Law and Disorder

The more you spend, the more you save: Giving credit where it is due

By A.J. Wagner

I enjoyed a recent peek at lawmaking coming out of the so-called fiscal cliff talks. If you are following this story in the news, a story which hasn’t changed for more than a year but gets repeated every day, you will know that there isn’t much definition offered for the tax deductions that might be eliminated to improve government revenues.

One such deduction that might be looked at, according to speculators who know no more than you or I, is the mortgage interest tax deduction. Currently, individuals can deduct the interest paid on mortgages placed against their homes. This deduction provides a subsidy to homeowners of about $105 billion each year.

That’s the raw number. But the arguments for eliminating or keeping this treasured deduction are much more insightful and complicated.

A recent report published by the Center for American Progress puts forth the notion that the deduction, which is the third largest in the federal tax scheme, largely favors the rich and the coastal cities where houses are more expensive. But let’s start with an example of the deduction and how it affects an individual’s taxes.

These are approximations, but say you borrow $500,000 for a house at five percent interest. Your first monthly payment will be nearly $2,600. $600 will go to principal and $2,000 of the payment is interest. At the end of the first year you will have paid about $7,200 in principal and $25,000 in interest. If you earn $100,000 a year you will be able to deduct the $25,000 so that you will only be taxed on $75,000. That’s a savings of about $6,000 in taxes. You can take this deduction on the house you live in and a vacation home on a loan up to $1.1 million.

Renters do not get to deduct anything on what they pay to the landlord, so this is quite the incentive to purchase a home. Or is it?

You likely noticed in my example a house that is beyond the means of most people. Although the deduction helps those who itemize their deductions, if you are a taxpayer taking the standard deduction, the interest deduction has no bearing on your final tax bill. Those who buy less expensive homes, therefore, have no incentive to buy a home.

James Poterba and Todd Sinai, in their paper titled, “Tax-Expenditures for Owner-Occupied Housing: Deductions for Property Taxes and Mortgage Interest and the Exclusion of Imputed Rental Income,” note that for household incomes below $40,000 the average savings from the mortgage interest deduction is $91. On a household income between $40,000 and $75,000 the tax savings is about $523. These first two illustrations cover the majority of American households. Make between $75,000 and $125,000 and the average deduction goes up to $1,264.

So, you see, the deduction favors those with money. The more house you can afford, the more taxes you get to save. On top of that, a person in the top tax bracket saves $35 for every $100 deducted while someone in the lowest bracket will only save $10 for a $100 deduction. Another Occupy event in the making.

Some folks will borrow money against their house to make money. For instance, if I could borrow $100,000 (usually this would be a second mortgage or a line of credit) at five percent interest it will cost me $5,000 a year. If I then take that money and invest it in a stock that increases in value by 15 percent on the year, I will have a gain of $15,000 for a net of $10,000. The $10,000 gets taxed at a lower, capital gains rate when the stock is sold. This kind of speculation was a contributing factor to the recession of 2008 with 22 percent of American homes now worth less than the amount borrowed against them.

There are possible solutions to balance things out. One is to eliminate the tax, which is why some speculate the deduction could be targeted in fiscal cliff discussions.

The National Commission on Fiscal Responsibility and Reform has proposed that the deduction be turned into a nonrefundable tax credit equal to 12 percent of mortgage interest paid. That would equalize the deduction for all tax brackets. This same commission also suggested a debt cap of $500,000 as opposed to the current $1.1 million level while eliminating all deductions for second mortgages and lines of credit.

After several studies, no one can say if the deduction increases home sales or if it increases the prices on homes as sellers take advantage of the deduction’s value when they price the house.

So, should our laws change on the deduction? Good luck in getting an answer out of either side on this issue. The difficulty in explaining its effect probably means the interest deduction is here to stay.

Disclaimer: The content herein is for entertainment and information only. Do not use this as a legal consultation. Every situation has different nuances that can affect the outcome and laws change without notice. If you’re in a situation that calls for legal advice, get a lawyer. You represent yourself at your own risk. The author, the Dayton City Paper and its affiliates shall have no liability stemming from your use of the information contained herein. 

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A.J. Wagner is an attorney with the law firm of Flanagan, Lieberman, Hoffman and Swaim at 15 W. Fourth Street in Dayton. A.J. and his firm would be glad to help you with all of your legal needs. You can reach A.J. at (937) 223-5200 or at

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