Mortgage deduction resists change
Economists question the rationale of having an income-tax deduction for mortgage interest.
The New York Times
If you ask most people about the possibility of reducing or eliminating the tax deduction for interest on home mortgages, you will generally hear the same things you would if you suggested altering Social Security benefits.
It's political suicide. It will crush an already anemic economy. It's downright un-American.
Talk to most economists, though, and they are likely to question the rationale of having a tax deduction at all. They will tell you that countries like Australia, Canada and Britain do not have a deduction for mortgage interest, yet have higher rates of homeownership than the United States. And they will ask, what behavior is the U.S. government trying to encourage by favoring homeowners over renters?
Homeownership would be the obvious answer, but it is an incomplete one.
"Its intention was to increase the rate of homeownership," said Celia Chen, a senior director and housing economist at Moody's Analytics. "It hasn't helped to expand homeownership, but it's helped to support purchases of larger homes."
Many lower-income homeowners do not itemize their tax returns, because they do not have enough deductions to make it worthwhile. In filing the basic 1040 form, they do not benefit from the deduction.
Many older Americans — perhaps as few as 10 percent, according to one study — do not benefit from it either, because they have paid off their mortgages entirely or they rent.
The deduction overwhelmingly favors wealthier homeowners. The limits are quite high — up to $1 million of a mortgage's value and an additional $100,000 for home-equity loans — and the amount that can be deducted does not fall as people's incomes rise.
The deduction is not limited to a primary residence, so someone with two or three homes that fall under that $1 million limit could claim the deduction.
Even so, it is one of the few benefits for the wealthy that seems not to have been swept up in the recent tax-the-rich movements.
"Surveys that ask people if they're supportive of it get very broad-based support, because renters aspire to be homeowners," said Eric Belsky, managing director of the Joint Center for Housing Studies at Harvard. "The idea that it won't be available to them when it was available to others doesn't seem fair."
A New York Times/CBS News poll in June found that 9 in 10 Americans thought homeownership was an important part of the American dream, while 45 percent of respondents thought the government should do more to help the housing market.
Is it tenable to maintain the mortgage-interest deduction? Here is a look at the state of the deduction.
Almost 100 years old
The deduction began when the federal tax code was created in 1913. At the time, all interest was deductible because the government considered it a business expense.
The mortgage-interest deduction survived the overhaul of the tax code in 1986 when interest on credit cards, which had also been deductible, was eliminated.
No one I spoke to was willing to wager that the mortgage-interest deduction would go away. That was one proposal in the report released by Alan Simpson and Erskine Bowles, who headed a bipartisan panel created at the behest of President Obama to find solutions to the fiscal problems the United States faces.
The Simpson-Bowles report also offered a second idea: Reduce the limit on the deduction to $500,000 of a mortgage's value from $1 million, eliminate the deduction for home-equity loans and prohibit people from deducting the interest on a second home.
Robert Pozen, a senior lecturer at Harvard Business School and the former chairman of MFS Investment Management, said that approach was a logical way to reduce the cost of the deduction without discouraging people from buying homes.
"These three aspects have a weak relationship at best to promoting homeownership," he said. "How is this goal furthered by the mortgage-interest deduction for a second home in the mountains?"
Pozen calculated that taking those three steps would save the government $150 billion over the next decade.
The real-estate lobby objects strongly to any change in the current limits, even for second homes.
"Our members believe tinkering with the mortgage-interest deduction at the high end will trickle down," said Lawrence Yun, chief economist of the National Association of Realtors.
He argued that with a reduction at the top level, prices on more expensive homes would fall, but so too would prices on less expensive homes as certain buyers realized they could not afford as much house without the deduction.
"People view this as part of the social contract, as something that represents the American dream," Yun said. "Therefore any changes are changes to the property rights of homeowners."
In addition to being one of the oldest federal tax deductions, the mortgage deduction is the largest one.
The Congressional Joint Committee on Taxation estimated that it cost $90 billion last year and would cost $484 billion from 2010 to 2014. Depending on your point of view, this is either a very large revenue loss to the federal government or a very large saving for homeowning taxpayers.
About a quarter of all tax filers claim the deduction, said Belsky. But a look at other numbers shows how the deduction affects Americans disproportionately.
Sid Rosenberg, the William F. Sheffield Professor of Real Estate at the University of North Florida, calculated that the deduction would mean little to a person buying or selling a house in Florida, where the median price is $135,000.
He estimated interest deductions of $7,000, which is below the standard deduction of $11,600 a couple gets if they do not itemize all of their deductions on their tax return.
"To me it's a heck of a lot more valuable to people in New York than people in Florida," he said. "If you're moderate income and you're in Florida, you're probably not going to get much effective deduction. It's certainly not the case that not having it is going to hurt poor people, at least not down here."
But it does have an impact in states where income and housing prices are higher. Melissa Labant, technical manager at the American Institute of Certified Public Accountants, calculated two situations for middle- and upper-income homeowners in more expensive states.
In the first situation, consider a couple who earn $137,300 a year and are in the 25 percent tax bracket. If they owned a $350,000 house paying 5 percent interest on their mortgage, they would save $4,375 a year on interest of about $17,500.
For the wealthiest homeowners, the deduction is far better. People with $1 million homes with the same 5 percent rate would be paying $50,000 a year in interest. As they would most likely be in the top 35 percent tax bracket, they would save $17,500 a year in federal taxes through the deduction.
"The problem is, everyone's information is different, and that's what makes it so challenging," Labant said. "High-income taxpayers have benefited the most from being able to take advantage of the mortgage-interest deduction."
That should not be surprising — bigger mortgages equate to more interest and bigger deductions. But it does contradict the belief that the deduction helps lower-income people buy their first homes.
Impact on housing
The big question is what effect changing the deduction would have on the housing market. In the short term, it would be bad, and given the weak housing market, it could be worse than at some other time.
A change to the deduction would hurt people who already own homes more than new buyers, in two ways. If homeowners wanted to sell, they would, on average, get less for their house. That's because the prospective buyers would have to recalculate what they could afford to pay each month toward their mortgage — and thus the purchase price — if the deduction disappeared.
"The price of the deduction is built into the home, so eliminating it would have a negative impact in the near term," said Chen of Moody's Analytics. "If you reduced the limit of the deduction, it would hit higher-end housing, but the impact on lower-income households isn't that great."
First-time and lower-income buyers might get a break, however, because home prices would be lower.
Chen said the absence of a deduction was not likely to affect the number of homes sold at the high end because wealthier buyers would most likely still want to own a nice home (although it might affect the price, at least in the short term).
Where eliminating the deduction would have an impact would be on people who itemized their taxes and took the deduction. Belsky estimated that eliminating the deduction would increase their taxes, on average, about $2,400 a year. And in the broader economy, that means less demand for goods and services from spenders and less money for savers to use to buy stocks and bonds.
Ultimately a reduction of the deduction would not quash the dream of homeownership and, if modified, it might help certain buyers get their first homes. But it is impossible to predict what might happen given the current political stalemate.
Besides, most of the conversation is about revenue, not about the harder philosophical question of what the deduction is meant to do.
"We as a country should decide what types of homeowners we want to subsidize and how," Pozen said. "At present, we have a vaguely defined policy goal together with programs that are not well designed to accomplish that goal."