This is part of a new CAP series called the “Tax Expenditure of the Week.” The series aims to explain the often-confusing constellation of tax breaks in a way the average taxpayer can understand. Every Wednesday we will focus on one tax expenditure, explaining what it is, what purpose it is intended to serve, and whether it is effective toward that purpose. We will also review relevant reform proposals.
Subjecting these dozens of tax breaks to greater scrutiny is part of our broader focus on making government work better and achieving better results for the American people, which is the goal of CAP’s “Doing What Works” project.
The mortgage interest deduction is by far the nation’s largest housing program. This tax break, the country’s third largest, is expected to provide homeowners subsidies totaling about $105 billion this year, more than double the entire budget for the federal Department of Housing and Urban Development.
And yet this special tax provision, like many tax expenditures, receives far less scrutiny than direct spending programs that serve similar purposes.
What is the mortgage interest deduction?
If you take out a loan to buy a home, the interest you pay on the mortgage is tax deductible.
To see how this works, consider two families with equal incomes of $100,000. One family owns its house and pays $2,000 in interest on its mortgage each month, or $24,000 annually. The other pays $2,000 a month to rent an apartment. The family that owns its home can deduct $24,000 from its taxable income and pay taxes as if it only earned $76,000. The renter family is taxed on all $100,000 of its income.[1] The homeowners pay about $6,000 less in taxes a year.
On its face, that’s a powerful incentive to borrow money and buy a house. Or a second house. Mortgage interest is deductible not only on primary residences but also on second homes, including vacation homes, on total debt up to $1.1 million.[2]
Why is it a “tax expenditure”?
The mortgage interest deduction is written into the tax code. It is an exception from the general rule that you can’t deduct personal expenses (for example, interest on your credit card or the cost of a new television set isn’t deductible, and neither is one’s rent). Such special provisions are considered “tax expenditures” if they cost the federal government revenue.
Economists use the word “expenditure” in this context because these tax breaks are essentially the same as spending programs. If the government wrote checks to homeowners to help them cover their mortgage payments instead of giving them a tax break, the effect on both the taxpayers and the federal Treasury would be the same.
Is the mortgage interest deduction effective at promoting homeownership?
The mortgage interest deduction helps millions of middle-class homeowners.[3] But it helps wealthy families much more.
If the purpose of the deduction is to encourage homeownership, one way to gauge its effectiveness is to see how well it targets the so-called marginal homebuyer, for whom a tax subsidy could mean the difference between being able or unable to afford a home purchase.
It turns out the mortgage interest deduction is poorly targeted according to this criterion. Households with incomes between $40,000 and $75,000 receive, on average, $523 from the mortgage interest deduction. Households with incomes above $250,000 receive $5,459, or more than 10 times as much.[4]
This “upside-down effect” happens for two main reasons:
- Wealthier individuals naturally tend to have more expensive homes and bigger mortgages, and therefore more deductible interest.
- Tax deductions confer a bigger benefit on taxpayers in the highest income brackets. For a family in the 35 percent tax bracket, a $100 deduction is $35 less he owes the IRS at year’s end. That same $100 deduction is worth only $10 to the family in the lowest 10 percent bracket.
In addition, the mortgage interest deduction is an “itemized” deduction. Most taxpayers, including most homeowners, claim the standard deduction instead because it is worth more to them. For millions of taxpayers, therefore, the mortgage interest deduction provides no added incentive to buy a home.[5]
OK, so it helps the wealthy more. But does this tax break lead to overall higher levels of homeownership?
The evidence here is mixed. Several studies have found a lack of evidence that the deduction increases overall homeownership rates.[6] Anticipated tax savings from the deduction might be built into the prices of homes, especially in high-cost areas. Those higher home prices could be preventing marginal and first-time homebuyers from taking the plunge.
Is encouraging people to take out home loans always a good idea?
The mortgage interest deduction has been criticized for encouraging household debt. It applies to up to $100,000 in home equity loans in addition to mortgages.[7] That encourages people to reduce the equity they have in their homes. The recent recession underscored the dangers involved in excessive debt and leverage. In the wake of recent housing price declines, 22.5 percent of homeowners are “underwater”: They owe more than their homes are worth.
