Mortgage Interest Deduction: Understanding How it Works Today and the Proposed Changes

Recent talk about eliminating the mortgage interest tax deduction has made headlines and, given all of the proposed changes, has caused confusion for many.  Below is an explanation of what the mortgage interest deduction is in its current form and the proposed changes being suggested by The National Commission on Fiscal Responsibility and Reform in an effort to reduce the national deficit.

How the mortgage interest tax deduction works today:

Currently the monthly interest paid on your mortgage is considered a tax deductible expense, meaning you can take the amount you paid in mortgage interest throughout the year and deduct it from your taxable income–but only if you itemize your taxes, something only about one-third of Americans do each year. This is not to be confused with a tax credit, which reduces the amount of tax you pay. The first-time home buyer tax credit is an example of a tax credit. For example, if you owed $10,000 in taxes in 2010 but were able to claim the full, first-time home buyer tax credit of $8,000, the amount of taxes you would owe would go down to $2,000.

Mortgage interest can only be deducted for your primary and secondary homes. Interest paid on third or fourth homes is not tax-deductible. The amount of mortgage interest paid can be found on your 1098 Mortgage Interest Statement from your bank. Should you decide to itemize your taxes for deductions rather than take the standard deduction, you will be asked to provide your 1098 Mortgage Interest Statement to your tax preparer. According to Investopedia, only taxpayers whose total itemized deductions are greater than the standard deduction will itemize their taxes. As a rule of thumb, if the amount of mortgage interest and points paid during 2010 exceeds the standard deduction ($5,700 for single taxpayers, $11,400 for married taxpayers filing jointly, $8,400 for head of household) you will likely benefit by itemizing your deductions.

As a side note, Primary Mortgage Insurance paid in 2010 is also fully tax deductible for taxpayers whose adjusted gross income (taxable income) falls below $100,000 and is partially deductible for those with taxable income between $100,000 and $109,000.

Proposed changes to the mortgage interest tax deduction:

The National Commission on Fiscal Responsibility and Reform is proposing a change to the current tax deduction that would modify what is eligible, not eliminate the deduction altogether. The proposal eliminates the tax deduction for secondary homes, homes with mortgages exceeding $500,000 and mortgage interest on home equity loans. The majority of American homeowners who have primary home mortgages of less than $500,000 would not directly feel the affect the impact of the proposed mortgage interest tax-deduction changes.

Arguments for and against proposed mortgage interest tax deduction modifications:

Proponents have come out in droves both for and against the proposed changes. According to a recent Los Angeles Times article, the National Association of Realtors is currently 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.”

However, the article goes on to say,

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.

Here are a few good articles with expert commentary about the pros and cons of modifying the mortgage interest tax deduction from its current form:

Wall Street Journal: Homeowner Perks Under Fire

Los Angeles Times: Tax Deduction for Mortgage Interest Could be on the Chopping Block

AOL HousingWatch: Mortgage Interest Deduction: Do You Need It?