Higher mortgage rates increases the urgency for mortgage deduction changes

As mortgage rates increase it will put the mortgage interest deduction question back into focus. This has been a rumor that has circulated for several years.  For the extreme high income earners the mortgage interest tax deduction has a phase scale.  It’s called the PEP and Pease tax rules that phases out the mortgage interest for couple earn more than $25o,000 per year.  The PEP and Pease is the first successful attempt to reduce the deduction.  There are other several proposals to phase it out, but it will probably a modification of this law that will pass.  If fact, Congress would have to do is just lower the income threshold and increase the phase out calculation to apply the PEP and Pease to capture additional households.

How the Mortgage Interest Deduction Could Change

Congressional action on the U.S. tax code could dramatically alter one of its sacred cows: the mortgage interest deduction. And the change could come in 2013.

House Ways and Means Committee Chairman Dave Camp (R-Mich) held tax reform hearings in April to eliminate loopholes. He said he’s “carefully looking into revising” the popular provision that many in the real estate business consider crucial to the industry.

Camp said he’d like a total tax reform package before the year is out.

One analyst says the time is ripe to change the deduction-in existence since 1913- which is costing the U.S. government billions in tax revenue while doing little to help home ownership.

“It costs at least $70 billion a year in lost tax revenues,” said Will Fischer, a senior policy analyst at the Center on Budget and Policy Priorities, and  co-author of a study released last month  that called for changing the mortgage interest deduction intto a tax credit.

“It only benefits about half of homeowners that pay interest,” Fischer said. “I think there’s real interest in reforming the mortgage interest deduction to help more people, while bringing in more tax revenue.”

Right now, taxpayers who itemize their deductions can deduct up to $1 million of the interest paid on their mortgages, plus up to $100,000 of the interest on home equity loans, a type of loan in which borrowers use the equity in their home as collateral. Homeowners can do the same on a second home.

In his paper, Fisher states that in 2012, 77 percent of the benefits from the mortgage interest deduction went to homeowners with incomes above $100,000. Close to half of homeowners with mortgages-mostly lower and middle-income families-received no benefit from the deduction, according to Fisher.

Only about 30 percent of eligible taxpayers actually use the mortgage interest deduction each year.

 “You can make the case for the deduction, but it really does promote home ownership for mostly upper income levels,” said Mark Goldman, a real estate professor at San Diego State University.

“And I’ve never had a deal happen or not happen because of the deduction,” added Goldman, who is also a real estate broker.

 This deduction is used mostly by the high priced states like California and New York.  What phased out it’s usage in lower cost states was the low mortgage rates.  But mortgage rates are on the increase again.  New buyers and homeowner that have refinanced will be more depended on it to afford their house or  qualify for their refinance.  The table below illustrates the impact of mortgage rate increases on the effectiveness of the mortgage interest tax deduction on a $500,000 home with a 20% down.  I have also included property taxes as part of the deduction.

House: $500,000

Loan Amount: $400,000

Property Tax Rate: 1.04%

Property Taxes: $5,200

Mortgage Rate Loan Amount Payment (yr) Interest (yr) Property Taxes Total Deduction Standard Deduction
 3.5%  $400,000  $21,749  $14,000  $5,200  $19,200  $12,500
 5.0%  $400,000  $26,021  $20,000  $5,200  $25,200  $12,500
 6.0%  $400,000  $29,060  $24,000  $5,200  $29,200  $12,500
 7.0%  $400,000  $32,235  $28,000  $5,200  $33,200  $12,500

I added the standard deduction just as a comparison.  What is the impact of this deduction on your taxes?  Let’s apply this deduction to combined 34% federal and state income rate and see what is the potential rebate.

Deduction Tax Rate Refund Amount
$12,500 34% $4,250
$19,200 34% $6,528
$25,200 34% $8,568
$29,200 34% $9,928
$33,200 34% $11,288

I started with 3.5% mortgage rate, because that was the recent bottom mortgage and increased to 7%.  Even the “high” rates of 7% is still on the low end of the average of 7% to 9%.  As mortgage rate increased to from 3.5% to 7% the total deduction increased from $19,200 to $33,200, that’s $14,000 increase.  The potential refund amount increased to $11,288 from $6,528.  This is only a $500,000 house, if you start applying this calculations to the a million dollar the refund is over $20,000 which is just about your property tax bill.

Of course this won’t affect most people with low fixed rate mortgage if the deduction is lower.  However, homeowners that will refinance and new purchases will be affected.  That’s why there is a little more urgency to get this past.  As time moves forward more homeowners will have these higher rates and likelihood of this passing this law decreases.   And it needs to repeated most of the homeowners that take average of this deduction are in the coastal states.