Mitt Romney might have lost the battle for the White House, but his proposal to cap itemized tax deductions is far from defeated.
As the nation's leaders turn their attention toward the fiscal cliff—a nasty, potentially recession-inducing combination of deep government spending cuts and steep tax increases—lawmakers on both sides of the aisle are likely to find the fallen GOP challenger's idea an attractive option to raise revenue while avoiding tax hikes.
But while a proposal to limit tax deductions might help politicians save face while shaving down the nation's ballooning deficit, it could have a serious consequences for homeowners. About a third of taxpayers itemize their deductions (the rest choose to take the standard deduction) and among those who itemize, about 35 percent of their total deductions are for mortgage interest (with another 14 percent for real estate taxes). For most homeowners, mortgage interest is the largest tax deduction they claim.
How much would a cap on deductions impact the mortgage interest deduction itself? Assuming a $25,000 deduction, the effects are actually limited to a fairly small number of metropolitan areas. Naturally, neighborhoods with higher home values (and correspondingly higher mortgages and itemized deductions) are likely to see a larger number of homeowners affected by a cap on deductions. Similarly, areas with median household incomes exceeding $100,000 will likely feel the largest impact when it comes to mortgage interest deductions.
That said, it's not the just the wealthy that will feel the impact of a cap on tax deductions. Median household incomes in 38 percent of the top 50 most-affected ZIP codes are less than $75,000, and 22 percent have median household incomes of less than $50,000. However, these effects are almost entirely limited to the New York metropolitan area.
Overall, a $25,000 cap on itemized deductions would not have a broad impact on most homeowners with the bulk of the effect falling on higher-income households, which is part of the reason why the option is so attractive to lawmakers. The beauty of the cap on deductions from a politician's perspective is that they can both avoid raising taxes and singling out particular tax deductions for elimination. In contrast, the Simpson-Bowles deficit cutting commission proposed the specific elimination or reduction of most tax expenditures including the deductions for mortgage interest, charitable giving and employer-provided health care. Predictably, this raised the ire of the lobbies behind these deductions.
By capping deductions across the board, a politician doesn't have to go after any specific deduction by name, instead allowing taxpayers to continue to claim any of them while limiting the total amount overall.
And there's big money at stake when it comes to capping deductions. With a $17,000 cap on deductions, The Tax Policy Center estimates an extra $1.7 trillion in additional revenue over the next 10 years, even after cutting marginal tax rates by 20 percent and eliminating the Alternative Minimum Tax (AMT). In this scenario, the use of a cap on deductions versus their outright elimination also spares more middle-class families from tax increases: About 83 percent of the additional revenue from a $17,000 cap on deductions in 2015 would come from the top 20 percent of taxpayers, with another 40 percent of the revenue from the top 1 percent.
Naturally, the higher the cap, the smaller the additional revenue gain. Assuming again a 20 percent cut in marginal tax rates and elimination of the AMT, the revenue gain is only about $1.3 trillion over 10 years with a $25,000 cap and about $760 billion with a $50,000 cap.
While capping tax deductions isn't directly related to housing policy, the downstream effect on homeowners is very real. And despite its chief proponent going down in flames at the polls, I suspect this is an idea that we'll be seeing again very soon.
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Stan Humphries is chief economist at Zillow, an online real estate marketplace that provides information on home buying, home selling, homeownership, mortgages, and rentals.