Contributor Post Created with Sketch. Yes, It’s Time to Reform the Mortgage Interest Deduction

 

Housing policy should be at the heart of America’s economic policy debates. Housing was a catalyst for the Financial Crisis. Housing costs constrain America’s most productive cities and regions. Housing tax breaks distort the economy and reduce government tax revenues by at least $70 billion annually. If you’re interested in the US economy growing faster in the next decade than it has in the past decade, then smart housing policy would be a key accelerant. Housing reform is a key structural reform to creating sustained fast growth in the decades to come.

Of course given that housing is central to people’s lives, big changes would inevitably mean big political controversy. So I totally get why Hugh Hewitt is concerned that the incoming Trump administration is considering capping the mortgage interest deduction. Hewitt makes a number of arguments in his Wall Street Journal op-ed from the other day: (a) the value of every US home would immediately fall by 10-15%; (b) it’s unfair to change the rules in the middle game; (c) it would be an unfair and shocking surprise since no politician ran on this issue; (d) the political fallout would consume the GOP – especially in high tax states – and destroy its chance to “realign politics” and get more important things done, such as filling judicial vacancies and rebuilding the military.

So how to address a terrible misallocation of national resources in a way that is seen as fair and avoid a political conflagration? A few thoughts:

  1. While it would have been great for the 2016 campaign to have been a forward-looking and serious one — addressing a variety of issues to create balanced, sustained growth in a modern economy—instead we got a retrograde one focusing on all manner of walls. But better late than never to focus on substantive issues, including housing.
  1. Most of the serious proposals, right and left, are a bit more complicated that just cold-turkey capping mortgages at some lower level. Here is one version, from my AEI colleague Alan Viard:

    I propose to replace the mortgage interest deduction with a 15 percent refundable credit … available to all homeowners, including those who claim the standard deduction and those with no income tax liability. The credit is limited to interest on $300,000 of mortgage debt (in 2013 dollars), with no tax relief for mortgages on second homes or on home-equity loans. The dollar limit is indexed to the consumer price index (CPI) in the same manner as the bracket endpoints and other dollar values in the tax code. Taxpayers with existing debt are allowed to claim 90 percent of the current-law deduction in 2014 on that debt, declining 10 percent per year thereafter, with the option to switch to the credit at any time.

    And why do this? Again, Viard:

    There may be good economic grounds, and there is certainly strong political support, for promoting homeownership, but there is no case for subsidizing bigger or more-expensive homes. Yet, the current tax treatment is more geared toward the latter objective, offering the largest benefits to taxpayers in the highest brackets and providing more-generous treatment to taxpayers who itemize than to those who claim the standard deductions. Indeed, the current tax policy may actually impede homeownership for taxpayers of more modest means because the preferences for high-bracket itemizers drive up the demand for homes and boost home prices.

  1. A couple more things: There are a number of options as you transition from one system to the other, including to grandfather existing mortgage debt and phase in a cap gradually over time. Also, estimates of sharp housing price declines may be overstated.
  1. If you are worried about the finanical hit to upper-middle class and wealthier Americans, don’t forget the large tax cuts being promised by the president-elect.
  1. Even if you accept the plan as briefly outlined by Treasury Secretary-elect Steven Mnuchin, it would only affect a small number or borrowers, as CNBC’s Diana Olick notes:

    For those who do itemize, here’s how the math works: Let’s say you have a $500,000 30-year-fixed mortgage at 4.5 percent, and you’re in the 33 percent tax bracket. In the first year of your loan, the deduction saves you just more than $10,000 in taxes. If the Trump administration caps deductions at even $100,000, as Mnuchin suggested, that would not hit most borrowers because on that $500,000 (which is more than most loans in general) the total annual interest payment was about $23,000. Granted, homeowners may have other deductions, medical expenses, charitable, religious or otherwise, but most would not make it to $100,000 even with the mortgage.

  1. Are we also not going to reform Medicare and Social Security? Because it supposedly changes the rules of the game, at least for some people. That seems like a recipe for policy paralysis.
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  1. I Walton Member

    Could we just stop trying to be clever. We aren’t. Lower upper tax rates and end the deductions and all other subsidies. Everybody wins.

