This tax law change could affect you

Rich Smith, writing for The Motley Fool, talks about a US tax law change proposed by Rep John Dingell. Rich's is writing for investors, warning them to watch out if you own companies affected by housing (homebuilders, and the banks which finance mortgages). That's not so interesting. See my commentary at the end.



Fear members of Congress with good intentions. According to Saturday's Washington Post, there's a movement afoot on Capitol Hill to cut a sizeable stake from that most sacred of America's sacred cows -- the home mortgage interest deduction.

Good intentions
Before I begin to criticize the effort, let's first give it some props: Its intentions are good. In an effort to fight global warming, Rep. John Dingell (D-Mich.) aims to reduce carbon emissions in the U.S. by at least 60% by 2050. His plan would attack the problem in several ways -- all of which raise taxes. (This is Congress, after all.) First, there would be a new $0.50-per-gallon tax on gasoline purchases. Second, new taxes would be placed on oil, natural gas, and coal production. Third, and most controversially, the home mortgage interest deduction would be reduced.

According to the congressional Joint Committee on Taxation, home mortgage interest deductions cost the U.S. Treasury about $80 billion in tax revenue each year -- enough to make it the fourth largest category of tax loophole in the Infernal Revenue Code. Dingell's plan would leave the loophole intact for homes of 3,000 square feet and less, but it would slice off 15% of the deduction as homes grow toward 3,200 square feet, 60% as they balloon to 3,800 square feet, and 90% as they rise up to 4,200 sq.ft. As for homes measuring 4,200 square feet and up -- well, their sacred cows would be taken out back and shot.

The unintended consequences of the law
So why target big houses? Dingell will tell you it's because they have a larger carbon footprint. Bigger houses require more fuel to heat, and since they tend to crop up in suburbs that are distant from jobs, they also cause more gasoline to get burned, as the homeowner needs to get to the place where he earns a living to pay the mortgage. Both of these factors put more global-warming gases in the atmosphere.

But there's an ulterior motive to taxing homes more heavily. Originally designed to encourage homeownership, the sheer lucrativeness of the mortgage interest deduction has morphed it into a subsidy for McMansion ownership. Simply put, the more house you buy, the bigger your deduction. Ergo, the tax break gives taxpayers an incentive to buy bigger houses.

Big fleas have little fleas upon their backs to bite 'em. And little fleas ...
Of course, for a bigger house to be bought, someone must first build it. And someone else must finance first the construction, and then the purchase, of the home. Thus, even though it was first intended to subsidize homeownership, the tax break also acts to support homebuilders such as Centex (NYSE: CTX), D.R. Horton (NYSE: DHI), and Toll Brothers (NYSE: TOL). On the other side of the equation, it generates business for construction companies, as well as home-loan business for bankers such as Bank of America (NYSE: BAC), Countrywide (NYSE: CFC), and Washington Mutual (NYSE: WM).

None of these companies will welcome a curtailment of the tax break that fills their revenue streams to brimming.

That's an awful lot of Indians, General Custer
But it gets worse. Some 68% of Americans own their own homes. That's a sizeable interest group that's likely to oppose Dingell's plan. These people bought homes they could afford -- whatever the size -- in the expectation that they could count on the interest deduction to help pay the mortgage bill. Repeal the deduction, and a lot of homeowners could face sudden and severe cash-flow problems -- and maybe even foreclosure.

From worse to worst
Of course, what really gets people nervous, when they hear that the mortgage interest deduction is in peril, is the potential for declining home values. Take away the deduction, and you lower the amount that people can pay for a house. Lower the ability to pay, and you reduce the price that homeowners can charge to unload their domicile. In other words, Dingell's plan will almost certainly add fuel to the fire that's burning up home equity across the country.

According to the National Association of Realtors (warning: bias alert), every 1% decline in the nation's median house price gives rise to about 70,000 foreclosures. Unsurprisingly, the NAR also opposes Dingell's plan. It argues that since houses larger than 3,000 square feet make up 15% of the housing stock in the U.S. -- more than 10 million homes -- limiting mortgage interest deductions could depress home values by 4% nationwide.

That's more than a quarter of a million potential foreclosures, folks. And Dingell's floating this plan in an election year? Good luck.

Foolish takeaway
Considering the array of interest groups that Dingell's plan would offend, and the presidential and Congressional elections on the horizon, I'd say there is a very slim chance that this deduction curtailment will pass. That said, Al Gore did just win a Nobel Prize for his fight against global warming. That could help Dingell's cause. But time will tell.

Foolish investors should watch this legislation closely. The closer it gets to passing, the more you should be watching your homebuilding and banking stocks.

[Dingell has stonewalled us on vehicle fuel economy standards. I'm therefore deeply suspicious of his attempts to target housing. He does likely want to draw attention away from his ties to the auto industry.

However, he does have a point. American houses are rather large, with proportionate energy costs. Additionally, the fact that mortgage interest is deductible is a bigger benefit for the rich than for the middle or working classes. We need to start providing incentives for people to build smaller houses.]