As the federal government grows increasingly desperate for money, Congress looks for more creative ways to grab more of our cash. One sure way to raise taxes without necessarily raising tax rates is to do away with deductions.
The current budget battles have brought the mortgage interest deduction under attack yet again.
The idea of killing the mortgage interest deduction was floated in the early 1990s by the Clinton administration as a way of getting its arms around annual deficits, which at the time were about $400 billion. Today's annual deficits are more than three times that amount, which is why politicians on both sides of the aisle believe they need to grab more cash.
The 1990s attack on the mortgage interest deduction resulted in limits on the amounts that could be deducted. For example, no deduction may be claimed for interest on a primary mortgage to the extent that the loan exceeds $1,000,000. Also, no interest can be claimed on a home equity line of credit to the extent that it exceeds $100,000.
The ideas currently being batted around include two possibilities. The first would be to eliminate the deduction for mortgage interest on second homes. Under the current law, you can deduct mortgage interest on a second residence if you use it as a personal residence at least 14 days out of the year.
The second idea is to kill the deduction for mortgage interest on a home equity line of credit. As mentioned, there is already a severe and strict limitation on the ability to deduct mortgage interest on an equity line of credit. Most people (and too many tax pros) are not familiar with this limitation, and they end up stuck with tax bills when the IRS audits their returns.
But if the current idea goes into law, there will be no allowable deduction for interest on a home equity line of credit. As such, the tax debt of the typical homeowner family will likely rise, because many have used their equity lines to buy big-ticket items they otherwise would have had to finance independently and for which the interest would be nondeductible. Examples include cars, boats, and vacations.
The idea of killing the interest deduction on second homes is fueled by the same class-warfare, greed, and envy-mongering that fuels much of the tax debate today.
Millions in Crosshairs
The fact is that millions of middle-income Americans enjoy second homes in the form of modest weekend lake homes, cabins, RVs, and boats. All of these qualify as second homes as long as they have cooking facilities and a separate bathroom and sleeping quarters.
The other reality that's overlooked in this debate is that although many of the mega-rich do own multiple homes in exotic locations, those homes are largely paid for and carry no mortgages. The elimination of the deduction for interest on a second home will have little or no impact on that class of citizen.
Another important consideration is that for middle-income Americans who own second residences in vacation regions, most of those properties function as commercial rental properties. Hence they are income-producing assets, not merely extravagant indulgences of a rich fat cat.
And to the extent that income-producing assets incur interest charges, that interest is fully deductible, regardless of the current or proposed future limits on the mortgage interest deduction for a person's primary residence. That’s because the tax code fully recognizes expenses necessary to earn income are deductible from the gross receipts earned by the activity, whether it's a rental activity or otherwise. Nothing in the proposed limitations would change that.
Money in the Middle
Consequently, the only people who would pay more taxes as a result of this are in the middle-income group. Proponents of these changes know that. The middle is where the money is. There are not enough rich people who claim mortgage interest deductions on second homes to make a difference.
In fact, there's not much revenue to be gained at all by eliminating the deduction. The Treasury Department estimates disallowing the deduction would raise tax revenue $7 billion to $8 billion annually—hardly close to filling the budget hole Congress has dug. Even that figure could be an overestimate because it’s are based upon the assumption that the top tax bracket will return to the 36.5 percent level that was in effect before the tax cuts of 2001 and 2003.
What proponents of such proposals really want to do is kill the deduction altogether. That would net around $130 billion per year in increased taxes for the federal government. Congress simply does not have the political nerve to propose an outright elimination of the deduction outside the context of major tax reform.
The changes that would be brought about by these proposals would make middle-income Americans poorer without solving any of the nation's debt problems.
Our tax code is a deplorable mess and must be bulldozed. We have to start over, with an entirely new system that spreads the burden of taxation across all economic lines in a rational, constitutional manner.
Dan Pilla (firstname.lastname@example.org ) is a tax litigation consultant and author of 11 books on IRS defense strategies. He runs the TaxHelpOnline.com Web site and publishes the Pilla Talks Taxes newsletter.
“Ten Principles of Federal Tax Policy,” Dan Pilla: http://www.heartland.org/budgetandtax-news.org/article/28542