WASHINGTON — Fifteen years ago, Carol Nietmann and her husband bought a spacious house in Calvert County near the Chesapeake Bay. And thanks to the time-honored tax deduction for mortgage interest, she says, their new place was a little bigger and a little nicer than they otherwise would have been able to afford.
Perhaps the most sacred of all the sacred cows in the tax code, the home mortgage deduction has long been seen as critical to a major element in the American dream — owning your own home. It's also a boon to home builders, construction workers, the financial services industry and local governments that benefited from fatter real estate tax revenue.
But after nearly a century, the mortgage deduction may face a day of reckoning. Though out of the spotlight for the moment while the lame-duck Congress thrashes to an end, the mortgage deduction issue is likely to resurface next year when new representatives — including a lot more deficit-hawk Republicans — take their seats.
In part, the hoary deduction has a target on its back as a result of policymakers' rethinking the whole issue of home ownership. After the havoc that followed the bursting of the housing bubble — a calamity that still shadows the U.S. economy and will for years — it's no longer clear that near-universal home ownership should be a paramount goal.
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 — generating billions of dollars more in federal revenues that could be used to cut the deficit while inflicting surprisingly little pain on most middle-class homeowners.
However, the National Association of Realtors is already running ads warning that tampering with the deduction would hurt "hard-working American families." The ads point out that 65 percent of the taxpayers who took the deduction made less than $100,000.
What the group doesn't say is that about 75 percent 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 on average saved $2,330 in 2008. But for those reporting incomes of $200,000 and over, the average savings were nearly triple that amount.
In fact, only about one-half of all homeowners in the United States — and just one-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 cities on the East Coast and in California — reap a disproportionately large share of the tax savings.
Not surprisingly, this geographical and financial divide can be seen in people's reaction when asked how they would feel if the home mortgage deduction were scaled back — or replaced by a tax credit, as President Barack Obama's deficit commission 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 Corsica, Texas. Home prices in his town, about 50 miles from Dallas, average less than $100,000, he says. With a mortgage just over $60,000 on their ranch-style house, Hyden and his wife don't pay nearly enough mortgage interest to enjoy 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 in the amount of 12 percent of interest paid on mortgages up to $500,000. So Hyden, who's making about $3,300 in interest payments this year, would stand to get a home mortgage 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 many parts of Pennsylvania, Illinois, Florida, California and other states — at least outside their priciest urban areas. According to the Federal Housing Financing Agency, the average mortgage loan as of October was $215,000.
On the other hand, many homeowners in high-end markets dread the idea. Take Hyun K. Chung of Orange County, Calif.
The 37-year-old occupational therapist has a mortgage of about $500,000 on her house, which she bought near the height of the market in 2006. Her loan carried an interest rate of 6.4 percent 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, although Nunns says the difference could be significantly offset by lower tax rates and other changes under the commission's proposal.
Nietmann, the Maryland homeowner, says the mortgage she has with her husband is mostly paid off, so the loss of the deduction would have little effect. Still, she would like to keep the status quo. The reason? "For my children," she said.
Others insist that the housing market is too banged up to absorb a tax shock. With prices still depressed and more than one-fifth of homeowners owing more than their properties are worth, reducing or eliminating the mortgage deduction would be disastrous, they say.
Independent analysts are not nearly as alarmed. Replacing the mortgage deduction with a tax credit such as the commission's "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.
Other scholars have long argued that the current mortgage deduction is neither equitable nor economically efficient. While home ownership may be desirable — for building community and personal wealth, many say — the recession highlighted the downside of throwing excessive public support at programs to help people buy their own homes.
Countries such as Canada and Australia have home ownership rates similar to that of the United States — which is currently at 67 percent — but they don't have tax subsidies that encourage people to take on bigger homes and debts.
Besides mortgage interest, taxpayers can deduct property taxes on their federal income tax returns, and they save tens of billions of dollars a year more in tax exemptions for profits when they sell their homes.
"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 University of Southern California's Lusk Center for Real Estate Development.
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 various 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 rich and poor.
Alice Rivlin, a top budget official in the Clinton administration and a member of Obama's deficit commission, says any big change in the mortgage deduction won't happen by itself. It would 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. Although reluctant to assess its chances, Rivlin says the time may finally be coming because of the magnitude and urgency of the nation's budget deficits. "It's certainly possible," she said.