    • #1
    • January 11, 2017, at 1:06 PM PST
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  2. Steve C. Member

    I Walton (View Comment):
    Could we just stop trying to be clever. We aren’t. Lower upper tax rates and end the deductions and all other subsidies. Everybody wins.

    I agree but I don’t think that would find many sponsors in Congress.

    I’ve always supported the idea of a two option personal income tax system.

    Option 1: The current system, as is, no changes

    Option 2: Flat tax of 10% of total income. From first dollar to last.

    You get to choose your system every four years, coinciding with Presidential elections. Then you have to live with that choice until the next election.

    I think it would be an interesting experiment in choice to see the percentage and demographics of tax payers over an 8 year period.

    I think I read something about “tax choice” years ago in National Review, I’m not taking credit for this as an original idea.

    • #2
    • January 11, 2017, at 1:13 PM PST
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  3. bridget Inactive

    (d) the political fallout would consume the GOP – especially in high tax states – and destroy its chance to “realign politics” and get more important things done, such as filling judicial vacancies and rebuilding the military.

    Two quantitative questions: to what extent does the GOP have much to lose in high-tax states? Many states with the high homeownership costs and taxes (California, New York, Massachusetts, Illinois, etc.) are solidly blue on the state and federal level. Here in Massachusetts, many towns (including my own) have a median home price north of a million dollars, and the state hasn’t sent a Republican to Congress since 1994.

    How many people cannot take the full value of their home mortgage interest deduction because they are already subjected to alternative minimum tax? Would a Trump proposal that streamlines and simplifies the tax code result in them paying the same or less in taxes?

    • #3
    • January 11, 2017, at 1:14 PM PST
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  4. Fezzik Inactive

    I would not mess with this deduction right now for the simple reason that it’s an important bargaining chip if/when we get serious about tax reform. Implementation of a flat tax or some other flattening mechanism will require the sacrifice of the mortgage interest deduction (and other popular deductions). I would hold onto this for that day and not waste the political time and energy futzing around.

    • #4
    • January 11, 2017, at 1:23 PM PST
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  5. Shawn Buell, Jeopardy Champ! Contributor

    bridget (View Comment):

    (d) the political fallout would consume the GOP – especially in high tax states – and destroy its chance to “realign politics” and get more important things done, such as filling judicial vacancies and rebuilding the military.

    Two quantitative questions: to what extent does the GOP have much to lose in high-tax states? Many states with the high homeownership costs and taxes (California, New York, Massachusetts, Illinois, etc.) are solidly blue on the state and federal level. Here in Massachusetts, many towns (including my own) have a median home price north of a million dollars, and the state hasn’t sent a Republican to Congress since 1994.

    How many people cannot take the full value of their home mortgage interest deduction because they are already subjected to alternative minimum tax? Would a Trump proposal that streamlines and simplifies the tax code result in them paying the same or less in taxes?

    When you put it like that it makes me like the idea merely from the perspective of punching blue state leftists in their wallets.

    • #5
    • January 11, 2017, at 1:26 PM PST
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  6. Fake John/Jane Galt Coolidge

    The GOP. Destroying the american dream of owning their own place one tax at a time.

    • #6
    • January 11, 2017, at 1:27 PM PST
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  7. Vectorman Member

    What most people don’t realize is that the original definition (1915) of income had nothing to do with wages. Income was something you received for having capital – if you rented your farm, it was income. If you received interest from a bank, that also was income.

    So if you paid interest to a bank for a loan, that was considered negative income. Like with a Value Added Tax (VAT), your net Income Tax was based on the amount you paid vs. the amount received. Hence the mortgage deduction. The lending institution would also pay income tax based on the amount received from you less the interest paid to depositors.

    • #7
    • January 11, 2017, at 1:32 PM PST
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  8. EDISONPARKS Member
    EDISONPARKSJoined in the first year of Ricochet Ricochet Charter Member

    I like Hugh Hewitt and honestly do not understand his mortgage interest deduction fetish.

    If you want to decrease special interest political donations/lobbying/(corruption?) then you have to get rid of the industry specific items in the tax code(real estate, home builders, mortgage banking, building supplies, etc.) .

