Mortgage Interest Deduction Living on Borrowed Time

In 2013, Congress is expected to explore a number of tax reforms in order to address staggering deficits and a crippling $17 trillion in debt owed by the Federal government.

No proposed tax reform will be more controversial this year than attempts to alter the Home Mortgage Interest Deduction (HMID).

Considered the holy grail of tax deductions, the annual tax break to homeowners, which provides more than $100 billion a year in tax relief, could see significant changes, thus affecting the finances of millions of Americans.

But in order to understand how these changes could affect you, one needs to understand how this tax break became so monstrous in the first place, and what the impact of such proposals could have on the housing markets.

In fact, this very issue proves why even grander tax reform is necessary right now in the United States.

Is it Your Money or the Government's?

Tax breaks - known as tax loopholes by those who enjoy spending taxes instead of paying them - are public policies that provide discounts on your taxes and encourage economic activity that the government deems beneficial to the Americans and the economy.

According to the Congressional Budget Office, tax breaks "cost the government" $1.2 trillion annually, with roughly 75% going to the top 20% of wage earners.

Such activities include starting a business, buying a home, going to college, or having a child (after all, productive members of society become productive taxpayers in the end).

However, the problem is that any activity can be considered beneficial to the economy if one wanted to stretch their imaginations. For example, joining a gym is technically a beneficial activity because health and wellness decreases your strain on healthcare services and prolongs your economic activity to the country.

And proposals have been put forward that gym memberships should be tax deductible, and, in some cases for specific employment classes, actually are.

For these reasons, the number and size of tax breaks has dramatically increased over the years. Critics argue that the federal government forfeits money that would have otherwise been collected as revenue, and that these breaks are little more than subsidies that add up over time and favor the wealthiest classes.

Proponents argue these forms of stimulus are necessary in order to drive economic activity and encourage businesses to hire, Americans to buy houses, and students to go to college.

The problem is... both sides are wrong.

The Mother of All Tax Breaks

Under the current structure of the HMID, the U.S. government permits homeowners to deduct up to $1 million each year in mortgage interest, including the purchase of second homes and vacation houses.

And the amount of money deducted is relatively staggering. The Congressional Budget Office projects this specific annual tax break will cost the government more than $1 trillion over a decade.

But more interesting is the stratification of the benefits across various classes in the United States. The HMID mostly benefits households earning $75,000 to $500,000 a year. According to the Tax Policy Center, this range of Americans earns 77 percent of the tax savings from the HMFD.

Despite this overwhelming benefit to higher households (the median household income in the U.S. hovers near $50,000), many Americans do not have the appetite for removing this form of stimulus.

Even though 77 percent of the breaks go to higher income levels, nearly every American homeowner receives some form of benefit.

So, while no one believes the tax break will go away completely, reform is likely.

Considerations include a simple paring back of the income limit. According to the Tax Policy Center, an annual cap of $500,000 (from $1 million) and using a credit system instead of a deduction, the Federal government could raise $213 billion over the next 10 years.

But even tweaking the cap could have a big impact on the housing market in the short-term. Just the mere mention of altering the deduction would send some ripples through the markets. After all, we just saw what Bernanke's thoughts of the paring back of $85 billion a month to the economy did to the stock market.

Lobbyists Prepare to Defend the Deduction

Critics and lobbyists have long argued the U.S. is only now showing signs of emerging from a years-long housing crisis and that changing the deduction would have a serious impact on housing prices.

Jamie Gregory, a lobbyist of the National Association of Realtors, told Politico that curbing the deduction would harm housing prices, primarily in vacation communities.

"We finally have housing and the economy headed in the right direction, and we don't think this is a good time to be messing around with it," he said.

And Gregory is accurate. In a nation full of subsidies, the mortgage deduction, by definition, creates an incentive and thus inflates the housing market by subsidizing homes that people wouldn't be able to afford otherwise.

This is free money from the government to finance the service on loans to purchase houses.

In fact, many financial and tax advisers encourage homebuyers to use that deduction to their advantage when evaluating properties to buy. Having an extra few thousand dollars annually (and in some cases tens of thousands) adds up, and enables some people to purchase homes they wouldn't consider without the subsidy. This creates a distortion down the value chain of the housing industry.

Naturally, eliminating the deduction would have a ripple effect across the economy, but at the same time, it would move the housing markets back toward equilibrium, where it should have been after the crash. The financial incentive of the mortgage deduction would be removed, and Americans would purchase homes without the need for the subsidy.

However, the impact on aggregate home purchases isn't entirely clear following a potential downturn. Congress creates tax breaks in order to stimulate demand, but it is clear that unintended consequences of this deduction have been the artificial increase in the purchase of more expensive homes.

This is just one more tool of Keynesian economics that creates false realities and reliance by taxpayers to encourage more of the same sort of gifts to certain classes and special interest groups.

The reality is that the tax system is so Byzantine and favors the few at the expense of the rest. The reality is that lower tax rates coupled with the elimination of these deductions would provide far more equality and stability to Americans, and reduce the need for this ridiculous argument in the first place.

By lowering tax rates, the government would automatically erase any need for these special interest stimuli. If someone wants to buy a house with the money they save on taxes... they will buy a house.

But in the end, what would all the tax advisers and lawyers do?

Now we know why the spending on lobbying is at an all-time high for both of these industries... and real estate interests doubled their lobbying cash in 2012. It's all about the tax code... and its failures.

In the end, this complex economic issue will be handled by Congress. Given that only 25 percent of our sitting Congressmen and Senators have any form of economics training whatsoever, I'm sure that this matter will be handled with the utmost care and attention it deserves. It's not like Congress was responsible for the last housing bubble...

The housing recovery seems to be for real. Read how you can profit from it.

So what do you think? Has the Home Mortgage Interest Deduction affected your home purchasing strategy in anyway?

Share your thoughts in the comments section below.