Mortgage-interest deduction in jeopardy? REAL ESTATE Fighting to keep full deduction of mortgage interest

Image 1 of / 4 Caption Close Mortgage-interest deduction in jeopardy? 1 / 4 Back to Gallery

Shirley Ann Stern is such a big Giants fan that she's buying a new one-bedroom condo near AT&T Park in Mission Bay. At $819,000, the one-bedroom would be considered top of the line almost anywhere in the country but here, where it's just a notch above San Francisco's median home price.

Being able to deduct all her mortgage interest from her taxable income makes the payments much more manageable, said Stern, who works as a software security program manager. The deduction lops several thousand dollars a year off her tax bill.

"I'm a single woman well into middle age," she said. "I have no other tax deductions because I don't have children. I make a fairly decent salary, but frankly in this area it would be hard to afford a nice place to live without a mortgage deduction. It really helps."

But now, as the "fiscal cliff" looms, the mortgage-interest tax deduction is in the spotlight as Congress and the Obama administration consider ways to reduce spending and raise revenue. It's a big-bucks target, costing Uncle Sam more than $100 billion a year.

Critics say much of that help goes to affluent people with more expensive homes and thus more interest to deduct, noting that lower-income people don't itemize deductions so they don't benefit. Moreover, the perk pumps up home prices, they say, thus hurting entry-level buyers.

"There are strong reasons not to have a mortgage-interest tax deduction," said Patricia Cain, a law professor at Santa Clara University. "It inflates house prices and skews decisions about buying real estate. Given our recent experience with the housing bubble, we should stop skewing decisions to invest."

Housing recovery

But supporters, such as the real estate and home-building industries, as well as homeowners, say the deduction promotes middle-class home ownership. Tampering with it now could derail the housing market's nascent recovery, they say.

One point that both sides agree on: The deduction has a bigger impact in high-cost markets. In fact, three-quarters of the mortgage-interest deduction went to just three metropolitan areas - San Francisco, Los Angeles and New York, according to a 2004 economics study.

"The rest of the country thinks we're all wealthy in California," said Don Faught, a Pleasanton real estate broker who is president of the California Association of Realtors. "In Alabama or Georgia, $750,000 buys a very, very nice house. Out here, that gets you a three-bedroom, two-bathroom."

Congress is unlikely to wipe out the entire deduction, which is widely popular. Instead, it may change it in a variety of ways:

-- Impose a $500,000 cap on the amount of principal eligible (it's now $1 million). That would have the biggest impact in high-cost markets, like the Bay Area. "To cut it from $1 million to $500,000 is cruel for people living in Northern California," said Cain. "The geographic difference in tax burden would be tremendous."

Indeed, the change would mean residents of the San Francisco and San Jose metropolitan areas collectively would have to pony up an additional $648 million in taxes, according to a report by John Burns Real Estate Consulting of Irvine.

-- Replace the deduction with a 12 or 15 percent tax credit, again with a $500,000 cap on principal. A tax credit would mean lower-income filers who don't itemize deductions would share in the benefit.

-- Impose a 28 percent cap on the income tax rate for any itemized deductions, including this one. The idea, supported by the Obama administration, would affect those with adjusted gross incomes over $250,000 for couples and $200,000 for singles.

Two changes that seem likely but won't net that much tax revenue: eliminating the deduction for second homes and for home equity lines of credit.

Martin Sullivan, chief economist at Tax Analysts, a Virginia nonpartisan publisher of tax information, said another approach would be to tie any cap on principal to home prices in different areas. That already happens in the lending world, where jumbo loans are defined differently depending on a region's home prices.

"Obviously, if it had to happen, for folks in your area that would be a better way of doing it," he said.

In the end, though, Sullivan believes that rather than quickly revising the mortgage-interest tax deduction during the fiscal cliff negotiations, Congress is more likely to launch an extensive examination of the subject in the new year.

Real estate experts have varying views of how important the deduction is.

Informed decisions

"When people decide if they want to buy a home, they want to make an informed decision on how much they will get back on their income taxes," Faught said. "When you compare renting versus buying, your mortgage payment may be higher, but with tax incentives it can pencil out to be a better decision."

But Julian Hebron, vice president of RPM Mortgage in San Francisco, said lenders don't consider the deduction when deciding what size mortgage a buyer can afford.

"Lenders approve loans by calculating what percentage of a borrower's income is going toward housing cost and other debt," he said. "This calculation is made using total housing costs before tax benefits. And as San Francisco rents have risen sharply in the past 12 months, more than half of my client scenarios work out where the total cost to own a home before any homeowner tax deductions is cheaper than renting."

Others in the real estate industry said the timing is particularly bad, with the housing market just emerging from several years of severe decline.

"I wish (changing the mortgage deduction) could be taken off the table while the real estate market is in such a fra-gile state of recovery nationwide," said Diane Crosby, branch manager of RPM Mortgage in Orinda.

'Irresponsible' move

"For millions of Americans, mortgage-interest deductibility is seen as a critical part of tax planning and their housing budget. It is irresponsible for our leaders to make it a ball in the budget volley right now. This is about perceptions - if I buy a home this year, will the tax benefits still be there? We need to see the government in solid support of sustained real estate market recovery."

Jim and Holly Young bought a house in Oakland this year after their San Francisco apartment, which was not covered by rent control, had a huge rent hike. The deduction, which saves them about $7,000 a year, was key in deciding to buy, they said.

"It was very significant," said Jim Young, a financial adviser with Trilogy Financial Services in San Mateo. "A good portion of my income is self-employment. I need all the tax deductions I can get. If the deduction had been taken away, I would have seriously considered continuing to rent. Getting rid of it for vacation homes seems fine; that's a luxury. But don't mess with the roof over my head."