    If you leave this one area of the tax code alone then how do you justify getting rid of any others.

    • #8
    • January 11, 2017, at 1:33 PM PST
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  9. Jamie Lockett Inactive

    Majestyk (View Comment):

    bridget (View Comment):

    (d) the political fallout would consume the GOP – especially in high tax states – and destroy its chance to “realign politics” and get more important things done, such as filling judicial vacancies and rebuilding the military.

    Two quantitative questions: to what extent does the GOP have much to lose in high-tax states? Many states with the high homeownership costs and taxes (California, New York, Massachusetts, Illinois, etc.) are solidly blue on the state and federal level. Here in Massachusetts, many towns (including my own) have a median home price north of a million dollars, and the state hasn’t sent a Republican to Congress since 1994.

    How many people cannot take the full value of their home mortgage interest deduction because they are already subjected to alternative minimum tax? Would a Trump proposal that streamlines and simplifies the tax code result in them paying the same or less in taxes?

    When you put it like that it makes me like the idea merely from the perspective of punching blue state leftists in their wallets.

    Thanks.

    • #9
    • January 11, 2017, at 1:57 PM PST
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  10. Jamie Lockett Inactive

    This article really doesn’t address the drastic hit to home values these plans would produce. Anyone care to unpack that?

    • #10
    • January 11, 2017, at 1:58 PM PST
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  11. I Walton Member

    Steve C. (View Comment):

    I Walton (View Comment):
    Could we just stop trying to be clever. We aren’t. Lower upper tax rates and end the deductions and all other subsidies. Everybody wins.

    I agree but I don’t think that would find many sponsors in Congress.

    Yes because they’re innumerate but leadership can threaten them with embarrassment. Lower income folks don’t benefit because their marginal tax rate is too low, the wealthy are capped and the rest of us would get more with a lower rate and wouldn’t have to go through the agony of itemized deductions. If we leave things to Congress we can’t get anything done because they are forced to log roll, like everyone else cannot understand the existing tax code. They have to be given a new tax system based on a simple idea. Sell the idea and challenge all those who attempt to fiddle as against the wonderful new idea. This works even better when it really is a better idea that people can understand.

    • #11
    • January 11, 2017, at 1:58 PM PST
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  12. Stad Thatcher

    James Pethokoukis: (d) the political fallout would consume the GOP – especially in high tax states – and destroy its chance to “realign politics” and get more important things done, such as filling judicial vacancies and rebuilding the military.

    Or these high-tax states would elect Republicans to lower their taxes . . .

    I would love to have a flat tax (or Fair Tax in the future) that has one rate with no deductions, one rate that is neutral on my personal status (marriage, # of kids, sexual orientation, source of income, etc.), one simple rate that means I can sign the 1040 without have to cross my fingers praying that we filled the forms out correctly.

    • #12
    • January 11, 2017, at 2:13 PM PST
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  13. Doug Kimball Thatcher

    If you are talking simplification, it can be done in the context of tax neutrality, that is neither more nor less tax being paid by each new bracket. In fact, other than charitable contributions and standard deductions, I see no real reason for any deductions at all. Let’s eliminate the local income tax deduction, the property and excise tax deduction – in fact, let’s eliminate all itemized deductions other than charitable contributions. With respect to 2nd or third homes, allow deductions for them only to the extent that they are truly income properties. Otherwise, no deduction. In this context, FICA and Medicare can be eliminated as well. Just make sure that each bracket pays its pre-change portion of the taxes remitted under the previous law. I would eliminate tax on interest. I would eliminate tax on C Corp dividends. I would tax net short term capital gains as ordinary income and net long term capital gains would be discounted for an annual inflation factor and taxed as ordinary income as well. Transfer payments like social security, welfare, unemployment, and the dollar value equivalent of all varieties of government subsidies like HUD subsidies, health insurance subsidies, snap funds, utility subsidies, would all be taxable income. Everyone would pay something, say $100.. The tax on married couples would be calculated based upon the bracket for exactly 1/2 their gross income. The individual standard deduction would be based on the average US poverty level for a single person. There would be further deductions for children and dependent seniors living with you full time. It would be simplicity personified.

