Is the Mortgage Interest Deduction Impeding Home Ownership?

The Hamilton Project, an economic policy initiative at the Brookings Institution, invited 15 economists of different philosophies to submit proposals for rethinking the Federal Budget.  In the eighth of the resulting papers Alan Viard, Resident Scholar, American Enterprise Institute, proposed to replace the mortgage interest deduction with a refundable credit to reduce the artificial incentive for the construction of high-end homes by better targeting the tax breaks for housing.

Viard says current tax policy offers unwarranted subsidies for the purchase of expensive homes by high-income taxpayers, but does little to promote homeownership by those of more modest means.  He contends that, in addition to the actual mortgage interest deduction, homeowners receive an additional benefit from the tax code in the form of an exemption from tax on imputed rent. 

Imputed rent is value of housing services 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 of business capital; the tax system would need to tax homeowners on this return while allowing a deduction for the associated costs, including mortgage interest payments.  Instead, under the current tax system the homeowner gets the best of both worlds, paying no taxes on imputed rent but yet still deducting mortgage interest payments. 

Taxpayers who itemize deductions rather than taking the standard deduction may deduct the interest paid on up to $1 million of mortgage debt plus up to $100,000 of home equity loans. Mortgage interest on a second home may also be deducted as long as the total remains within the dollar limits. Essentially the same rules apply under the alternative minimum tax, except that home equity loan interest cannot be deducted.

Viard said the mortgage interest deduction would be allowed under a neutral tax system but not the tax exemption for imputed rent.  He provides the following example, breaking the tax advantage into two components, one of which is linked to mortgage interest.

"Suppose that a taxpayer who itemizes deductions 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 of imputed rent and pays $50,000 of mortgage interest. Under a neutral 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 tax saving from deducting the mortgage interest. The $30,000 total tax advantage provided by the current tax system, which is equal to 40 percent of the imputed rent, can be broken down into a $20,000 benefit from the mortgage deduction and a $10,000 benefit from the failure to tax imputed rent minus mortgage interest."

The Treasury Department classified the mortgage deduction as a $111 billion tax expenditure and the failure to tax imputed rent minus mortgage interest as a $59 billion tax expenditure for fiscal 2014.

Viard said there may be a good economic case for promoting home ownership but no case for subsidizing bigger or more-expensive homes. Yet the current tax treatment benefits most taxpayers in the highest brackets and provides more-generous treatment to taxpayers who itemize than to those who claim the standard deductions.  This tax structure may actually impede homeownership for lower income taxpayers he says by driving up the demand for homes and boosting home prices.

Viard proposes that starting in 2015, the mortgage interest deduction be converted to a 15 percent refundable tax credit available to all homeowners whether they itemize or not or have any income tax liability. The credit would be limited to interest on $300,000 of mortgage debt (in 2013 dollars), with no tax relief for mortgages on second homes or on home-equity loans. The dollar limit is indexed to the consumer price index (CPI).

Taxpayers with existing mortgage debt would be allowed to claim 90 percent of the current-law deduction in 2015 with the deduction declining by 10 percent in each subsequent year.  The homeowner could switch to the credit at any time.

Viard says his proposal could increase tax revenues by approximately $300 billion over ten years.

This plan does not end the tax preference for homeownership, but merely scales it back and retargets it toward less-expensive homes and taxpayers of more modest means.  While Viard thinks it would be preferable to directly eliminate the tax advantage for expensive homes by taxing imputed rent on such homes, this is politically impossible and administratively difficult so his proposal leaves the current tax advantage for the equity that homeowners have in their homes intact and limits the tax advantage only on the mortgaged portion of home value.

Viard acknowledges his plan has some weaknesses. First, taxpayers may neutralize the effects with changes in assets and debts.  For example, if a heavily mortgaged high income homeowner sells other assets to pay off the mortgage, then the proposal does not diminish the housing tax advantage and raises no revenue. The tax savings previously obtained from deducting interest on the mortgage are replaced by the tax savings from no longer paying tax on the income from other assets and the taxpayer continues to fully enjoy the benefits of tax-free imputed rent.   The taxpayer could achieve the same results by paying off the mortgage with money borrowed against other assets and deducting the interest on the new debt as investment interest.

Second, any reduction of the mortgage deduction is likely to reduce the value of existing homes but Viard says the transition period should cushion the blow to current homeowners and that the price impact is likely to be more modest than some observers have suggested.

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