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What do Changing Mortgage Interest Deduction Rates Mean for You?

Currently, fewer than 30 percent of all homes in the United States are eligible to take advantage of the Mortgage Interest Deduction (MID). But with proposed tax changes on the horizon, analysts say that number could fall to under five percent. According to data published by the Internal Revenue Service (IRS), the most recent tax reform proposals have provisions to double the standard traditional deduction and eliminate the deduction rate of state and local taxes, including property taxes.

Mortgage interest refers to interest paid on a loan that is secured by a primary or secondary home. It does not apply to personal loans. Qualifying loans that are applied to a primary or secondary residence include a mortgage used to buy a home, a second mortgage, a home equity loan, and a line of credit. For those who qualify, the mortgage interest deduction can be especially lucrative during the first few years of a mortgage when homeowners' monthly fees are applied primarily to interest instead of the loan's principal.

Currently, a homeowner looking to purchase a home on the market has to spend at least $305,000 to qualify for itemized deductions, and to make deducting mortgage interest amounts and state and local property taxes worthwhile. Zillow data states that right now, only 30 percent of homes in the United States are worth that amount or more. Add in the proposed tax reforms, and that means that people will have to buy homes worth $801,000 or more to qualify for the standard deduction and to eliminate the deductibility of state and local taxes. That requirement would reduce the number of eligible home buyers to a mere five percent. To make these assumptions, leaders assume several conditions for consistency. First, they assume that a home is purchased using a 30-year fixed rate mortgage. They also assume a mortgage rate of 4 percent, and a loan-value ratio of just below one percent. They also totaled mortgage interest payments during the first year of a loan. They do not account for any state income taxes, which can also be deducted in accordance with state and local tax deduction policies.

Statistics show that while two thirds of all Americans own a home, only 25 percent claim the MID. Matthew Desmond, a sociologist at Harvard University, says that the disproportionate number of people who apply to, and receive, the MID, explains the nation's wealth inequality. He adds that the deduction benefits mostly privileged homeowners in the highest tax brackets. Currently, federal housing policy transfers money to wealthy homeowners. It provides little benefit to middle-class homeowners, and virtually none to lower-class renters and homeowners, says Desmond. Some Americans are spending up to 50 percent of their income on housing costs with the MID, while experts advise spending no more than 30 percent of income on housing costs. In 2015, the federal government spent approximately $71 billion on the MID. In that time, households earning $100,000 or more received almost all (90 percent) of the benefits. This is due to the fact that the value of the deduction rises as the cost of a mortgage increase. In addition to the mortgage interest deduction, the Tax Policy Center adds that collectively, deductions and exclusions available to homeowners are more helpful to homeowners in higher tax brackets than lower tax brackets. They point out that a taxpayer in the top tax bracket saves about $792 after deducting $2,000 in property taxes. However, that same deduction only saves a taxpayer in the 15 percent tax bracket $300. Even though they comprise only about 20 percent of the taxpayer base, homeowners who report over $100,000 in income annually receive around 85 percent of all tax benefits for mortgage interest deductions. The Tax Policy Center cites three differences for the higher earning homeowners' benefits. First, they have comparatively higher marginal tax rates. They also pay more in mortgage interest rates and property taxes. Lastly, they are more likely to file tax returns with itemized deductions.

Several conditions apply for homeowners to be eligible for the MID's benefits. First, the policy only applies to primary and secondary residences. It does not extend to additional properties or vacation rentals. To be eligible for the deduction, a primary residence must have a cooking area, a place to sleep, and toilet facilities. Mobile homes, apartments, condominiums, boats, and recreational vehicles can all be considered primary residences. Under current law, you can make itemized deductions if you pay for a mortgage on a main or secondary home. However, there are some restrictions. The deduction is reserved for the primary borrower, who is also legally responsible for paying the debt. However, if you are married and your spouse also signs for the loan, you are both considered the primary borrowers. The loan's benefits do not extend to parent-child relationships unless the parent co-signs the loan. Deductions also come with a limit. In most cases, the deduction is limited if all mortgages that are used to improve upon, construct, or purchase the home amount to $1 million, or $500,000 if spouses are filing separately. Individuals can typically deduct interest on a home equity debt up to $100,000, or up to $50,000 if they are filing separately from a spouse.

While it is difficult for many to reap the benefits of the MID, other tax benefits have historically helped home-owning Americans. One such benefit is the property tax deduction. If homeowners itemize deductions, they can potentially lower their taxable income by deducting property taxes too. The property tax deduction essentially transfers federal funds to municipalities that impose a property tax. This mostly applies to local governments, but it includes some state governments as well. Through the property tax, towns and states can increase property tax revenue while lowering the amount that residents have to pay. In fiscal year 2016, the Joint Committee on Taxation (JCT) says that the deduction collectively saved US homeowners roughly $35 billion.

Imputed rent is another tax benefits for US homeowners. Homeownership is considered an investment, and one benefit for homeowners is that they can then live in their home without paying rent. Imputed rent, or relief from rental fees, is not considered taxable income. In a typical situation, for tax purposes, landlords must count rental revenue as income. Renters cannot deduct the rent they pay from their income. The tax code considers homeowners to be both landlords and renters, but it treats homeowners as renters to eliminate taxes. In fiscal year 2015, the Office of Management and Budget estimates that federal revenue was reduced by about $79 million due to the exclusion of imputed rent.

Profits from house sales can be another deduction for homeowners. Taxpayers who sell goods typically pay capital gains taxes on revenue earned from those sales. However, homeowners who meet certain criteria can exclude up to $250,000 (or $500,000 for those filing jointly) worth of capital gains from selling their home, provided they meet certain criteria, including living in the home as a primary residence in two of the past five years. Additionally, homeowners cannot have a capital gains exclusion for selling another home in the past two years. The JCT says that in fiscal year 2016, homeowners nationwide collectively saved about $29 billion in income tax through the capital gains exclusion.

If the proposed changes come to fruition, experts say it makes more sense to implement the MID in some communities rather than others. Forbes experts say that the MID makes the most sense when used in communities with high housing prices and high local tax rates. A good example is San Francisco; in the San Francisco metro area, almost all homes (99 percent) are worth enough money to make the MID and property tax deductions worthwhile. In the Los Angeles metropolitan area, approximately 96 percent of homes are eligible for the MID's benefits. That same standard does not apply nationwide, however. In St. Louis, MO, only 13 percent of residences rise above the proposed minimum value threshold. For those homes, the MID and property tax deductions are not a viable option. The same is true in Pittsburgh, where only 10 percent of all homes qualify for the deduction.

Ideally, the Tax Policy Center notes, the tax code would provide for an inclusive income tax where all income is taxable, and all costs associated with that income would be deductible. That, the TPC says, should include deductions for property taxes and mortgage interest. It remains to be seen what will happen with the proposed tax reform, but homeowners should brace for higher standards to receive the mortgage interest deduction.

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