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Mortgage deduction changes on the table
The president's tax-reform panel may propose reducing the deduction and capital-gains exemption.
October 12, 2005: 2:16 PM EDT
By Jeanne Sahadi, CNN/Money staff writer
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WASHINGTON (CNN/Money) - Owning a home may become less tax-friendly than it has been, if suggestions from the president's tax-reform panel are considered seriously by Congress in the next year or so.

The bipartisan panel, which held a public meeting on Tuesday, is charged with making proposals for ways to reform the tax code. President Bush instructed the panel to come up with suggestions to make the tax code simpler, fairer and more geared to promoting economic growth.

Among other things, Bush instructed the panel to make sure that any revised code continues to promote homeownership.

While preserving tax incentives to buy a home, the panel said Tuesday it was considering changes that address issues of fairness and economic growth.

Current breaks Currently, the interest on mortgages up to $1 million may be deducted at a homeowner's marginal -- or top -- income tax rate. That is, the rate on which their last dollar is taxed.

In addition, when selling a home, owners may keep $250,000 in capital gains tax-free if they're unmarried, or $500,000 if they're married, filing jointly.

How fair are they? Those breaks are heavily skewed toward high-income tax payers, said panel member James Michael Poterba, associate head of the economics department at MIT.

The top 2.2 percent of tax returns claim 22 percent of the benefits from the mortgage-interest deduction, he noted.

And the deduction disproportionately benefits homeowners who itemize their deductions. In 2002, of the 130 million federal tax returns filed, only 46 million itemized. Of those, 37 million claimed the mortgage-interest deduction. (Those who don't itemize just take the standard deduction, which they would get even if they didn't own a home.)

The growth issue The current code, economists argue, disproportionately favors real estate over other investments. That's because there is not an exemption on capital gains earned on stocks and many bonds.

Economists say that investment in other forms of capital would increase productivity and thereby economic growth at a much greater rate than a home purchase.

Possible changes

The panel hasn't made any firm decisions about what it will propose in its final report, due Nov. 1. But it is considering a number of options. Among them:

  • Reducing from $1 million the size of a mortgage on which interest may be deducted. If such a proposal were made, it's possible that the mortgage size would vary by region depending on local home prices.
  • Replacing the mortgage-interest deduction with a tax credit, allowing all homeowners with a mortgage to get a tax break -- not just those who itemize.
  • Reducing the tax rate at which mortgage interest may be deducted. Likely a proposed rate would be a middle-income tax rate, such as 15 percent or 25 percent. That would preserve the benefits of homeownership for middle-income taxpayers, Poterba said.
  • Reducing the total capital gains exempted from tax.
  • Combining two of these elements -- say, reducing capital-gains exemption threshold and lowering the deduction rate on mortgage interest.

Members of the panel stressed that if any changes were made, there would have to be a gradual transition period so as not to upset the housing market, or harm current homeowners. The transition might involve grandfathering in the tax breaks enjoyed by current homeowners, or phasing them out slowly.

"There's a basic fairness issue, not to change the rules of the game (on current homeowners)," Poterba said.  Top of page

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