How might the mortgage interest deduction be reformed?
There have been many proposals to reform or eliminate the mortgage interest deduction, from eliminating it for second homes to limiting it to lower mortgage amounts. These and other proposals would help right the deduction’s “upside-down” effect.
The National Commission on Fiscal Responsibility and Reform recently proposed to transform the deduction into a nonrefundable tax credit equal to 12 percent of mortgage interest paid. That would give homeowners in all brackets the same tax savings that a household in the 12 percent bracket would receive from the current mortgage interest deduction.[8] The commission also proposed to lower the debt cap for the deduction from its current level of $1.1 million to $500,000. Under the commission’s plan, there would be no credit for interest on home equity lines of credit or second-home mortgages.
But reform is difficult. Eliminating the subsidy abruptly would be very harsh on homeowners who determined how big a mortgage they could afford with the assumption that they would receive this tax break. In addition, the deduction has probably driven up home prices. Eliminating it would lower home values to the detriment of current homeowners—although future owners could see lower prices. Particularly right now, when falling home prices have hurt the overall economy, this could have an adverse affect on economic growth.
The mortgage interest deduction is closely associated with homeownership and, by extension, the American Dream. But as a $100 billion government spending program, it deserves as much scrutiny as any program of similar magnitude.
Seth Hanlon is Director of Fiscal Reform for CAP’s Doing What Works project. We hope you’ll find this series useful, and we encourage your feedback. Please write to Seth directly with any questions, comments, or suggestions.
Next week: A closer look at the fourth-largest tax expenditure: the deduction for state and local taxes. Thanks to CAP’s James Hairston, and Sarah Hirsch with the Pew Subsidyscope Initiative.
Endnotes
[1]. This example ignores other exemptions or deductions that would be available to both taxpayers, lowering their taxable income.
[2]. The $1.1 million limit is the combined limit for “home acquisition” debt ($1 million) and “home equity debt” ($100,000). The IRS has ruled these two limits may be combined for a single mortgage loan, making the limit effectively $1.1 million. See: Internal Revenue Service, IRS Revenue Ruling 2010-25 (Department of the Treasury, 2010), available at http://www.irs.gov/pub/irs-drop/rr-2010-25.pdf.
[3]. Homeownership may not have been the deduction’s original purpose but it is clear that Congress has preserved it because of its connection to homeownership. For more on the history of the deduction, see: Dennis J. Ventry Jr., “The Accidental Deduction: A History and Critique of the Tax Subsidy for Mortgage Interest,” Law and Contemporary Problems 73 (1) (2010): 233–284.
[4]. James Poterba and Todd Sinai, “Tax-Expenditures for Owner-Occupied Housing: Deductions for Property Taxes and Mortgage Interest and the Exclusion of Imputed Rental Income,” available at http://real.wharton.upenn.edu/~sinai/papers/Poterba-Sinai-2008-ASSA-final.pdf.
[5]. Richard K. Green, “Mortgage interest deduction.” In Joseph J. Cordes, Robert D. Ebel, and Jane Gravelle, eds., The Encyclopedia of Taxation and Tax Policy, 2nd ed. (Washington: The Urban Institute Press, 2005).
[6]. William G. Gale, Jonathan Gruber, and Seth Stephens-Davidowitz, “Encouraging Homeownership Through the Tax Code,” Tax Notes (June 18, 2007): 1171–1189; Edward L. Glaeser and Jesse M. Shapiro, “The Benefits of the Home Mortgage Interest Deduction”. Working Paper 1979 (Harvard Institute of Economic Research, 2002). A summary of the research can be found in Eric Toder and others, “Reforming the Mortgage Interest Deduction” (Washington: Tax Policy Center, 2010).
[7]. Interest on home equity debt that exceeds the home’s fair market value cannot be deducted, even if it is within the $100,000 cap.
[8]. 12 percent is the lowest tax bracket under the commission’s plan.