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 home builders, 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 while the lame-duck Congress thrashes to an end, 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 homeownership. In the wake of 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 homeownership 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 USC Lusk Center for Real Estate.
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 revenue that could be used to cut the deficit while inflicting surprisingly little pain on most middle-class homeowners.
The National Assn. of Realtors already is running ads warning that tampering with the deduction would hurt "hard-working American families." The ads point out that 65% of the taxpayers who took the deduction made less than $100,000.
What the group doesn't say is that about 75% 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.
Not surprisingly, this geographical and financial divide can be seen when homeowners are asked how they would feel if the mortgage deduction were scaled back — or replaced by a tax credit, as President Obama's deficit commission has recently proposed as part of a broad overhaul of the tax code.
"I don't have a problem with it," said Sterling Hyden, 51, an insurance agent in Corsicana, Texas.
Home prices in his town, about 50 miles south of Dallas, average less than $100,000, he said. With a mortgage of a little more than $60,000 on their ranch-style house, Hyden and his wife don't pay nearly enough mortgage interest to benefit from the tax deduction.
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.
The deficit commission's plan would do away with itemized deductions altogether and allow every homeowner to get a tax credit equal to 12% of interest paid on mortgages up to $500,000.
So for someone like Hyden, who is paying about $3,300 in interest this year on his mortgage, he would stand to get a tax credit of nearly $400, as opposed to nothing under the current system.
"As long as it's something fair across the board, I wouldn't mind it at all," Hyden said.
Much the same would be true in the vast majority of the country. Even in big coastal states, many people don't live in high-priced housing markets. For example, about a third of Californians live in counties where home prices average $200,000 or less — and many others, especially older homeowners, have relatively small mortgages.
The average nationwide mortgage loan as of October was $215,000, according to the Federal Housing Financing Agency.
On the other hand, younger homeowners in wealthier areas are likely to feel the biggest pinch. Take Hyun K. Chung of Orange County.
The 37-year-old occupational therapist has a mortgage of about $500,000 on her house, which she bought at the peak of the market in 2006. Her loan carried an interest rate of 6.4% last year, putting her interest payments at about $32,000.
Chung doesn't remember how much her mortgage deductions saved her in taxes, but based on rough estimates, it was probably about $6,600, said James Nunns of the nonpartisan Tax Policy Center.
The deficit commission's plan would slice that to about $3,800, though Nunns said the difference could be significantly offset by lower tax rates and other changes under the commission's proposal. The possible tax changes are still too imprecise to calculate exactly how they would affect people.
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.
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 the tax code. That means home prices wouldn't necessarily drop as a result, but if values in those markets increased 10%, 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.
Nietmann, the southern Maryland homeowner, worries about what the change would mean for the next generation. She said the mortgage on her home was mostly paid off, so the loss of the deduction would have little bearing on her and her husband. Still, she wants to keep the status quo. "For my children," she 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 benefits to keeping a big home loan.
Analysts point out that other countries, such as Canada and Australia, have high homeownership rates similar to the U.S., currently at 67%, 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 wouldn'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 might finally be coming because of the magnitude and urgency of the nation's budget deficits. "It's certainly possible," she said.