Mortgage-interest deduction could be on the table in ‘fiscal cliff’ debate

Of all the deductions woven into the sprawling U.S. tax code, few have been more fiercely guarded than the enormous tax break that lets homeowners deduct the interest they pay on their mortgages.

But as Congress and the White House negotiate the first major rewrite of tax laws in decades, changing the generations-old mortgage-interest deduction — which costs the government roughly $100 billion a year — has gone from far-off possibility to part of the conversation.

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At the White House Wednesday, President Obama addressed a group of Americans whose taxes would go up if Congress failed to extend the middle class tax cuts.

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The outcome of that debate could have profound long-term effects on homeowners across the country — and particularly those in the Washington area, who tend to benefit from the tax break more than many other Americans due to the region’s hefty home prices and high incomes.

As the Obama administration and lawmakers on Capitol Hill scramble to defuse automatic spending cuts and tax increases set to take effect Jan. 1, a herd of sacred cows — from Social Security and Medicare to deductions for charitable giving and mortgage interest — are in danger of losing their untouchable status.

Members of both parties have largely steered clear of detailed proposals so far. But plans put forth in the past year by President Obama and Mitt Romney to place limits on annual total tax deductions are likely to crimp the mortgage-interest deduction for certain taxpayers. Top congressional Republicans also have expressed openness to limiting total tax deductions as part of an overall budget deal. In addition, the presidentially appointed Simpson-Bowles fiscal commission suggested scaling back the mortgage-interest deduction as part of its own set of tax-related proposals.

Current law allows homeowners to deduct the interest paid on mortgage balances up to $1 million, including on second homes, as well as on $100,000 worth of home-equity loans. The deduction overwhelmingly benefits wealthier families, partly because they tend to have larger mortgages and pay more interest, and partly because most low- and middle-income Americans do not itemize deductions on their tax returns. It also tends to favor homeowners on the East and West Coasts, as well as those in large cities such as Chicago, where average home prices are higher.

Edward Kleinbard, a tax expert and law professor at the University of Southern California, said the mortgage-interest deduction represents the kind of government “extravagance” that the country no longer can justify, given its fiscal troubles.

“We simply cannot afford wasteful government subsidy programs anymore, and this is one of the most important examples of that,” Kleinbard said. “It’s very much a subsidy to those Americans who need it least.”

True enough, said Moody’s chief economist Mark Zandi, but the deduction nevertheless has become ingrained in the psyche of home buyers over generations, and reducing it would have real effects.

“It’s a very visceral thing for people,” Zandi said. “People account for it when they think about how much house they could afford to buy. You take that away, and house prices are going to weaken. They are going to decline.”