These 2 Big Tax Deductions Could Disappear

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The threat of higher taxes has been around for years. But earlier this week, the chances of some major disruptions for some taxpayers got a whole lot bigger, as it became clear that several popular deductions are potential targets for raising revenue in post-election federal budgets.

Republican Presidential candidate Mitt Romney gave some details on his plans for a budget proposal should he be elected in November. Although his calls for lower tax rates across the board run counter to Democratic calls to let current rates rise back to decade-ago levels for upper-income taxpayers, a couple of things he proposed actually suggest at least a little bit of common ground. But they could spell problems for taxpayers who take advantage of the provisions he's proposing to cut -- as well as the businesses that thrive on those provisions.

Say goodbye to mortgage interest deductions?
Romney's call to end the mortgage interest deduction for second homes doesn't go as far as some analysts believe is appropriate, but it's a step toward removing one of the largest subsidies in the tax code. By getting rid of some of the incentives of owning homes, the U.S. might help avoid a future repeat of the housing bubble and the financial devastation that followed.

Housing-related tax provisions abound and are highly favorable to homeowners. Deducting mortgage interest and real estate taxes are just two of the benefits. Joint-filing homeowners can also exclude as much as $500,000 in capital gains when they sell their homes -- avoiding tax entirely on that amount. That's a far better tax break than investors get on stocks, bonds, and other investments.

Of course, getting rid of mortgage interest deductions doesn't do the industries that rely on them any favors. Homebuilders Hovnanian (NYSE: HOV  ) and PulteGroup (NYSE: PHM  ) build homes in areas that are popular destinations for second-home buyers, and thus taking away the tax incentive to borrow to purchase second homes could have a direct adverse impact on their demand. Similarly, as Bank of America (NYSE: BAC  ) and Wells Fargo (NYSE: WFC  ) try to boost the credit quality on their loans and demonstrate that they're actually lending the cheap money that the Federal Reserve provides, taking away at least one source of fairly creditworthy borrowers won't help them meet their goals.

Killing the deduction on state taxes
The other tax proposal Romney made was to eliminate the deduction for state taxes for high-income taxpayers. That has the potential to be far more divisive, as it hurts taxpayers in high-tax states while leaving untouched those who live in states with low or no taxes.

However, one thing that a lot of people don't realize is that for many, the benefits of state taxes already get eliminated under the current tax code. That's because the alternative minimum tax, which hits millions of taxpayers each year, forces you to reverse itemized deductions on state income and property taxes you pay, making them worthless.

Losing that tax benefit would likely hurt not only individuals who live in those states but also the businesses that rely on hiring skilled workers. Already, no-tax states like Texas and Washington have a huge advantage over high-tax states like California, which partially explains the migration of tech companies toward lower-tax environments over the years. With Apple's (Nasdaq: AAPL  ) provision for state income taxes eclipsing the $550 million mark in fiscal 2011, there's clearly incentive for companies to make tax-saving moves. Further tilting the scales to hurt high-tax states could have significant competitive effects on the industries that produce high-paying jobs -- exactly the ones that states are courting more than ever.

Keep your eyes on your money
In an election year, it's highly unlikely that lawmakers will make much progress even on tax proposals that gain bipartisan support, let alone more contentious issues. But as you consider what moves to make with your finances, be sure to think about how taxes might affect you. If you don't, you could end up making ill-advised decisions that will cost you money.

Taxes are a key part of your overall financial plan, but you also have to have the right investments. Take a close look at The Motley Fool's special report on long-term investing, which includes three stocks to help you reach all your financial goals. Best of all, it's free -- so get your free report today while it's still available.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter here.

Fool contributor Dan Caplinger would love to see a simpler tax code. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Bank of America, Apple, and Wells Fargo, and has created a covered strangle position in Wells Fargo. Motley Fool newsletter services have recommended buying shares of Wells Fargo and Apple, as well as creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy will never disappear.

Read/Post Comments (10) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 18, 2012, at 9:59 AM, DrRoberts1 wrote:

    First off, Willard is not the favorite to win this election. A recent poll shows that respondents split 62 to 36 with the majority believing Obama will be elected to a second term. Secondly, mortgage interest deductions and the deductability of state taxes benefit residents living primarily in Blue states. Don't forget that Dems can use the fillibuster just like the current minority party should Romney win in a nail-biter and the Congress go Republican. In other words, this article is premature. And that is a kind assessment.

  • Report this Comment On April 18, 2012, at 10:21 AM, OnTheContrary wrote:

    The only problem with Romney's proposals is that they don't go far enough. What we really need is a flat tax with all deductions eliminated, both personal and business, but in the meantime eliminating the mortgage deduction altogether, and the deduction for state and local taxes are entirely appropriate. The mortgage deduction has been a prime culprit in the overbuilding bubble that got us into our present financial mess, and it is a tax break for (a) the wealthy, who can afford expensive homes, and/or (b) those who choose to live in high property tax states. As such, the mortgage deduction is a subsidy to those states at the expense of all the other states and the individuals who live in them. The federal government has no constitutional mandate to get involved in the taxation policies of states.

