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Tax bill is missing deductibility of mortgage insurance

The behemoth $136 billion pre-election tax bill signed into law by President Bush on Oct. 22 sprinkled financial goodies over a wide swath of corporate America, from NASCAR racetrack owners to Hollywood filmmakers and importers of Chinese ceiling fans.

But for ordinary homeowners and buyers, the bill turned out to be a bust. It's more notable for what it left out — and what it took away — than for anything it added.

What it didn't do: The final version of the American Jobs Creation Act of 2004 omitted a popular, Senate-passed tax-code change that would have allowed millions of home buyers to deduct their mortgage insurance premiums. Not only had the plan been approved by the Senate, but it had the bipartisan co-sponsorship of more than half of the members of the House. Plus, it had the endorsements of an unusually diverse coalition of labor, business, banking, civil-rights and consumer-advocacy organizations.

The Senate-passed provision would have nullified a ban by the IRS against mortgage insurance deductions on federal income tax filings. It would have sanctioned full write-offs of Federal Housing Administration (FHA) insurance payments, private mortgage insurance (PMI) premiums and Veterans Affairs (VA) guaranty payments for households with annual incomes up to $100,000. Households with incomes above that threshold would have been limited to partial write-offs under a phaseout formula.

Deductibility of mortgage insurance is an issue with significant social as well as financial implications. That's because mortgage insurance premiums are paid for primarily by home buyers with modest incomes and insufficient savings to make a conventional down payment. FHA mortgage insurance, which allows buyers to make minimal 3 percent down payments, predominantly serves first-time and minority purchasers. Private mortgage insurance serves a similar group of modest-income consumers.

In 2001, according to industry estimates, mortgage insurance covered more than half of all new loans made to African-American and Hispanic home purchasers, and 54 percent of all mortgages extended to borrowers with incomes below the median for their areas.

Proponents of deductibility argued successfully in the Senate that mortgage insurance premiums are the functional equivalent of mortgage interest payments, which are deductible for homeowners on up to $1.1 million in mortgage debt. Why not allow less-wealthy buyers to write off premiums that get tacked onto their monthly principal and interest payments solely because they couldn't make a 20 percent down payment? Even the IRS acknowledges this: When a lender incorporates a borrower's mortgage insurance premiums into the note rate — bumping it up by a quarter of a percentage point or more — the IRS permits the rolled-in premiums to be fully deducted, just like interest.

What happened to deductibility in the final $136 billion tax bill? Good question. The Senate and House went to conference — the proverbial smoke-filled room on Capitol Hill. The Senate bill contained a deductibility plan limited to one year, with the tacit understanding that it would be extended in future tax legislation. The estimated revenue cost was $452 million — hardly a budget-buster by high-roller federal tax bill standards.

The House bill contained no deductibility provision despite the support of 220 House members who cosponsored a separate bill sanctioning the write-offs. When the smoke cleared and the tax bill rolled out of conference, it contained new tax subsidies for dozens of congressional pet projects, but nothing for moderate-income and minority home buyers. The House conferees had won the day by excluding the Senate's plan and presumably devoting the revenue savings to other, more vocal constituencies.

Proponents of the deductibility concept say they will be back. "Obviously, we are disappointed," said Jeff Lubar, spokesman for the Mortgage Insurance Companies of America. "With the heavy support we enjoyed, we had hoped for" a place in the final tax bill. "Now we will have to re-evaluate our strategy" to get passage in both houses of the new Congress.

Another little-noticed home real-estate tax provision in the $136 billion bill: Congress amended the capital gains rules to narrow a loophole that allowed some savvy investors to turn commercial property gains into tax-free home sale gains. Under the amended law, taxpayers who acquire an investment property through a "Section 1031" tax-deferred exchange, and convert the property into a principal residence, will not be able to use the standard $250,000-$500,000 tax-free principal home sale exclusion on gains until they've owned and used the converted property for five years.

Previously, some taxpayers were using the principal home sale exclusion rules to shelter gains actually racked up on investment real estate. Now they'll have to wait a little longer to do so.