Deficit-Fighters Eye Mortgage Interest

There is a serious possibility that the Bush Administration and Congress will raise tax revenue by cutting your deduction for mortgage interest.

That’s right, the big tax deduction of the American middle class may come under the knife, say Washington sources, because budget negotiators need a way to close the government’s yawning deficit.

And limiting mortgage interest deductions, which now total about $35 billion a year, could certainly help do that. One idea being discussed could raise more than $50 billion in tax revenue in the next five years.

Paying that $50 billion extra to the government would be people in the 28% tax bracket, meaning anybody with income above $30,950 for couples filing joint returns and $18,550 for single taxpayers.

“There’s no doubt it would raise a lot of revenue,” says David Shulman, head of real estate research for Salomon Bros., “but also no doubt that it would be a negative for housing and home prices.” That would be true especially where home prices are high--California and the Northeast and areas around major cities where homes run to several hundred thousand dollars and mortgage interest can total tens of thousands.

To be sure, nobody contemplates eliminating the deduction entirely. Rather, the talk in Washington is of limits--one congressional staffer suggests that a cap of $20,000 be put on all interest deductions.

Significantly, there is growing support for limiting the mortgage deduction to the lower 15% tax bracket, meaning that any amounts deducted from gross income would reduce one’s taxes by 15%, not 28%.

To understand, you have to think in tax dollars, say congressional experts. For example, let us say a $60,000 gross income is reduced $12,000 by deducting mortgage interest of $10,000 and real estate taxes of $2,000. At 28%, that deduction reduces the taxes that would otherwise be paid by $3,360. So it is said to “save” the taxpayer $3,360 in tax dollars and, correspondingly, to “cost” the government that amount. But if that $12,000 deduction is allowed only at the 15% bracket, it reduces taxes due by only $1,800. That means the taxpayer would pony up $1,560 more in taxes--the difference between $3,360 and $1,800.

The result would be a lot of people paying more in taxes.

Yet the idea of treating mortgage deductions at the 15% rate appeals to both Republicans and Democrats, according to Washington sources. Republicans like it because it would allow them to raise tax revenue without, at least formally, raising tax rates. Democrats like it because it would equalize the tax benefit, in percentage terms, of deductions for the millionaire’s mansion and Joe Sixpack’s bungalow.

That’s political bunk, of course. The big tax revenues would be raised, as they always are, from the broad middle class--not only from millionaires. And whether taxes are raised by higher rates or lower deductions, the effect is that people will pay more in taxes.

In addition, of course, limiting interest deductibility could have broad effects in the U.S. economy. It would tend to reduce credit, and thus further weaken housing markets and home prices. It would put a crimp in home equity loans, which banks now market as a middle-class tax shelter.

Yet there are those who say it’s an idea whose time has come. The thought of achieving tax fairness by treating all deductions--including state and local taxes and charitable contributions--at a single rate was included in initial proposals for the 1986 Tax Reform Act by Sen. Bill Bradley (D-N.J.) and Rep. Richard Gephardt (D-Mo.). It aroused opposition on practical lines--from state governors and the housing industry--but not on party or ideological lines.

Conservatives don’t oppose the idea because they believe that interest deductions have distorted the U.S. economy, encouraging too much financing for second homes and not enough for industry. “We have been diverting capital to housing that might be put to better uses,” says Dale Jorgenson, professor of economics at Harvard.

Truth is, policy is shifting. Housing has received strong support in this country since Congress made mortgage interest deductible in 1913, and introduced federal mortgage insurance in 1934. As a result, the United States, with allowances for those who are ill-housed or for various reasons homeless, is the best-housed nation in the world.

But other countries, Canada, Japan and Britain to name three, have high rates of home ownership and yet do not grant full mortgage interest deductibility. And now the question of how much tax support U.S. housing needs has begun to be asked.

That doesn’t mean that change will come easily. The debate over interest deductibility will be a political blowout, with middle-class homeowners everywhere protesting vigorously.

Still, the government deficit is huge, and sizable alternatives for financing it are scarce.

The 1986 Tax Reform Act, which cut tax benefits on commercial property, left residential real estate relatively untouched. Nonetheless, it established the principle of limiting deductions for mortgage interest--if only by setting the limit at $1 million.

Budget negotiators in 1990 are likely to go much further.