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Tax Reforms and the American Homeowner

For many people, having a mortgage interest deduction makes buying a home a reality. The recently proposed tax reform, however, threatens to eliminate this deduction for prospective homebuyers nationwide. The new plan will raise, even double, the standard deduction threshold, which will automatically disqualify a large number of applicants. Based on the new threshold, many homeowners will not have enough deductions to meet the itemized standards.

Gary Cohn, chief economic advisor, says that the tax reform won't have a major impact on prospective home buyers. The reason people buy homes, Cohn says, is because they are excited and confident about buying a home, and they believe in the economy. Those in favor of reducing the mortgage interest deduction say that the deduction is not benefitting everyone, which makes it obsolete. Statistics from the Center on Budget and Policy Priorities show that in 2012, over 75 percent of mortgage interest deductions went to individuals making $100,000 or more each year. Among all homeowners, only about 25 percent of all tax returns claim the mortgage interest deduction. Those who have taken advantage of the mortgage interest deduction say that it is the reason why they were able to purchase their homes. This is particularly true in the Northeast, where home prices tend to be higher than the national average. For prospective buyers, having a mortgage interest deduction available makes unlocks new possibilities in the market and makes homes that would otherwise be unaffordable viable options.

However, members of the National Association of Realtors (NAR) disagree. They say that if homeowners lose the opportunity to have a mortgage interest deduction, the number of home sales will fall, and home values may be negatively affected. Home prices will be particularly hard hit in high-cost places, and they might fall by up to 15 percent if the mortgage interest deduction goes away. NAR members say that this homeownership incentive has been embedded in US tax code for over 100 years for the simple reason that it works. Losing it, they fear, will affect the health of the US home sale market.

A home mortgage interest deduction lets taxpayers who own their own homes reduce their taxable income by the amount of interest paid on the loan. The loan is usually secured by a primary residence, but it can also apply to a second home (additional homes, like third and fourth homes, do not apply). For tax purposes, a residence includes a traditional single family home, condominium, cooperative, mobile home, boat, or recreational vehicle that's used as a main residence. The Internal Revenue Service (IRS) allows any place with sleeping, cooking, and toilet facilities to be a place of residence. In the United States, the home mortgage interest deduction is established in the Internal Revenue Code, which imposes several limitations. First, the taxpayer must choose qualifying items to deduct. The total of those itemized deductions must exceed the standard deduction for the applicant to receive a tax benefit. Secondly, the deduction only applies to interest on debts secured by a primary residence or a second home. Finally, interest is only deductible on the first $1 million of debt that is used to acquire, improve, or construct the home, or up to $100,000 on home equity debt regardless of the purpose or nature of the loan.

Homeowners are sometimes confused about what actually counts as a mortgage interest. Turbo Tax says that mortgage interest is any interest paid on a loan secured by a main or second home. Loans can include a mortgage to buy the home, a second mortgage, a home equity loan, or a line of credit. A loan that is not secured debt on the home counts as a personal loan, in which case the interest paid is not deductible. Only the primary borrower can take the deduction, and he or she is legally responsible for paying off the debt and making other payments. If a person is married and his or her spouse signs for the loan, both parties are the primary borrowers.

Sometimes, special circumstances affect mortgage interest deductions. The first applies to properties that are rented. A primary or secondary home must be used for at least 14 days each year, or for more than 10 percent of the number of days that it is rented out at fair market value to be considered a residence and not a rental property. Secondly, a different home can be treated as a second home each year provided it meets the standard qualifications. Living in a home before the purchase becomes final means that any payments made for that period of time are considered rent and cannot be deducted as interest. If proceeds of a home loan are used for business purposes, interest is attributed to an activity for which loan proceeds were used. That can be either Schedule C for a sole proprietor or Schedule E if proceeds were used to purchase rental property. Owning rental property and borrowing against it to buy a home means that interest does not qualify as mortgage interest because the loan is not secured by the home. Interest paid on that loan can't be deducted as a rental expense either, as funds were not put towards the rental property. Interest expense in that case is considered personal interest, and it is therefore not deductible. Finally, using proceeds of a home mortgage to purchase securities that generate tax-exempt income, or purchasing single-premium life insurance or annuity contracts means that one cannot deduct the mortgage interest. Special conditions also apply for homes that are refinanced. When a mortgage is refinanced, the balance of the new mortgage is also treated as acquisition debt up to the balance of the old mortgage. The excess of the old mortgage is treated as home equity debt.

To date, the program has helped some homeowners, but not all. According to the 2005 President's federal tax reform advisory panel, only 54 percent of taxpayers who pay interest on their mortgages get a tax benefit. Roughly 45 percent of homeowners pay interest but don't get any benefit. The few who do receive less than they expected to. Because mortgage interest is generally the largest expense of a taxpayer's life, having that deduction is an incentive to move forward with buying a home. To determine eligibility, a homeowner must account for other expenses like interest, medical expenses, and property taxes. Taxpayers who don't have deductions exceeding standard deduction amounts cannot itemize their deductions. Even those who itemize taxes and qualify for the mortgage interest tax deduction pay minimal interest on the mortgage. What confuses some taxpayers is that the tax credit, if applied, amounts to pennies to each dollar spent instead of being a dollar-to-dollar break, which is how most credits work. For instance, a taxpayer might spend $12,000 on mortgage interest and pay taxes at an individual income tax rate of 35 percent. He or she can then exclude $12,000 from income tax liability, which results in a total savings of $4,200. In this case, the taxpayer paid the bank $12,000 in interest to get a taxation exclusion of one-third that amount. The benefits for taxpayers become even smaller in lower tax brackets.

If the mortgage interest deduction is cut, homeowners can still take advantage of other home ownership tax incentives. One incentive is capital gains on the sale of real property if it's used as a primary residence for two of five years before the date of the sale. This deduction allows an exclusion of up to $250,000 or $500,000 for a married couple filing jointly. This deduction mostly benefits people in high-cost, high-income areas. For instance, a homeowner in San Francisco, CA receives approximately $26,385 per year, while a homeowner in El Paso, TX receives about $2,150 per year. This is roughly a 1,225 percent difference.

If you are on the fence about buying a home, here are some tips. Industry experts encourage new buyers is to purchase a home with cash if possible. This eliminates interest rates and fees, which can amount to significant amounts of money saved. Another option, which carries some risk, is to pay the interest rates from mortgages and invest the rest of your money in the stock market. This works well when the stock market is going up, but can bring big problems when the stock market declines. It also artificially inflates the price of homes, so when the stock market drops by 40 percent, house values also fall by 40 percent. Ultimately, homeowners are left owing more on their mortgages than their homes are work. Thinking conservatively, the best approach is to avoid interest payments if possible. If that is not an option, you should aim to pay off the house quickly. It can be tricky to determine if you qualify for the current mortgage interest deduction, but several resources are available to help consumers out. This includes community-based services, free software, and even books.

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