Tax Reform: Proposals to Reform or Eliminate the Mortgage Interest Deduction

An issue currently under negotiation in the widely debated tax reform is the possible elimination of the mortgage interest deduction.  Currently, itemizing taxpayers can deduct their mortgage interest on up to $1 million of a qualified principal (and, in some cases, a second) residence; meanwhile, those who rent a home are not granted a similar deduction.  Itemizing taxpayers can also deduct interest on up to $100,000 of home equity debt.  According to various estimates, this deduction cost the Treasury Department between $80 and $103 billion in 2010, and its value over the next 10 years is anticipated to surpass $1 trillion.

Download PDFpdf-icon 

Arguments in Favor of and Against the Mortgage Interest Deduction.  Proponents of the mortgage interest deduction argue that it encourages home ownership and makes it affordable (and in some cases, possible) to taxpayers who would otherwise not be able to own a home.  Critics respond that, rather than encouraging home ownership, the deduction actually encourages middle-class and wealthy taxpayers to take on more debt and buy larger homes than they otherwise would.  Further, critics make the assumption that the deduction tends to benefit taxpayers with larger incomes who likely would have purchased a home regardless of the deduction.

Another complaint of critics is that the deduction artificially drives up home prices; however, this same argument is cited by those who favor the deduction, who observe that eliminating the deduction could further impact home prices in an already depressed market by forcing current homeowners out of their homes and creating a market that would make it even more difficult to sell real property.

The mortgage interest deduction is also criticized as being an “upside-down” subsidy, in that it tends to provide greater benefit to taxpayers with higher incomes. The amount of interest paid by lower- and moderate-income taxpayers is less likely to be sufficiently high to make it worthwhile to forego the standard deduction, so they are less likely to receive any benefit from it.

Proposals.  Many proposals have been advanced regarding the mortgage interest deduction. Due to the widespread popularity of the deduction (as well as the strength of the real estate lobby), it appears unlikely that it would be repealed outright.  In general, the proposals have focused on converting the deduction to a credit, capping the maximum mortgage amount, and limiting the credit to a primary residence.

  • The President’s Fiscal Commission proposed a 12% nonrefundable credit on up to a $500,000 mortgage, with no credit for a second residence or for home equity.
  • The Debt Reduction Task Force would have a 15% refundable tax credit capped at $25,000 (while other proposals suggest a 20% credit).
  • Another proposal is to simply have a fixed credit for owning a home as opposed to having a mortgage.
  • President Obama’s 2012 budget proposal, as well as his 2011 proposal, suggested capping itemized deductions, including mortgage interest, for taxpayers in the top two tax brackets (33% and 35%). Under this proposal, these taxpayers would only be able to reduce their tax liability by a maximum of 28%.

(The Joint Committee on Taxation estimates that President Obama’s proposal to limit upper-income taxpayers’ itemized deductions to 28% would yield $293,261 million over the 2011 through 2021 period.)

Economic effect. Given the amount of income “saved” or revenue “lost” due to the deduction (depending on the stance of the taxpayer), the effects of reforming or repealing the provision could be significant.

If the deduction was repealed entirely, the Urban-Brookings Tax Policy Center (TPC) estimates that the average tax bill of those who claim the mortgage interest deduction would increase by $710.  However, this increase would inevitably vary widely among taxpayers.  Those earning $30,000 to $40,000 per year would end up paying an average increase of $70, whereas those making over $1 million would pay an average increase of $4,000.

According to the TPC, replacing the current mortgage interest deduction with a 20% nonrefundable credit, limiting mortgages eligible for the credit to $500,000, and limiting the credit to primary residences would only have a nominal or positive effect on the majority of the tax bills of those who claim the deduction.  (Of course, those who would face the largest increase are taxpayers in the top tax brackets with the largest mortgages.)

The economic effect of replacing the deduction with a flat credit for home owners, regardless of whether their home debt-financed, would obviously depend on the amount of the credit. In general, credits are considered more progressive than deductions, and the benefit of a flat credit to higher-income taxpayers would presumably be less than that under the current regime. However, the incentive towards home ownership would remain intact.

Conclusion.  Although it seems unlikely that the mortgage interest deduction will be repealed in its entirety, it is quite possible that this significant tax deduction could be reduced or limited in some way. The context of the massive and impending debt crisis may be the determining factor which forces lawmakers to make decisions regarding this issue.