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Reforming the Mortgage Interest Deduction

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Document date: April 01, 2010
Released online: May 26, 2010


The mortgage interest deduction (MID) is the largest single federal subsidy for owner-occupied housing, but the benefits are not evenly distributed among taxpayers. Only individuals who itemize deductions can benefit from the MID, and the value of the deduction increases with the marginal tax rate. If the government wishes to promote homeownership, a refundable tax credit available to all taxpayers would be more effective. This report presents new distributional estimates both of the current deduction's benefits by income group, family type, and race/ethnicity and of proposals to eliminate, scale back, or replace the MID with more broad-based tax incentives.

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The mortgage interest deduction (MID) is one of the oldest and largest tax expenditures in the federal income tax and is the largest single federal subsidy for owner-occupied housing. The president's fiscal year 2010 budget reports that, in 2012, the MID will cost the federal Treasury an estimated $131 billion, much more than the total of all outlays by the Department of Housing and Urban Development ($48 billion). Homeowners also benefit from other federal tax preferences, including deductibility of residential property taxes on owner-occupied homes ($31 billion), and exclusion of tax on the first $250,000 ($500,000 for joint returns) of capital gains on housing ($50 billion).

The MID was not originally placed in income tax law to subsidize home ownership. When the modern federal income tax was enacted in 1913 shortly after ratification of the 16th Amendment to the U.S. Constitution, all interest payments were made deductible on the grounds that interest payments were an expense of earning business and investment income. Congress made no distinction, however, between interest incurred for the production of taxable income (such as interest on business loans) and interest incurred to generate non-taxable "imputed" returns from homes and consumer durables.1 The deduction had little effect on housing investment before World War II because only the very highest-income individuals paid any income tax.

The conversion of the income tax from a "class" to a "mass" tax during World War II, followed by a large postwar growth in home ownership rates fueled by the increased availability of long-term mortgage finance, converted the mortgage interest deduction from a provision used by only a few taxpayers into a major subsidy for middle- and upper-middle-income homeowners. By the time the Treasury and congressional agencies began publishing annual lists of tax expenditures in the 1970s, the mortgage interest deduction had become one of the largest single preferences in the tax law.

The 1986 Tax Reform Act (TRA 86) eliminated many tax preferences in the federal income tax to finance lower marginal tax rates and higher personal exemptions, but left the deductibility of mortgage interest largely intact.2 TRA 86 eliminated the deductibility of all consumer interest, including credit card debt and loans to finance cars, furniture, and other consumer durable items. But TRA retained the deductibility of mortgage interest on loans up to $1 million. In addition to the deduction on new (and re-financed) mortgage loans, taxpayers may deduct up to $100,000 of interest on home equity loans (i.e., additional housing debt incurred subsequent to the initial home purchase).3

Although the mortgage interest deduction rivals Social Security benefits as a "third rail" provision that elected officials would tamper with at their peril, many analysts have nonetheless raised concerns about it. The Congressional Budget Office usually includes proposals to eliminate or scale back the MID in its list of budget reduction options.4 The MID disproportionately benefits taxpayers in the top fifth of the income distribution (Toder, Harris, and Lim 2009). Those who do not itemize deductions on their tax returns receive no benefit and the subsidy rate is larger for individuals in higher marginal tax rate brackets. Because most who benefit would own homes without the deduction, it mostly provides an incentive to live in more expensive homes, not to own instead of rent. Other countries without an MID have similar homeownership rates. If the government wishes to promote homeownership, a refundable tax credit available to all taxpayers, not just itemizers or those with positive tax liability, would be more effective. Given the large and growing projected federal budget deficits, it is worth reexamining the effectiveness of all federal spending programs, including those embodied in the federal income tax.

The next section briefly reviews issues and findings from previous research. We then present new estimates of the deduction's distributional benefits by income group, family type, and race/ethnicity as well as the distributional effects of proposals to eliminate, scale back, or replace the MID with more broad-based tax incentives.

(End of excerpt. The full report is available in PDF format.)

Topics/Tags: | Cities and Neighborhoods | Economy/Taxes | Housing

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