Three Points on the Mortgage Interest Deduction

December 8, 2017

Among the key differences between the House and Senate versions of the Tax Cuts and Jobs Act are the changes to the mortgage interest deduction (MID). As the chambers work together to produce a conference report, capping the MID will be one of the big differences to work out.

By way of background, under current law, individuals who itemize can claim a deduction for interest paid on up to $1 million of home mortgage debt for a qualified residence. A qualified residence can be the taxpayer’s principal residence as well as a second place of residence. Taxpayers may also deduct interest paid on up to $100,000 of home equity debt.

The House version of the tax reform bill would make several important changes to the MID. The cap would be lowered to $500,000 of mortgage debt and limited to first homes only. Thus, the deduction could not be used for interest paid to purchase a second home. The bill would also disallow a deduction for interest paid on home equity debt. This change is one of several limitations on itemized deductions in the House bill, which would combine to increase federal revenues by $1.524 billion over ten years.

In no particular order, here are three points that lawmakers should consider:

  • The MID disproportionally benefits high-income taxpayers. In tax year 2015, 46 percent of the MID’s benefits flowed to households making $200,000 or more according to the Joint Committee on Taxation. The value of the MID can lead to higher home prices, allowing the economic benefits to flow to home builders and realtors. Capping the mortgage debt limit at $500,000 and disallowing the deduction for second homes would result in a tax increase that falls primarily on high-income taxpayers, with the largest tax increase likely falling on the top 1 percent. Middle- and lower-income taxpayers would be much less likely to see a tax increase due to these changes.
  • The MID was not originally intended to be a federal housing subsidy, but some proponents now defend it as such. However, most evidence suggests that the MID has almost no impact on the level of homeownership in the United States. Taxpayers who claim the MID are not the same taxpayers at the margin between renting and buying; those at that margin are lower-income taxpayers who are less likely to itemize. For example, Canada does not have a mortgage interest deduction, but its homeownership rate is equal to that in the U.S. And, considering that the House and Senate versions of the bill both include a higher standard deduction, even fewer taxpayers will elect to itemize. Ultimately, the MID functions to incentivize taxpayers to live in more expensive homes. It can even reduce homeownership attainment in places where the housing supply is relatively inelastic and the MID is capitalized into housing prices. These findings have been confirmed not just in the United States, but also globally; an international survey of several countries found that the MID does not generally increase homeownership.
  • The MID distorts the market by favoring housing over other parts of the economy. A research paper from the Organisation for Economic Co-operation and Development suggests there is a positive relationship between tax-favored treatment of mortgage debt and housing price variability. This relationship, observed across OECD countries, illustrates that tax incentives lower the cost of taking on debt, and thus can make the market more prone to cycles. Though not the primary cause of the housing crisis, the MID did play a role in encouraging families to become overleveraged by purchasing homes that they could not otherwise have afforded.

In its current state, the MID primarily benefits upper-income taxpayers, has no discernable positive impact on promoting homeownership, and likely contributes to housing price instability. As the House and Senate conferees begin negotiations, capping the “accidental deduction” should not be a difficult difference to resolve.

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