Eliminating the mother of all tax deductions

It is the mother of all deductions.

An analysis of IRS data by Reason.com found that out of the $1.26 trillion in income that was excluded from 2008 tax base, the largest deduction — accounting for some 36 percent of all deductions — was the mortgage interest deduction.

The Congressional Joint Committee on Taxation said the deduction cost about $90 billion in 2010.

Is it any wonder that such a large potential source of revenue regularly draws attention?

Over the years, the mortgage interest deduction has been targeted for reduction and elimination. Most recently President Barack Obama's (Simpson-Bowles) deficit reduction commission were considering taking it out in attempts to balance the budget.

Change, however, has the deck stacked against it. The deduction is certainly popular — with about half of mortgage holders taking advantage of it and, no doubt, wanting to hold onto it. Today mortgage interest deduction's main justification is it is a great incentive for creating more homeowners — making it more affordable to buy a home. Its critics are saying that it is an ineffective policy and other incentives would help people better to get into homes. Both sides worry, however, that any changes in today's fragile housing market could have negative consequences.

BEGINNINGS AND REASONS

Richard K. Green, director of the Lusk Center for Real Estate at the University of Southern California, said the mortgage interest deduction wasn't created to encourage home ownership. But as time went on, helping people afford homes became the battle cry to keep it.

The original 1913 income tax code allowed people to deduct all interest from their income when figuring out their income tax. All the way until the Reagan era, credit card interest, car loan interest, student loan interest and more were all tax deductable — with some limitations. "There was a worry that this was encouraging people to take on too much debt," Green said, "which is sort of funny if you look at how much debt people had then compared to today."

Initially the proposals in the mid 1980s would have eliminated all interest deductibility. But in a speech in 1984 to the National Association of Realtors, President Ronald Reagan carved out an exception. "I strongly agreed with the home mortgage interest deduction, which is so vital to millions of hard-working Americans. And in case there's still any doubt, I want you to know we will preserve that part of the American dream," he said. "Well, that is the thing, that deduction, that symbolizes, I think, that American dream."

The Tax Reform Act of 1986, in the end kept the deduction — but the elimination of other deductions allowed the top marginal tax rate to drop from 50 percent to 28 percent. It did, however, limit the deduction to mortgage debt from a principal residence and a second home. It was capped at $1 million and not much has changed since then (except $1 million can't buy what it used to).

The Realtors were relatively happy then and still fight today to keep the mortgage interest deduction from falling to any new tax proposals. "NAR firmly believes that the mortgage interest deduction is vital to the stability of the American housing market and economy," NAR president Ron Phipps, said in a statement. "NAR will remain vigilant in opposing any plan that modifies or excludes the deductibility of mortgage interest."

"I don't blame them for taking this position," Green said. "If I'm representing their members, it is the policy that is in the best interest of their members."

But is the deduction in the best interest of all Americans — and does it really encourage home ownership?

INCENTIVES FOR HOME OWNERSHIP