Mortgage deduction: America's costliest tax break

NEW YORK (CNNMoney.com) -- The mortgage-interest deduction is America's favorite tax break -- and it's also the costliest.

Between 2009 and 2013, the government will lose out on nearly $600 billion because of it, according to the Joint Committee on Taxation.

While there's no way to stabilize U.S. debt without making tough choices on the tax and spending sides of the ledger, some sacred cows are more sacred than others. And the mortgage-interest tax break is still deemed untouchable.

Case in point: a new bipartisan tax reform proposal that has been gaining currency in policy circles. Co-sponsored by Sens. Ron Wyden, D-Ore. and Judd Gregg, R-NH, the proposal would simplify the income tax system, streamline the numbers of credits and deductions, and lower the corporate tax rate.

But it doesn't touch the mortgage deduction.

"We wanted a politically viable vehicle," Gregg said at the Heritage Foundation last month.

Currently, individuals owning a first or second home can deduct the interest on up to $1 million in loans used to buy, build or improve the home. They can also deduct the interest on an additional $100,000 on loans secured using the home as collateral, regardless of how the money is used.

Many policy experts have proposed modifying the interest deduction for three reasons: It takes a big bite out of federal coffers; it favors higher-income tax filers; and it distorts investment decisions.

And while the deduction is seen as a big spur to housing sales, which in turn can bolster big swaths of the economy, some think the generous deduction may have contributed to an unstable rise in home prices.

Of those who had mortgages in 2008, roughly 72% claimed the mortgage deduction. But those who benefited most were higher-income households, according to the Joint Committee on Taxation.

Almost half of the returns claiming the deduction were from filers with incomes over $100,000, and roughly 75% in foregone revenue that year went to them.

Meanwhile, 32% of the money went to households with incomes over $200,000, even though they accounted for only 11% of the returns claiming the deduction.

Moreover, since housing is treated more favorably tax-wise than other investments such as stocks, some economists believe the home tax breaks distort people's investment decisions. By making the mortgage deduction less valuable, they argue, that could make the economy more efficient overall.

To correct for all these imbalances, here are two key proposals that have been made in the past several years:

Lower the cap on deductible interest: One proposal is to reduce the loan size on which interest may be deducted. Doing so could reduce the amount of tax revenue Uncle Sam foregoes, and it would make the deduction less skewed toward higher income households.

It can be done in different ways. One way is to base the interest cap on regional housing prices, an idea that former U.S. comptroller general David Walker supports.

That would mean a homeowner in the Midwest, where home prices are relatively modest compared to those in the Northeast, wouldn't get to deduct interest on as big a loan as someone in pricey Manhattan.

A similar approach was proposed by President Bush's 2005 Tax Reform Advisory Panel: It recommended basing the deduction on the conforming loan limits set by Fannie Mae, Freddie Mac and the Federal Housing Administration.

Today, the maximum limit for single-family residences ranges between $417,000 and $729,750 in the 48 contiguous states, and between $625,500 and $938,250 in Alaska, Hawaii, the U.S. Virgin Islands and Guam.

Meanwhile, the Congressional Budget Office examined a proposal to slash the loan amounts on which interest could be deducted to $500,000 by 2018.

Convert the deduction to a credit: Another idea put forth by the 2005 tax reform panel is to convert the mortgage deduction to a tax credit.

The current deduction benefits only those tax filers who itemize. And those with highest incomes benefit the most because deductions reduce taxable income by a percentage equal to one's top tax rate. The higher the income, the higher the top rate, and hence the bigger the deduction.

By contrast, a tax credit is a dollar-for-dollar reduction of the taxes one owes, and is typically available to all qualifying tax filers whether or not they itemize.

The panel proposed that the credit be equal to 15% of the interest paid by all homeowners on mortgages up to the interest cap.

The CBO estimates that $388 billion could be saved between 2013 and 2019 if a credit were implemented and the cap on the interest deduction were lowered to loans of $500,000.