The Backstory: How Everyone Came To Have a Second Mortgage

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A quarter-century
ago, only someone in desperate need of cash would take a second
mortgage. Then Congress changed the tax rules, and today, millions
of Americans have “home equity” lines.

Banks are losing
$30 billion a year
on these products, and untold thousands of
families stand to lose their homes to foreclosure. Is this another
example of a law’s unexpected consequences? Nope. This outgrowth
of the Tax
Reform Act of 1986
was perfectly foreseeable, and in fact, foreseen.
But, then as now, Congress tended to tune out warnings that it preferred
not to hear.

Prior to the
tax reform, taxpayers could deduct nearly any sort of interest expense,
including interest on credit card balances, automobile loans, and
life insurance loans. After the tax reform, nearly all non-business
interest expense was no longer deductible.

But a few exceptions
remained. The most important was (and is) that taxpayers still can
deduct the interest on up to $1 million of mortgage debt incurred
to buy or improve a principal residence or a vacation home. The
real estate industry lobbied hard to keep this benefit in the law.

The tax reform
law also preserved a benefit for second mortgages. Taxpayers are
permitted to deduct interest payments on up to $100,000 of debt,
regardless of the purpose for which the debt is incurred, so long
as they put their home up as collateral. The Internal Revenue Service
explains: “Generally, home mortgage interest is any interest
you pay on a loan secured by your home (main home or a second home).
The loan may be a mortgage to buy your home, a second mortgage,
a line of credit, or a home equity loan.” So, even if you plan
to use the money for a big screen TV or a vacation, if you borrow
against your home, you can take the deduction.

In recent years,
many home equity lines of credit have greatly exceeded the $100,000
cap. Interest on the excess debt is nondeductible. However, the
government has no easy way to know the size of the loan on which
the interest is being paid. Over more than two decades in the tax
business, neither I nor any of my co-workers have ever been asked
to demonstrate that the interest deductions claimed on a tax return
are for a loan within the allowable limits. We follow the law anyway,
but we can safely assume that many taxpayers do not, either out
of ignorance or otherwise. In practice, therefore, taxpayers can
end up taking deductions for interest expense on debt well above
the limits.

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the rest of the article

September
2, 2010

2010
Economic Policy Journal

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