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 end up on the chopping block as the country's deficit mounts.
Every April 15, about 40 million Americans claim the mortgage interest tax deduction. It was estimated by Congress' Joint Committee on Taxation that between 2009 and 2013, this deduction will allow about $600 billion in potential tax revenue to stay in homeowners' bank accounts instead of going to the Treasury. In 2009, the tax break was worth over $80 billion to homeowners, about 2 percent of all federal spending.
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.
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.
Why no change is expected anytime soon
But Obama's proposal has received little support in Congress so far. There is concern about how it would affect both the housing market and charitable contributions.
The deduction is likely to stick around. The big winners -- 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. Today, no one wants to deal any more blows to the housing market. Industry spokespersons say that reducing the deduction would hurt housing markets at the worst possible time. "It seems very counterintuitive to impose this kind of pain on an industry that's already suffering more than any industry in America," says Jerry Howard, chief executive of the National Association of Home Builders. For better or for worse, America will continue to be married to the mortgage interest deduction for some time to come.
Gina Pogol has been writing about mortgage and finance since 1994. In addition to a decade in mortgage lending, she has worked as a business credit systems consultant for Experian and as an accountant for Deloitte.