Is the Mortgage Interest Deduction Impeding Home Ownership?

by devteam February 28th, 2013 | Share

The Hamilton Project, an economicrnpolicy initiative at the Brookings Institution, invited 15 economists ofrndifferent philosophies to submit proposals for rethinking the FederalrnBudget.  In the eighth of the resultingrnpapers Alan Viard, ResidentrnScholar,rnAmericanrnEnterprise Institute,rnproposedrnto replace the mortgage interest deduction with a refundable credit to reducernthe artificial incentive for the construction of high-end homes by betterrntargeting the tax breaks for housing.</p

Viard says current tax policy offers unwarranted subsidies</bfor the purchase of expensive homes by high-income taxpayers, but does little to promote homeownership by those of more modest means.  He contendsrnthat, in addition to the actual mortgage interest deduction, homeowners receivernan additional benefit from the tax code in the form of an exemption from tax onrnimputed rent.  </p

Imputed rent is value of housingrnservices provided by an owner-occupied home as measured by the cost of obtaining the same services from a rental property.   Viard says to maintain neutrality with respect to the current taxation ofrnbusiness capital; the tax system would need to tax homeownersrnonrnthis return while allowing a deduction for the associated costs, including mortgage interest payments.  Instead,rnunder the current tax system the homeowner gets the best of both worlds, payingrnno taxes on imputed rent but yet still deducting mortgage interestrnpayments.  </p

Taxpayers who itemize deductions rather than taking thernstandard deduction may deduct the interest paid on up to $1 million of mortgage debt plus up to $100,000 of home equity loans.rnMortgage interest on a second home</bmayrnalso be deducted asrnlong as the total remains within the dollar limits. Essentially the same rulesrnapply under the alternative minimum tax, except that home equityrnloanrninterest cannot berndeducted.</p

Viard said the mortgage interest deduction would bernallowed under a neutral tax systemrnbut not the tax exemption for imputed rent.  He provides the following example, breakingrnthe tax advantage into two components, one of which is linked to mortgage interest. </p

“Suppose that a taxpayer who itemizesrndeductions and is in the top 39.6 percent bracket (rounded to 40 percent for simplicity) owns a home worth $1.5 million with a $1 million mortgage. If the home provides a 5 percent rate of return in terms of housing services and the mortgage rate is also 5 percent, then the taxpayer receives $75,000 ofrnimputed rent and pays $50,000 of mortgage interest. Under arnneutral tax system, the homeowner would pay $10,000 of tax on imputed rent minus mortgage interest; under the current tax system, the homeowner actually receives a $20,000 taxrnsaving from deducting the mortgage interest. The $30,000 total tax advantage provided by the current tax system, whichrnisrnequal to 40 percent of the imputed rent, can be broken down into a $20,000 benefit from the mortgage deduction andrna $10,000 benefit from the failure to tax imputed rent minusrnmortgage interest.”</p

ThernTreasury Department classified the mortgage deduction as a $111 billion taxrnexpenditure and the failure to tax imputed rent minus mortgage interest as a $59 billion tax expenditure for fiscalrn2014. </p

Viard said there may be a good economicrncase for promoting home ownership but no case for subsidizingrnbigger orrnmore-expensivernhomes. Yetrnthe current tax treatment benefits most taxpayers in thernhighest brackets and provides more-generous treatment to taxpayers who itemize than to those who claim the standardrndeductions.  This tax structure may actually impede homeownership for lowerrnincome taxpayers he says by driving up the demand forrnhomes and boosting home prices. </p

Viard proposes that starting in 2015, the mortgage interest deduction bernconverted to a 15 percent refundable tax credit available to all homeowners whether they itemize or not or have anyrnincome tax liability. The credit would be limited to interest onrn$300,000 ofrnmortgage debtrn(inrn2013 dollars),rnwith norntaxrnrelief for mortgages on second homes or on home-equity loans. The dollar limit is indexed to the consumer price index (CPI). </p

Taxpayers with existing mortgage debt would be allowed to claim 90 percent of the current-law deduction in 2015 with the deduction declining by 10rnpercent in each subsequent year.  Thernhomeowner could switch torntherncredit atrnanyrntime.</p

Viard says his proposal could increase tax revenues by approximately $300rnbillion over ten years.</p

This plan does not end the tax preference for homeownership, but merely scales it back and retargetsrnitrntowardrnless-expensivernhomes and taxpayers ofrnmorernmodest means.  While Viardrnthinks it would be preferable to directly eliminate the tax advantage for expensive homes by taxing imputed rent onrnsuchrnhomes, this isrnpolitically impossible and administratively difficult so his proposal leaves the current taxrnadvantage for the equity that homeowners have in their homesrnintact and limits the tax advantage only on the mortgaged portion ofrnhomernvalue.</p

Viard acknowledges his plan has some weaknesses. First,rntaxpayers may neutralize the effects with changes in assets and debts.  For example, if a heavily mortgaged highrnincome homeowner sells other assets to payrnoffrnthe mortgage, then the proposal does not diminish thernhousing tax advantage and raises no revenue. The tax savingsrnpreviously obtained from deducting interest on the mortgage are replaced by the tax savings from no longerrnpaying tax on the income from other assets and the taxpayer continues to fully enjoy the benefits of tax-freernimputed rent.   The taxpayer could achieve the same resultsrnby paying off the mortgage with money borrowed against other assets and deducting the interest on the new debt as investment interest. </p

Second, any reduction of the mortgage deduction is likely tornreduce the value of existing homes butrnViard says the transition period should cushion the blow to current homeowners andrnthat the price impact is likely to be more modest than some observers havernsuggested.</p

The availability of the credit tornall homeowners may reduce the number of taxpayers choosing to itemize, diminishing incentives to engage in other tax-deductiblernactivity such as charitable giving.

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About the Author


Steven A Feinberg (@CPAsteve) of Appletree Business Services LLC, is a PASBA member accountant located in Londonderry, New Hampshire.

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