional Joint Committee on Taxation of the latest data available.
Based on the committee's numbers, taxpayers who took the mortgage deduction saved, on average, $2,330 in 2008. But for those reporting incomes of $200,000 and more, the average savings were nearly triple that amount.
About half of all homeowners in the U.S. —and just a quarter of all taxpayers — benefit from the mortgage interest deduction at all. That's because most people don't have home loans or don't pay enough in mortgage interest to take advantage of the benefit.
Also left out are many homeowners in cheaper housing markets, though people with pricier homes and larger mortgages — many of them affluent younger Americans in coastal cities in California and on the East Coast — reap a disproportionately large share of the tax savings.
Last year, couples filing joint federal returns needed mortgage interest and other deductions exceeding $11,400 to make it worthwhile to file itemized tax returns and take advantage of this tax preference.
Tax credit instead?
The deficit commission's plan would do away with itemized deductions altogether and allow every homeowner to get a tax credit equal to 12 percent of interest paid on mortgages up to $500,000.
Replacing the mortgage deduction with a tax credit "would reduce the tax subsidy by a decent amount for a small fraction of the population and increase it by a small amount for a large number of lower-income households," said Todd Sinai, a real estate and taxation specialist at the University of Pennsylvania's Wharton School.
Would it hurt values?
He predicted that the upper-end housing market could see a decline of a few percentage points relative to what would happen without a change in tax code. That means home prices wouldn't necessarily drop as a result, but if values in those markets increased 10 percent, they would grow a few points less.
Even that may be too much for the banged-up housing market to absorb, homeowners and industry executives fear. With prices still depressed and more than one-fifth of homeowners owing more than the value of their properties, reducing or eliminating the mortgage deduction would be disastrous, they said.
Many experts don't think an elimination of the mortgage deduction will hurt homeownership, though they say it is likely to influence the size of homes people buy — and eventually what builders put up — as well as other personal financial decisions. More people may pay down their mortgages or invest in bonds or stocks if they see less tax benefit to keeping a big home loan.
Analysts point out that other countries, such as Canada and Australia, have high home ownership rates similar to the U.S., currently at 67 percent, without such housing tax subsidies.
Even so, it won't be easy for policymakers to discard the mortgage interest deduction. It's been around since 1913, having survived Washington's last big tax overhaul in 1986 and subsequent efforts that would have eliminated the provision.
Even without the current intense partisan divide, the issue pits lawmakers in high-end housing districts against those representing less expensive areas. Americans have never been comfortable with governmental redistribution of income, yet many are growing increasingly uneasy about the widening gap between the rich and poor.
Alice Rivlin, a former top budget official in the Clinton administration and a member of Obama's deficit commission, said any big change in the mortgage deduction won't happen by itself. It'll be part of a broader makeover of a tax system that she and leaders in both parties agree is too complicated and riddled with special deductions and exclusions.
"It's got to be a wholesale reform," she said. Though reluctant to assess its chances, Rivlin said the time may finally be coming because of the magnitude and urgency of the nation's budget deficits. "It's certainly possible," she said.