    And that is also the reason eliminating the federal deduction for state taxes, which disproportionally benefits those who choose to live in high tax (and usually high wealth) states.

    Bottom line is that both of these deductions disproportionately benefit those in the upper income echelons, and they subsidize both the housing and real estate related industries, and the high tax states, which (just coincidentally) also tend to be the politically most important ones. Eliminating them is a small step in the direction of tax fairness.

  • Report this Comment On April 18, 2012, at 11:24 AM, CMFSoloFool wrote:

    While I don't believe a flat tax will ever be enacted during my lifetime, I am simply amused that the Repubs are even talking about raising taxes. READ MY LIPS....

    Politics these days are beyond comprehension, and focus solely on partisan rather than general good. I vote for the third party... the one that isn't either republican or democrat.

  • Report this Comment On April 18, 2012, at 1:27 PM, ditcap wrote:

    The have basically already done with the AMT

  • Report this Comment On April 18, 2012, at 3:02 PM, DJDynamicNC wrote:

    ---> "As such, the mortgage deduction is a subsidy to those states at the expense of all the other states and the individuals who live in them. The federal government has no constitutional mandate to get involved in the taxation policies of states." <---

    From the Constitution: "The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States; but all Duties, Imposts and Excises shall be uniform throughout the United States"

    In other words, Congress can set tax policy and mandate that certain aspects of it be uniform throughout the states. That's pretty clear. Of course, here Congress isn't even mandating that the states do anything; it's simply using state-provided data to set its own formulae for taxation. This is in no way unconstitutional

    As for subsidizing states, take a look at the inflow fo tax dollars vs the outflow for every state and see where they stack up.Take a look:

    The high wealth states (and their taxpaying citizens) are HEAVILY subsidizing the less successful states. If you really want tax fairness, you should be looking at increasing flows of federal funding to the states that are actually paying for it.

    However, what we as a nation have decided is that the more successful should take care of the less successful, and so here in New York I continue to subsidize Mississippi's attempts to break out of a bottom five ranking in every positive category, which is far better for the nation than just abandoning Mississippi to continue without the resources it needs to try to improve. Contrast that with the Eurozone; the European Central Bank refuses to subsidize poorer nations on the success of wealthier nations, and so instead those nations are collapsing because they've been denied the monetary tools they need to act, but are also being denied the centralized policies and subsidies that would get them through the crisis (in the same way that the US is facing the crisis as a cohesive unit, thanks to its strong federal government).

    In fact, right now, the notion of strong states with a weak central government is getting real-world testing in the European Union. I'll leave it to you to judge how its faring.

  • Report this Comment On April 19, 2012, at 9:03 AM, rossirina wrote:

    I would like to offer you a thoughtful short article called "The Hidden Costs of Paying Off Your Mortgage". It goes beyond the tax benefits your mortgage offers. Here is a link:

  • Report this Comment On April 19, 2012, at 10:30 AM, DJDynamicNC wrote:

    Rossirina, that was an interesting article with some good points, thank you for posting it. I enjoyd it but I must note that I grow wary any time an article "assumes" that your house will appreciate in value. That's a very big assumption to make.

  • Report this Comment On April 20, 2012, at 10:00 AM, rossirina wrote:

    DJDynamicNC, we are still living the subprime aftershock but with a bit optimism things would change and in the long run real estate prices (in specific areas) may increase again. Anyway I value all the other goodies offered in the article ignoring the real estate value increase assumption.

  • Report this Comment On April 20, 2012, at 10:54 AM, DJDynamicNC wrote:

    Definitely an interesting article despite the assumption, thanks for posting the link.

  • Report this Comment On April 22, 2012, at 9:33 PM, Lordrobot wrote:

    Dr. Roberts a CAPs player with <20 says

    "First off, Willard is not the favorite to win this election. A recent poll shows that respondents split 62 to 36 with the majority believing Obama will be elected to a second term."

    That must has been the black caucus poll because Gallop said the race is close now and quite frankly that means Obama is in trouble.

    The crazy idea of this <20 is that he seems to think that obama is out to save him from taxes.

    The elimination of the interest deduction on a second home only applies if the home is not rented and is not used as an investment. All money borrowed on investments is deductible.

    Further what is needed is to lower all tax rates across the board and expand the tax base. The thought that 50% of worker pay no tax is insane and the the top 15% are expected to pay 90% of the tax is unconscionable. It is shocking to me that liberals feel they deserve the bounty of another's work. In the real world, the animal world, they would starve and liberalism would die which would benefit everyone else.

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