    All we have to do is the math.

    • #13
    • January 11, 2017, at 2:24 PM PST
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  14. Brian McMenomy Inactive

    Jamie Lockett (View Comment):

    This article really doesn’t address the drastic hit to home values these plans would produce. Anyone care to unpack that?

    The implied deduction figures into individuals (and mortgage companies’) calculations on how much someone can afford, so the size of mortgages that people will qualify for will be affected (and thus the price someone will offer for the house). Also, the raw return on investment is impacted if you aren’t going to get X thousand in tax savings, so that will impact how much people will offer for house Y.

    There may be some price dislocation, particularly in the higher-priced suburbs and urban areas; however, that wouldn’t be the worst thing in a lot of these areas. Irrational exuberance is the only proper phrase for some of these markets (Denver and Seattle come to mind, never mind SF, NYC, etc.). Long term, we can have a very healthy housing market without the distorting effect of the mortgage deduction. Example A; our neighbors to the north. Certain Canadian markets (read: Vancouver, Toronto) have their own price bubble issues, but they aren’t due to a government-induced distortion; everybody wants to live there (especially Vancouver).

    • #14
    • January 11, 2017, at 3:01 PM PST
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  15. Shawn Buell, Jeopardy Champ! Contributor

    Jamie Lockett (View Comment):

    Majestyk (View Comment):

    When you put it like that it makes me like the idea merely from the perspective of punching blue state leftists in their wallets.

    Thanks.

    My offer to move to Louisiana still stands!

    All kidding aside however, I prefer the plan of generally reducing the quantity of deductions in exchange for lower rates. One thing that hasn’t been considered here is the fact that the original distortion of prices in the housing market was caused by the home mortgage deduction in the first place. I don’t think it can be denied that the policy of granting deductions for paying interest incentivizes people to buy more house than they normally would and inflates housing prices in general.

    The effect of that distortion leaks out in the form of higher rental rates and generally higher costs for real estate everywhere.

    • #15
    • January 11, 2017, at 3:05 PM PST
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  16. Shawn Buell, Jeopardy Champ! Contributor

    Brian McMenomy (View Comment):

    There may be some price dislocation, particularly in the higher-priced suburbs and urban areas;

    This is the word economists sometimes use when they mispronounce “suffering.”

    • #16
    • January 11, 2017, at 3:06 PM PST
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  17. Brian McMenomy Inactive

    Majestyk (View Comment):

    Brian McMenomy (View Comment):

    There may be some price dislocation, particularly in the higher-priced suburbs and urban areas;

    This is the word economists sometimes use when they mispronounce “suffering.”

    When I see geniuses bidding up 1500 sq ft houses in Capitol Hill, Queen Anne, you name it (Seattle neighborhoods) up to over $100K over asking price, a little price suffering is in order. In case anyone hasn’t noticed, Seattle is trying hard to be the San Francisco of the Pac NW. Very soon, only the very wealthy or the homeless are going to be able to live there (either that, or live in a micro-condo; 100-150 sq ft is the future).

    I’m a homeowner in King County, WA (in the outer suburbs), so I have skin in the game. I don’t want a price collapse. But hyperinflation in any form, whether via printing money or pushing house prices to insane levels, is a bad idea. Letting some air out of the bubble is far from the worst thing that could happen. If reforming the mortgage-interest deduction helps on the margins, so much the better.

    • #17
    • January 11, 2017, at 3:35 PM PST
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  18. erazoner Coolidge

    The mortgage interest deduction benefits (1) sellers and developers (who sell the property at an artificially inflated price); (2) real estate listers and brokers (who earn more in commission); (3) mortgage brokers and lenders (who earn more in interest payments); and (4) state and local governments (who collect more in taxes).

    Who loses? The buyer, who pays the higher P&I, the higher insurance, the higher property taxes, and the higher broker fees, among other extra costs associated with the inflated price, all the while believing he’s benefiting from tax deduction that covers only a fraction of the total added costs.

    So it’s no wonder the “industry” loves this deduction. Kill it, but find a way to phase it out.

