Chipping Away at the Mortgage Interest Deduction

By: Stephen Welker

If you like your current mortgage interest deduction, you can keep it.  However, future homebuyers will face increased limitations on the second largest income tax deduction according to the House Ways and Means Committee Chairman Dave Camp’s tax reform proposal. Widely criticized as a large tax break for the wealthy, Rep. Camp’s proposed reform of the Mortgage Interest Deduction (MID) should be embraced as an important step in achieving a more equitable tax code.

The proposal preserves the deduction for mortgages obtained prior to 2015 (as well as any refinancing of them), but introduces an incremental reduction of the original $1 million limit on acquisition indebtedness to $875,000 for mortgages obtained in 2015, $750,000 in 2016, $625,000 in 2017, and finally $500,000 for 2018 and beyond. Further, the reform proposal would eliminate the deduction for home equity indebtedness, consistent with the rules of the Alternative Minimum Tax. While meaningful reform is unlikely given Rep. Camp’s party’s general lack of support for moving forward on any of Camp’s proposals in the near future, the proposal signals a welcomed willingness of members within the Republican Party to chip away at one of the tax code’s “sacred cows”.

The MID had humble beginnings. Indeed, it was not even originally created to incentivize home ownership. It was created at a time when very few US taxpayers paid any income tax, and thus it had a very limited effect on most taxpayers and the housing market in general. However, the post-WWII expansion of the tax base resulted in the increased importance of the deduction, and thus its increased political support. Currently, millions of homeowners enjoy a generous tax deduction for interest paid on their mortgages as well as home equity loans.

There are myriad reasons why economists and policy experts have decried the MID. First, by subsidizing the cost of an individual taxpayer’s mortgage, the tax code encourages people to buy larger, more expensive homes than they could otherwise afford or even need. Second, like most deductions in the tax code, the MID only benefits people who itemize deductions in the first place (skewing towards the wealthier), and within those who itemize, the value of the deduction increases both as household income rises and as the home value rises. Third, the deduction unfairly differentiates between taxpayers who choose to purchase and those who choose to rent; renters of similar means and with similarly valued properties cannot take advantage of the deduction. Fourth, studies have shown that the deduction gets capitalized into the overall cost of homes, working directly against its stated purpose of increasing home ownership by pricing potential homebuyers out of the market. Additionally, the price tag on the deduction is immense as it costs the U.S. government approximately $70 billion per year.

The MID is justified primarily as incentivizing homeownership, long considered an essential piece of the American Dream. But studies of the incentives revealed little evidence that homeownership is affected by the deduction. This makes sense because the benefits are reaped substantially by wealthier prospective buyers, less concerned with whether or not to buy a house and more concerned with how expensive or large their ultimate house purchase is. Indeed, the Congressional Budget Office (CBO) noted that the rate of homeownership in the United States is similar to Australia, Canada, and the United Kingdom, all countries that do not offer a MID.

The primary strength of Rep. Camp’s plan is its incremental limit reduction, which should ease concerns that immediately eliminating the deduction would damage a recovering housing market. While studies conflict as to the amount home values would drop as a result of the complete elimination of the MID, an incremental reduction in the limit would blunt the shock to housing prices. Further, by spreading the limit reduction over a few years, homeowners and prospective homebuyers would have ample time to plan for the commensurate impact on prices.

Ardent tax reformers might, for the reasons above, dismiss Representative Camp’s proposal as woefully insufficient, favoring a complete elimination of the deduction. However, given the substantial efforts of those opposing any reduction in the deduction, we must take what we can get. The incremental nature of American politics ensures that good ideas need repeating, and reform efforts are best accomplished slowly, lest they never get off the ground. The embrace of reducing the home Mortgage Interest Deduction (MID) by a leading member of the GOP, coupled with earlier interest by President Barak Obama and the Simpson‑Bowles commission, is encouraging news for proponents of meaningful income tax reform.  Rep. Camp should be thanked for his efforts and, indeed, his courage in supporting these tax reform efforts.

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