Gradually Eliminate the Mortgage Interest Deduction

The tax code treats investments in owner-occupied housing more favorably than it does other investments. For example, the owner of a rental house can deduct various expenses, such as mortgage interest, property taxes, depreciation, and maintenance, but has to pay taxes on the rental income--net of those expenses--and on any capital gain when the house is sold. In contrast, homeowners can deduct mortgage interest and property taxes from their income when they compute their income tax liability, even though they do not have to pay tax on the net rental value of their home. (Other housing-related expenses cannot be deducted from homeowners' income.) Homeowners also can exclude from taxation capital gains of up to $250,000 ($500,000 for joint filers) when they sell their primary residence.

Current law limits the total amount of mortgage debt that can be included in the calculation of an interest deduction to $1.1 million: $1 million for debt that a homeowner incurs to buy, build, or improve a first or second home; and as much as $100,000 in other debt (such as a home-equity loan) for which the owner uses the home as security, regardless of the purpose of that loan.

Beginning in 2013, with the expiration of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Public Law 111-312), the total value of certain itemized deductions--including the mortgage interest deduction--will be reduced if the taxpayer's adjusted gross income is above a specified threshold.

This option would phase out the mortgage interest deduction, beginning in 2014. By that time, the Congressional Budget Office forecasts, foreclosures will have subsided, construction will have returned to normal levels, and housing prices will have begun to recover. The option would reduce the maximum mortgage eligible for the interest deduction from $1.1 million in 2013 to zero in 2024 in annual increments of $100,000. That change would boost revenues by only $14 billion from 2012 through 2016 but by $215 billion through 2021 and by increasing amounts relative to the size of the economy through 2024.

One argument in favor of the option is that it would improve the allocation of resources in the economy. The current deduction encourages home buyers who can itemize deductions to buy houses when they might otherwise rent or, especially, to buy bigger houses than they would buy if all investments were taxed equally. As a result, it is argued, homeowners invest too much in their houses and too little elsewhere. Reducing the maximum amount of mortgage debt on which interest could be deducted--and then eliminating that deduction entirely--should make many people more willing to invest in stocks, bonds, savings accounts, or their own businesses rather than in housing. Between 1950 and 2009, about 36 percent of net private domestic investment went into owner-occupied housing. That share is large enough that a reduction in investment in owner- occupied housing could eventually boost the amount of capital available to other sectors of the economy and increase total economic output.

Another argument in favor of this option is that eliminating the mortgage interest deduction would curtail the tax advantage for homeowners who borrow against their homes to buy other goods or to fund tax-favored retirement savings accounts, such as 401(k) plans and individual retirement accounts. Allowing homeowners to deduct interest for loans used to finance other consumption distorts their choices between saving and consuming and probably reduces national saving. The deduction also favors owners over renters, who cannot deduct interest on normal consumer loans (such as automobile loans or credit card debt). Furthermore, allowing homeowners to deduct interest on mortgage loans at the same time that they contribute to tax-favored savings plans enables homeowners to take advantage of tax savings on both transactions. It thus provides an incentive for people to pay down mortgage debt more slowly and contribute more to retirement accounts than they would if mortgage interest was not deductible. Such transactions reduce federal tax revenues without increasing net saving because the higher retirement contributions are offset by larger amounts of outstanding mortgage debt.

A drawback of eliminating the deductibility of mortgage interest is that it could delay the recovery of home values, home construction, and home mortgage lending from their currently depressed levels. Even though the option would not take effect until 2014 and would be implemented gradually over a 10-year period, housing markets might begin to feel the effects sooner, as buyers anticipated the reduction--and eventual elimination--of the mortgage interest deduction. That would create new hardships, in addition to those already plaguing the housing market, for people who own homes (particularly those currently "under water" because they owe more on their mortgage than the house is worth), home builders, and lenders.

Another drawback is that this option might adversely affect individuals and their communities by reducing the rate of home ownership, particularly among younger and less wealthy people who must borrow in order to buy. Owning a home has been found to increase people's involvement in their community and local government. Moreover, it motivates people to better maintain their property, which benefits their neighbors as well as themselves. Even though such actions benefit communities, individuals typically do not consider those benefits when deciding whether to rent or own a home. Subsidies to encourage home ownership might offset that omission.

Although some incentive to become a homeowner may benefit communities, the mortgage interest deduction may be ineffective in that capacity. Despite the favorable tax treatment that mortgage interest receives in the United States, the rate of home ownership here is similar to that in Australia, Canada, and the United Kingdom, and none of those countries currently offers a tax deduction for mortgage interest. The effect of the deduction on people's decisions about whether to buy a house may be small because lower-income people--who face the greatest challenges in their efforts to become homeowners-- get the least benefit from the deduction. There are two reasons for that disparity. First, lower-income people may not have sufficient deductions to make itemizing worthwhile. Second, the value of an itemized deduction is greater for people in higher income tax brackets and with larger mortgages.