The mortgage interest deduction is the cornerstone of American housing policy. It makes owning a home more attractive, and proponents argue that it helps stabilize neighborhoods by increasing homeownership. But the mortgage interest deduction could eventually end up on the chopping block as the country's deficit mounts.
The recent changes to the tax code curtail the size of mortgage loans on which interest paid may be deducted and also strictly limits the deductibility of home equity debt, too.
Every April 15, about 34 million Americans claim the mortgage interest tax deduction. It was estimated by Congress' Joint Committee on Taxation [report JCX-3-17] that between 2016 and 2020, this deduction will allow about $357 billion in potential tax revenue to stay in homeowners' bank accounts instead of going to the Treasury. In 2017 alone, the tax break is estimated to be worth over $63 billion to homeowners.
Why the mortgage interest tax break was created
The deduction was added to the tax code in 1913. The idea was that it would increase homeownership and stabilize neighborhoods because homeowners are more involved in their communities than renters. That principle is the driving force behind the missions of Fannie Mae, Freddie Mac and FHA.
According to a study by the Tax Policy Center, these assumptions aren't true. For example, over a 50-year period, before the subprime boom put homeownership in reach of millions, American homeownership rates hardly changed even though the value of the deduction fluctuated widely. Furthermore, no clear connection has been found between homeownership and mortgage deductions in other countries.
While homeowners are more involved in their communities than renters, the relationship may not be cause and effect. Does owning a home change people's feelings about their area, or are the same kind of people who get involved in their communities more likely to buy homes?
Tax deduction not efficient way to accomplish goals
The deduction, whether it accomplishes its goals or not, is hardly the most efficient mechanism for doing so. The mortgage interest deduction confers the highest benefits on those who would probably buy homes anyway: the wealthiest segments of society. Economists James Poterba and Todd Sinai figured that it saves about $523 per year for those earning between $40,000 and $75,000, and $5,459 per year for taxpayers earning over $250,000. Those with the lowest incomes don't generally itemize, so they get no benefit at all from the tax deduction.
The average amount of the tax deduction varies widely. A Tax Foundation analysis found that the actual value of the deduction ranges from an average of $823 in West Virginia to as much as $3,175 in Maryland (2015 figures).
Tax credits: a better way?
So is there a better way? Studied alternatives range from eliminating subsidized mortgages entirely to capping the deduction or converting it to a credit. Each option creates winners and losers.
For example, how about replacing the deduction with a tax credit? After all, a 20 percent credit on $1,000 of interest is $200 no matter what your tax bracket or whether you itemize. But a $1,000 deduction refunds $350 to someone in the 35 percent bracket, only $100 to an itemizer in the 10 percent bracket and zero to taxpayers who take the standard deduction.
In a 2007 report, the Urban-Brookings Tax Policy Center argued that the deduction drives up land and housing costs. It recommended replacing the deduction with a tax credit and subsidized savings program for first-time homebuyers.
Implementing a non-refundable credit equal to 20 percent of mortgage interest paid would raise average after-tax incomes for 80 percent of families who own homes, while the 20 percent of homeowners who earn the most benefit less than they do now with the deduction.
President Barack Obama's February 2010 budget proposal included a provision that would reduce deductions for mortgage interest, charitable contributions, real estate taxes and other items for married filers with annual incomes exceeding $250,000, or individuals earning over $200,000. Instead of the 35 percent deduction they get today, they'd save 28 cents of tax liability for every $1 spent. As with many attempts to change the tax code, Obama's proposal received little support in Congress.
MID changes eventually came, anyway
Whenever modifying the mortgage interest deduction is discussed, concerns are raised about how it would affect both the housing market and charitable contributions. As popular as it is, the deduction is likely to stick around, but that doesn't mean it cannot be changed.
The big winners in the deduction sweepstakes -- upper-middle-class folks who mostly own homes, itemize deductions and spend a nice chunk of their incomes on mortgage interest -- have considerable political force. Add to that the powerful real estate lobby, mortgage brokers and home builders, and this makes change difficult.
However, sweeping tax reforms under the Trump administration did bring significant change to the deductibility of mortgage interest, most notably in that maximum loan amounts subject to the deduction were trimmed fro $1,000,000 (married persons filing jointly, $500,000 for singles or those filing separately) to $750,000 and $375,000 respectively, starting with mortgages made after December 14, 2017; existing first mortgages are "grandfathered" and can use the old limits. The new tax code in almost all cases also removes the deductibility for draws of equity (i.e. cash-out refinances, home equity loans and lines of credit) unless the proceeds are used to "substantially improve" a qualified residence.
Opinions vary as to whether or not the changes to the tax code will ultimately help or hurt the housing market. The reality of the changes -- which include a doubling of the standard deductions but limit the deductibility of state income and local property taxes to $10,000 -- is that there will be both "winners" and "losers" depending upon local market conditions, but the housing market will adapt to the changes in the tax code, just as it always has. Larger or smaller, and for better or for worse, America will continue to be married to the mortgage interest deduction for some time to come.
Keith Gumbinger contributed to this article.