by Archie M. Richards, Jr., CFP^®
November 14, 2005

David writes, "The President wants to simplify the tax code, but he said he'd reject repeal of the mortgage interest deduction. What's your opinion about this? How much do people benefit from the deduction?" Less than they think, David. For the nation as a whole, the mortgage interest deduction causes more harm than good. Here's the story, first for the individual:

Assume you obtain a 30-year home mortgage of $100,000, with an interest rate of 6.3 percent. Your payments each year are $7,428.

The interest portion in the first year totals $6,267.

Assume your taxable income, after exemptions, is $40,000. You're married, filing jointly. Not including the interest deduction, the 2005 federal tax is computed as follows:

The first $14,600 of taxable income is taxed at 10 percent. The next $25,400 is taxed at 15 percent. On the entire $40,000, your federal tax is $5,270.

After the interest deduction, your taxable income is $33,733 ($40,000 less the $6,267 first-year interest). With the lower taxable income, the tax is $4,330.

The interest deduction saves $940 in federal taxes ($5,270 less $4,330).

The net savings is 12.7 percent ($940 divided by the year's total mortgage payments, $7,428).

Were you aware that the percentage saving is this small? Remember that the biggest tax savings comes in the mortgage's first year. In every subsequent year, the interest portion gets smaller, making the savings less and less.

Only if you pay your income tax with the IRS's 1040 Long Form can you benefit from the deduction. The short form won't do.

For most individuals, then, the actual savings are minimal. For the entire nation, the home mortgage interest deduction is harmful. Here's why:

• It causes people to invest too much money in their homes. This raises the prices of real estate and therefore lowers the prices of alternative investments, like stocks and bonds. Yet it's stocks and bonds that people need for their retirements.

• The deduction causes people to buy bigger houses than necessary, increasing their energy costs.

• It favors the rich. Blacks and other disadvantaged people who can't buy homes gain no benefit from the interest deduction. Wealthier people have larger mortgages, enabling them to deduct more interest against higher tax rates.

• The interest deduction is one of thousands of tax loopholes, which, collectively, create a swamp of complexity in collecting government revenues. IRS Publication 936, entitled "Home Mortgage Interest Deduction," has 16 pages of small print. It describes scores of conditions about when the deduction is available and by how much. Tax experts inside and outside government who know such rules cost big money.

Record-keeping, notification, and filing cost huge amounts as well. Mutual funds of non-IRA accounts, for example, are required to classify income into taxable interest, non-taxable interest, short-term gains, long-term gains, dividends subject to the 15 percent rate, dividends subject to ordinary income rates, and other information.

You don't think those notices are free, do you? Oh no, the costs beef up the operating charges the mutual fund assesses against your account.

Federal income tax revenues from individuals and corporations total a little over $1 trillion. Tax compliance and tax-return preparation cost at least $250 billion a year. Plus, the inefficiencies caused by the things people do and the investments they make to avoid taxes costs the nation considerably more.

If all these deductions were repealed, as recommended by Steve Forbes in "Flat Tax Revolution," taxes could be prepared on a postcard. A single, low rate and no loopholes would unleash a phenomenal increase in the nation's wealth. The wealth of home owners - even those with mortgages - would be considerably higher than the wealth they're accumulating now because of modest tax savings from the interest deduction.

The home mortgage interest deduction should be repealed. It's a bum deal.