As lawmakers continue to debate how to handle the nation’s debt and do “something big” rather than simply patch the problem, it seems probable that many broader tax reform issues may resurface during the course of the negotiations. One such issue, which was addressed by President Obama in his 2012 and 2011 budget proposals, is the mortgage interest deduction—one of the largest tax expenditures. According to various estimates, the deduction cost the Treasury Department somewhere between $80 and $103 billion in 2010, and its value over the 10-year budget window is expected to exceed $1 trillion. This post examines the mechanics of the deduction, arguments for and against reforming it, reform proposals, and the projected effect of any changes on both taxpayers and the budget.
Background. Interest paid with respect to a mortgage on real estate is deductible interest on indebtedness. Itemizing taxpayers can deduct their mortgage interest on up to $1 million of qualifying acquisition debt on a qualified principal and, if applicable, secondary residence. A residence includes a house, condominium, cooperative, mobile home, house trailer, or boat. In effect, this deduction reduces the after-tax cost of financing a home. In contrast, taxpayers are not permitted to deduct the costs of renting a home.
Itemizing taxpayers can also deduct interest on up to $100,000 ($50,000 for married individuals filing separately) of home equity debt—i.e., debt secured by a taxpayer’s qualified residence up to the fair market value of the residence, as reduced by the amount of acquisition indebtedness on it.
Arguments for and against reforming the deduction. The mortgage interest deduction is often 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 claim any benefit from it.
Proponents of the deduction argue that it encourages home ownership and makes it affordable to taxpayers who would otherwise not be able to own a home. Critics claim in response 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 argue that the deduction tends to benefit taxpayers with larger incomes who likely would have purchased a home regardless of the deduction.
M&Q illustration : A married couple who takes out a $150,000 mortgage on January 1, 2011, payable over 30 years with 7% interest, pays $9,584.85 in interest in the first year. Unless the couple has other itemized deductions, they may simply opt for the $11,400 standard deduction.
If the same couple were to double their mortgage to $300,000, same interest and term, their interest payment in the first year is $19,169.71.
If the couple were to again double their mortgage to $600,000, the interest payment would be $38,339.42.
Critics of the deduction also claim that the deduction artificially drives up home prices. However, this same argument is cited by its proponents, who observe that eliminating the deduction could further impact home prices in an already depressed market.
M&Q observation: The effect of driving up prices may have contributed to the problem of “underwater” mortgages, where taxpayers owe more on their homes than the home is actually worth.
Proposals. A number of different proposals have been advanced regarding the mortgage interest deduction. In light of the popularity of the provision, and the strength of the real estate lobby, it appears unlikely that it would be repealed outright. In general, the proposals tend to focus 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. Other proposals suggest a 20% credit, whereas 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 the proposal, these taxpayers would only be able to reduce their tax liability by a maximum of 28%.
M&Q illustration : The current structure of the mortgage interest deduction reduces the after-tax cost for each $100 borrowed by a taxpayer in the 35% bracket to $65. However, the after-tax cost for each $100 borrowed by a taxpayer in the 10% bracket is $90. In other words, the higher a taxpayer’s tax bracket, the greater relative benefit he will receive from the deduction. The Administration’s proposal would limit the benefit to higher-income taxpayers by five or seven percentage points, such that the after-tax cost for each $100 borrowed would rise to $72.
M&Q observation: The effect of this proposal on taxpayers who are subject to the alternative minimum tax (AMT) would depend on a number of factors, including the taxpayer’s particular mix of income and deductions and the taxpayer’s marginal statutory rate. Although AMT taxpayers are already effectively subject to a 28% limit on deductions, the President’s proposal has an AMT element that would nonetheless result in an increase in the tentative minimum tax liability of certain AMT taxpayers.
Economic effect. Given the amount of foregone revenue from the deduction, the effects of reforming or repealing the provision could be significant.
If the deduction was repealed flat out, 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 vary widely among taxpayers—those with $30,000 to $40,000 incomes would face an average increase of $70, whereas taxpayers making over $1 million would face an average increase of $4,000. However, given the popularity of the deduction, its outright repeal seems unlikely.
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. Again, 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.
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. This increased revenue would be largely attributable to the limits on mortgage interest and charitable contribution deductions.
Conclusion. While it seems unlikely that the deduction will be repealed outright, it is nonetheless possible that this popular tax expenditure could be somehow reformed or curtailed. The context of the looming debt crisis may well provide the necessary push for lawmakers to take action on this issue. What choices will be made and when remains to be seen—stay tuned.