    • #18
    • January 11, 2017, at 4:49 PM PST
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  19. JcTPatriot Inactive

    I came up with this in 2001 while having a discussion about taxes with my family. We were just doing general griping about the system when my mother asked me what would be “fair”. I came up with this in about 30 minutes:

    The tax is 20% for everyone, after $24,000 deduction. That gets the Democrats off our backs about “the poor”. If you make less than $2,000 a month, you pay no taxes.

    So, if you make $50K a year, you pay 20% of $26K. If you make a million a year, you pay 20% of $976K. See how it works?

    Next, income is income. I don’t care how you made it – salary, interest, gains, baseball cards. No more separations.

    I still love my idea that everyone pays 1% minimum tax. That way, even the poorest have skin in the game. I would love to see some lady at a town hall yelling at her senator, “WHAT did you do with my fifty bucks, mister?”

    Next – oh, you thought there would be more? Nope, that’s it. The last person leaving the IRS, please hit the lights.

    • #19
    • January 11, 2017, at 5:24 PM PST
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  20. ModEcon Inactive

    JcTPatriot (View Comment):
    I came up with this in 2001 while having a discussion about taxes with my family. We were just doing general griping about the system when my mother asked me what would be “fair”. I came up with this in about 30 minutes:

    The tax is 20% for everyone, after $24,000 deduction. That gets the Democrats off our backs about “the poor”. If you make less than $2,000 a month, you pay no taxes.

    So, if you make $50K a year, you pay 20% of $26K. If you make a million a year, you pay 20% of $976K. See how it works?

    Next, income is income. I don’t care how you made it – salary, interest, gains, baseball cards. No more separations.

    I still love my idea that everyone pays 1% minimum tax. That way, even the poorest have skin in the game. I would love to see some lady at a town hall yelling at her senator, “WHAT did you do with my fifty bucks, mister?”

    Next – oh, you thought there would be more? Nope, that’s it. The last person leaving the IRS, please hit the lights.

    Simply put. Yes please!

    I like the everyone pays the same rate on every dollar version though. Also, how about a requirement that you have to file (though not necessarily have already payed) in order to vote. Lets make your tax return your voter registration.

    • #20
    • January 11, 2017, at 5:31 PM PST
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  21. Sabrdance Member

    James Pethokoukis

    1. Are we also not going to reform Medicare and Social Security? Because it supposedly changes the rules of the game, at least for some people. That seems like a recipe for policy paralysis.

    No. We’re not. There’s a question on this? We’re going to bankrupt the country in 2033. If not sooner.

    • #21
    • January 11, 2017, at 5:52 PM PST
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  22. Sabrdance Member

    Assorted serious comments:

    1.) We have deductions because we have to define “income.” Generally speaking, taxing “gross income” is a bad idea because it destroys low-margin businesses (which, lest you think that isn’t a big deal, includes grocery stores -a gross income tax regime would reduce your diet to apples -the computers, not the fruit). So long as we have to define income, we will have to define “legitimate cost of doing business.”

    2.) I am open to the argument that a home mortgage is not a legitimate cost of doing business -possibly on the argument that as we do not tax the implied rent (what it would cost to rent the house to yourself) we should not exempt the mortgage interest as a cost of doing business either. I would, however, like it demonstrated clearly that the the two actually offset, rather than merely asserted, and with a variety of specifications including things like “time and labor for upkeep of the house.” As it stands, I see a lot of people who rent (whose landlords can clearly deduct their interest payments as cost of doing business, thus lowering their rents) griping about homeowners getting to do the same thing, and I suspect a certain amount of urban classism is driving the analysis, not economics.

    3.) That said, I have no strong feelings on the matter, but concur with those who don’t think the politics are that big a deal, given who actually votes for Republicans.

    • #22
    • January 11, 2017, at 6:03 PM PST
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  23. The Reticulator Member

    I Walton (View Comment):
    Could we just stop trying to be clever. We aren’t. Lower upper tax rates and end the deductions and all other subsidies. Everybody wins.

    He’s trying to end deductions. So why are you slamming him? This is how you do it.

    • #23
    • January 11, 2017, at 6:05 PM PST
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  24. The Reticulator Member

    This is a good idea and a serious discussion.

