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The Mortgage Interest Deduction and The Housing Market

Many of us benefit from the mortgage interest deduction when we file our taxes each year. Policy makers have used the deduction as a way to encourage home ownership. Depending on one’s tax bracket, the interest you pay on your mortgage is effectively reduced by the deduction you receive on your tax return if you itemize your deductions. For example, if you are in the 28% tax bracket and paid $10,000 in mortgage interest last year, you saved $2,800 in taxes by itemizing your deductions.

Many have argued that the deduction has distorted the housing market and caused housing prices to rise to levels to which they should not have. The housing boom and bust is now leading policy makers to consider changes to this popular deduction. Here are some changes that have been floated:

Mortgage Balance Cap: in this proposal the interest deduction on a loan above $500k will be eliminated. An alternative to this in the President’s budget would be to cap the deduction at 28% for couples earning more than $250k/year. If this proposal was adopted it would have a negative impact on the high-end housing market.

Tax Credit & Mortgage Balance Cap: a 12% tax credit would be provided to those with a mortgage balance of $500k or less. This would replace the mortgage interest deduction. If this proposal was adopted if would hurt the high-end of the housing market even more signficantly then the previous proposal, but would actually help the low-to-middle end of the housing market. There are many folks who do not have enough deductions to itemize their taxes now, so this tax credit would actually be a benefit to them.

Eliminating interest deductibility for 2nd homes and HELOCs: this proposal would have a very negative effect on housing markets in typical vacation areas. (Think beaches and mountain areas.)

None of these proposals are set in stone so one should proceed with caution in making decisions based on proposals. That said, with all the talk about budgets and deficits some type of tax reform is likely in the few years and my best guess is that our lawmakers will do their very best to avoid raising income tax rates. Hence, while income tax rates may not go up, I expect income taxes to go up and this will likely take the form of fewer deductions allowed. Only time will tell if the housing market is impacted by future tax reform.

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