Mortgage interest, tax changes for 2013, hit the wealthy

For the past 18 months, the mortgage interest deduction (MID) took the most heat of any time since it was first introduced, but it came through the election year nearly unscathed.

Legislators and analysts from both parties threw stones at the once-untouchable tax benefit, considered by many to be a key incentive for home ownership, but the only dents made were to the deductions of high-income individuals. The primary focus of the fiscal cliff solution was to tax the rich, and when all was said and done, the rich got fewer deductions on their annual Internal Revenue Service returns.

Although the MID remains intact for now for most Americans who choose to itemize, many high-income taxpayers will see some reduction in the value of their deductions, including the MID. That’s because the fiscal cliff bill brings back the “Pease limitation,” which had expired in 2009. This provision reduces a taxpayer’s itemized deductions by 3 percent of the amount his or her AGI exceeds a threshold amount.

The guidelines are named after Congressman Donald Pease. The late Ohio Democratic who served eight terms became famous for writing tax code that raised revenue by curtailing deductions for high-income taxpayers. These limitations, first incorporated into the Omnibus Budget Reconciliation Act of 1990, usually are centered around state and local taxes, charitable donations and mortgage interest.

Under the new law, the Pease limitations begin at $300,000 for married taxpayers filing jointly and $250,000 for single taxpayers.

So, in an example provided by the IRS, a married couple with an adjusted gross income of $400,000 and $50,000 in itemized deductions (including home mortgage interest), would be $100,000 over the threshold. Because 3 percent of $100,000 equals $3,000, the couple’s itemized deductions would be reduced from $50,000 to $47,000. The couple ends up with $3,000 more in taxable income, which at their income level is taxed at a 33 percent rate. This results in an additional $999 in extra taxes.

No matter how high a taxpayer’s AGI, the Pease reduction cannot exceed 80 percent of the amount of itemized deductions otherwise allowable for the year. However, it could result in a very high-income homeowner losing up to 80 percent of his or her itemized deductions for home mortgage interest, state and local income and property taxes and charitable contributions.

The MID, once felt to be “in stone” and a write-off that would never be eliminated, is now used by fewer than 30 percent of all taxpayers. It is not a dollar-for-dollar deduction; rather the amount of interest paid reduces taxable income. According to the Internal Revenue Code, mortgage interest is deductible to an outstanding mortgage principal balance of a combined $1 million for a principal residence and one additional residence. In addition, interest payable on a home equity line of credit is limited to a loan balance of $100,000. Interest payments from money used to finance home improvements are not included in those ceilings.

In an October 2012 survey, a majority of the nation’s leading economists, real estate experts and investment strategists say eliminating or drastically changing the mortgage interest deduction would benefit the country’s economic outlook. Only 11 percent of the 113 respondents said the MID should remain as-is.

Another tax benefit in the news has been the extension of the Mortgage Forgiveness Debt Relief Act that had been set to expire December 31. The tax break, which has been extended to the end of 2013, allows homeowners facing short sales, reduced loan principals, or foreclosures to avoid paying taxes on any debt still owed to the bank. Otherwise, the debt would have been taxed by the IRS as income.

In some states, short sales have sold for $100,000 less than what the homeowner owed. Hence, a home seller in the 25 percent tax bracket who completed a short sale would have been faced with a $25,000 tax bill if the extension had expired.

While you don’t have to pay tax on the forgiven amount, there is no relief or tax deduction for selling your principal residence at a loss. There still is no benefit for homeowners who bought at the peak or made expensive remodels, then had to sell in a hurry and actually got less for their home than the cash they had invested in it.

Uncle Sam will not let you show a loss on your primary residence if you sell for an amount less than the purchase price.

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