Explaining the Mortgage Interest Deduction

Something strange has happened in the past few days as we have approached the Austerity Trap (aka "fiscal cliff"). Suddenly, people are actually talking about the possibility of cutting back on the home interest deduction, a "gift," as Mitt Romney might call it, that dwarfs most others the federal government distributes (among tax expenditures, only the deduction for health insurance costs the government more). I continue to believe that there's just no way Congress is going to touch the MID, cherished as it is by so many. But I could be wrong, and this is a good time to brush up on where the deduction came from and what its consequences are.

The mortgage interest deduction came about essentially by accident. When the Constitution was amended in 1913 to allow for an income tax, Congress made all interest payments deductible. Mortgage interest wasn't mentioned specifically, and there was no suggestion that this was something necessary to promote home ownership. But as more Americans began buying homes after World War II, people quickly realized what a boon it was. So around that time, the promotion of home ownership began to be regularly offered as a justification for the mortgage interest deduction (if you like, you can read a long history of the MID here).

Despite the almost universal condemnation of economists, the deduction has survived every round of tax reform in the last century. It has some powerful defenders, most notably the National Association of Realtors, one of Washington's most influential lobbying groups (realtors obviously have an interest in inflated home prices, which increase their commissions). It also survives because members of Congress aren't exactly eager to tell millions of voters that their tax bills are going to increase by thousands of dollars. According to the Treasury Department, the mortgage interest deduction cost the government $86.9 billion this year, and the number will top $100 billion next year. Over time, more of those benefits have gone to wealthier Americans. You can deduct interest on mortgages with a value of up to $1 million and home equity loans up to $100,000. The wealthier you are, the bigger your mortgage (most of the time), and the higher your income tax rate, making each dollar of deduction more valuable to you. That means the MID is a regressively distributed benefit. To borrow an example from the Center on Budget and Policy Priorities, a banker with a $1 million mortgage paying $40,000 in interest gets a government housing subsidy of $14,000 every year; he pays 65 cents of every interest dollar on his mortgage, while the government pays the other 35 cents. On the other hand, a nurse who makes $60,000 a year and pays $10,000 a year in interest will only get a $1,500 subsidy; she'll pay 85 cents of every interest dollar on her mortgage while the government will pay the other 15 cents.

So this is how the benefits of the mortgage interest deduction end up being distributed (the data come from the Joint Committee on Taxation):

As a homeowner, I love the mortgage interest deduction. Every year when I'm doing my taxes and I get to the step in the software where you enter in your mortgage interest, a wave of relief just washes over me, just as it surely does to millions of others. But I can't come up with any good argument to defend it. And there's the dilemma for lawmakers. They can make the case that eliminating (or scaling back) the deduction is good for the country's finances, but it's going to be hard for that case to be heard when taxpayers are screaming, "You're going to increase my taxes by how much?!?!" at them.

So I'd wager that if the deduction gets touched at all in these debates, it will be by putting some kind of cap on the amount of interest one can deduct. But that cap will be placed high enough—$20,000 of interest, say, or what you'd pay on a $400,000 loan at 5 percent—that very few homeowners would actually feel it. Which would limit the amount of money the government would recover, but also limit the political damage. And we know which one of those considerations is going to be felt more acutely on Capitol Hill.


Any deduction has the same impact, those who pay a higher rate get a bigger benefit. Why not look at the deductability of state and local taxes? Or is that sacred?

Another source of potential resistance to dropping the MID: an immediate drop in the value of every piece of residential real estate in the country. Deduction like this, that have become an economic "fact of life" are very hard to do away with.

If $87 billion is the tax amount lost, then most of this loss accrues to the highest 20% of households, incomes over $100,000. This article should specify what portion of the $87 billion is a benefit to the highest 10% and 20%, and lowest 50%, incomes under $49,000. Presently 28.3% of all income goes to the highest-earning 4.3%, all with incomes over $200,000 according to the Joint Committee on Taxation. That's over $$3 trillion, and their effective overall tax rate is around 30%. See Citizens for Tax Justice report Who Pays Taxes in America, http://www.ctj.org/pdf/taxday2012.pdf

The time to do away with this deduction, if we should, is now. I cannot see how the cost of this deduction is rising with mortgage rates falling for the past 2-3 years, and at record lows. I pay less mortgage interest on my $400k loan than my parents did on their $100k loan when they bought their home in the early 80's. The value of this deduction is becoming less and less. Say a median home is worth $200k, 80% mortgage, $160k loan. 4% rate, 6.4k in interest, saves 25% of that in tax, $1600. Not negligible, but not what it once was. Plus you need to get past the standard deduction to have it matter at all.

Rental properties will still deduct mortgage interest. The highest earners will have their accountants form LLCs to buy the property and then 'rent' it back from themselves, or some other gimmick. They get to keep the interest deduction, and that is why the deduction will be kept for everyone.

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