With federal income taxes due in less than a week, many homeowners will be relying on their home mortgage interest deduction to chop their tax bill down. With changes to the tax laws coming all the time, it's important to keep abreast of the proposals that top economic bodies are recommending, as these think-tank leaders have a lot of influence with Congress and the IRS.
In late 2005, the President's Advisory Panel on Federal Tax Reform recommended the elimination of home mortgage interest deductibility for income taxes. With the subprime mortgage crisis exposing how overstretched some homeowners have gotten with their mortgage payments, killing the mortgage interest deduction may be the final straw that topples their precarious finances.
The purpose of the Advisory Panel
The bipartisan panel was created in 2005. The panel, made up of many of the top academic public finance minds, had the goal of giving recommendations on how the income tax system could be made "simpler, fairer and more pro (economic) growth" for the long run.
The panel recommended many sweeping reforms and changes to the income tax code -- all of which you can find in the complete report -- but the most interesting and controversial of them all was to get rid of the mortgage interest deduction for homeowners. Eliminating this time-honored American tradition, which has been in existence since 1913, would affect those owning the more than 123 million homes in the U.S. -- but it's not bad news for everyone.
The proposalIn actuality, the panel's proposal for how to treat mortgage interest isn't as bad as it sounds. Instead of allowing the current tax deduction for up to $1 million in mortgage debt that is allowed now, the panel's recommendation is to scrap the deduction completely, replacing it with a flat 15% tax credit for mortgage interest paid up to the limit of average home prices in the region of the home.
For example, homeowners with $500,000 in mortgage debt at a 6% interest rate and earning $100,000 today get to take a tax break of about $8,400 on their tax bill. Here's the math:
$500,000 mortgage debt x 0.06 interest rate x 0.28 tax bracket = $8,400 in tax savings.
Under the new proposal, if these people lived in a region that has an average regional housing price of $227,000, then they would only be able to take a tax credit worth just over $2,000. Here's the math:
$227,000 max mortgage debt eligible for tax relief x 0.06 interest rate x 0.15 tax credit = $2,043 in tax savings.
The people most hurt by this proposal are those with large mortgages in markets with low average housing prices. For those in high-priced markets like California, the amount of tax savings would be higher, as the higher average would make more of their debt eligible for the credit.
There are other details of the proposal that would affect smaller groups of people, including eliminating the deduction for interest on second homes and home equity loans. For more on these, take a look at page 70 of the report.
Why economists like this planThere are several reasons why many economists prefer this new scheme covering mortgage interest. One of the most important is that the mortgage interest deduction encourages overinvestment in housing, and in the event of a crash in housing prices, economists would prefer not to have the housing sector push the entire economy into recession or depression. On a macroeconomic level, this is the same diversification principle that serves individual investors so well with their portfolios.
Economists are also concerned about finding ways to increase people's desire to save for retirement. As the tax code stands right now, housing gets huge subsidies, with mortgage and real estate tax deductions, as well as a large exemption from capital gains when homeowners sell their property. In contrast, interest, dividends, and investment capital gains are subject to tax. By eliminating housing as a tax break, more people may take advantage of Roth IRAs or 401(k) plans for tax savings.
Who gets hurtOf course, there'll be plenty of people upset with this proposal. The biggest group affected will be the 12% of homeowners with incomes of $100,000 or more, who reaped about 55% of the benefit of mortgage deductions, according to the report. At least 74% of the taxpayers falling into this income group would see their tax bills go up under this proposal.
In addition, the entire housing industry could suffer. Lenders like Countrywide Financial (NYSE: CFC) and homebuilders like Pulte
The future
Of course, with so many people affected, one wonders how politically feasible eliminating the mortgage interest deduction is at present or the near future. Then again, other dramatic tax changes in the past, such as the huge overhaul of the tax system in 1986, didn't seem very plausible at the time. The biggest takeaway from the panel's recommendations is that the only constant with the federal tax code is that it will always be in flux. Therefore, be sure you're not counting on continuing tax breaks to keep your finances afloat.
For great money tips and ways to boost your savings, take a free 30-day trial today to the Motley Fool Green Light newsletter. You'll get great content, including the current newsletter, back issues, members-only discussion boards, and advisor blogs.
Fool contributor Brian Lawler likes to build gingerbread homes and does not own shares of any company mentioned in this article. The Fool has a disclosure policy.