    Therefore, let’s change the subject.

    • #24
    • January 11, 2017, at 6:08 PM PST
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  25. The Reticulator Member

    Jamie Lockett (View Comment):
    This article really doesn’t address the drastic hit to home values these plans would produce. Anyone care to unpack that?

    2008 produced a drastic hit to home values.

    • #25
    • January 11, 2017, at 6:11 PM PST
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  26. The Reticulator Member

    EDISONPARKS (View Comment):
    I like Hugh Hewitt and honestly do not understand his mortgage interest deduction fetish.

    If you want to decrease special interest political donations/lobbying/(corruption?) then you have to get rid of the industry specific items in the tax code(real estate, home builders, mortgage banking, building supplies, etc.) .

    If you leave this one area of the tax code alone then how do you justify getting rid of any others.

    Excellent question.

    • #26
    • January 11, 2017, at 6:12 PM PST
    • Like
  27. The Reticulator Member

    Fezzik (View Comment):
    I would not mess with this deduction right now for the simple reason that it’s an important bargaining chip if/when we get serious about tax reform. Implementation of a flat tax or some other flattening mechanism will require the sacrifice of the mortgage interest deduction (and other popular deductions). I would hold onto this for that day and not waste the political time and energy futzing around.

    Keeping it in place is a good way to ensure that day will never come.

    • #27
    • January 11, 2017, at 6:14 PM PST
    • Like
  28. I Walton Member

    The Reticulator (View Comment):

    I Walton (View Comment):
    Could we just stop trying to be clever. We aren’t. Lower upper tax rates and end the deductions and all other subsidies. Everybody wins.

    He’s trying to end deductions. So why are you slamming him? This is how you do it.

    Of course we can rid of really distorting policies by postulating another complex approach that will also be distorting and since we can’t know exactly how it will distort, it’s hard to oppose. You get rid of them by putting forward a simple idea then beating opponents on their public heads with the idea. That is what leadership is. Turning an impossibly complex tax code over to the interests that created it and letting them log role it until everyone is happy isn’t reform it’s business as usual. Leadership builds its strategy on the high ground of simplicity and principles people can understand. It has to come from the White House.

    • #28
    • January 12, 2017, at 3:47 AM PST
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  29. Kwhopper Inactive

    James Pethokoukis: Even if you accept the plan as briefly outlined by Treasury Secretary-elect Steven Mnuchin, it would only affect a small number or borrowers, as CNBC’s Diana Olick notes:

    For those who do itemize, here’s how the math works: Let’s say you have a $500,000 30-year-fixed mortgage at 4.5 percent, and you’re in the 33 percent tax bracket. In the first year of your loan, the deduction saves you just more than $10,000 in taxes. If the Trump administration caps deductions at even $100,000, as Mnuchin suggested, that would not hit most borrowers because on that $500,000 (which is more than most loans in general) the total annual interest payment was about $23,000. Granted, homeowners may have other deductions, medical expenses, charitable, religious or otherwise, but most would not make it to $100,000 even with the mortgage.

    Hold on, hold on. It cost this hypothetical homeowner $23,000 to save $10,000 in taxes. Tell me again why the deduction has distortion effects on home prices? People are really doing this knowing they will actually pay more in interest than save in taxes? Maybe there’s some other scenario I don’t understand.

    The main reason to get rid of the deduction isn’t because of distortion effects. I’ve always thought it should go away to keep mortgage seekers from wasting a ton more money trying to get the deduction than what can be saved. Interest totals will FAR exceed the original $500,000 amount if the entire 30 years is used. In the long run, I suspect the government will get it’s taxes and then some from taxing that interest – not to mention taxes from maintenance costs over that time.

    • #29
    • January 12, 2017, at 7:41 AM PST
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  30. Jamie Lockett Inactive

    The Reticulator (View Comment):

    Jamie Lockett (View Comment):
    This article really doesn’t address the drastic hit to home values these plans would produce. Anyone care to unpack that?

    2008 produced a drastic hit to home values.

    And?

    • #30
    • January 12, 2017, at 8:09 AM PST
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