Question

Recently, Congress has passed legislation lowering the mortgage interest deduction limit from $1,000,000 to $750,000.

A. What is the mortgage interest deduction? Which types of mortgage borrowers benefit most from it, and why?

B. The mortgage interest deduction is often criticized by economists and others. What are some of the key problems or issues which are highlighted by these critics? Can you think of any counterarguments?

C. Thinking about the user cost model we studied in class, what effect would cutting or eliminating the mortgage interest deduction have on the cap rate for residential real estate. Would this effect be larger when interest rates are low or when rates are high? Explain.

Answer 1

A. What is the mortgage interest deduction? Which types of mortgage borrowers benefit most from it, and why?

The mortgage interest tax deduction was introduced in 1913. It has survived numerous tax reforms because of the incentive the tax provides for renters to buy homes.

The federal tax system offers a number of ways to promote homeownership, including the mortgage interest deduction, perhaps the most prominent among them. Here’s how it works and who benefits.

First off, only taxpayers who itemize their deductions can take it, so long as they tally more than the standard deduction, currently US$12,600 for a married couple. If you’ve met that threshold, then your benefit from the interest deduction will depend on how much greater it is than the standard deduction and what your marginal tax rate is. A higher rate will lead to greater tax savings.

For example, let’s imagine three couples filing jointly in 2019. Couple A has a modest income of $50,000 and pays $7,300 a year in interest but has only $4,000 in other expenses that can be itemized. This couple would have chosen the standard deduction and received no benefit from the mortgage interest it paid.

Couple B has the same mortgage but earns a lot more with a taxable income of $80,000. As a result, the couple paid $7,300 in state and local taxes the previous year, which can be itemized on its federal tax return. That gives the couple $14,600 in itemized deductions or $2,000 more than the standard. At a marginal tax rate of 25 percent, that means the couple would get a tax benefit from the mortgage interest deduction of $500.

Lastly, consider Couple C, with the same mortgage but a taxable income of $200,000, which puts it in the 28 percent tax bracket. The higher earnings mean it paid $12,600 in state and local taxes the previous year, which gives the couple $19,900 in itemized deductions. Since that’s $7,300 more than the standard deduction, it would be able to take advantage of all the interest it paid, reducing its tax liability by $2,044 (28 percent x $7,300).

B. The mortgage interest deduction is often criticized by economists and others. What are some of the key problems or issues which are highlighted by these critics? Can you think of any counterarguments?

Abundant evidence shows that the tax benefits from this deduction, which cost $70 billion in 2013, are highly skewed to high-income homeowners. Just under three-quarters of that went to the wealthiest 20 percent of earners, while the poorest 20 percent got nothing.

So how would the latest versions of the plans working their way through Congress change this?

Under current law, 44 percent of homes are valuable enough to make itemizing and taking the deduction worthwhile, according to Zillow, which operates several real estate listing portals including Trulia and StreetEasy. This would fall to 12 percent under the House plan and to 7 percent under the Senate proposal.

Both plans would double the standard deduction, thereby increasing the threshold before the interest deduction becomes useful, while eliminating the ability to deduct state and local income or sales taxes, thus making it harder to reach that much higher bar.

There are two key differences between the plans: The House bill would lower the cap on which mortgages are eligible from $1 million to $500,000, while the Senate plan would eliminate the deduction of state and local property taxes.

Under either plan, however, the mortgage interest deduction would become essentially worthless to middle-income taxpayers.

C. Thinking about the user cost model we studied in class, what effect would cutting or eliminating the mortgage interest deduction have on the cap rate for residential real estate. Would this effect be larger when interest rates are low or when rates are high? Explain.

Instead, the deduction encourages construction of larger, more expensive houses. This leads to higher energy costs and urban sprawl and reduces investment funds available for business. The resulting higher home prices may actually raise costs for first-time purchasers, most of whom don’t itemize or are in the 12% tax bracket and thus gain little or no direct benefit from the deduction anyway. By encouraging people to finance homes with high levels of debt, the deduction increased the likelihood of default when housing prices fell in the financial crisis.

Notably, despite the steep decline in eligibility for the deduction over the past year, housing markets seem to be doing fine, especially in high-cost, high-tax states that might have been thought to be most affected.

The deduction has always been regressive, and the 2017 tax changes made it more so. In 2018 almost 17% of the benefits will go to the top 1% of households, and 80% of the benefits will go to households in the top 20% of the income distribution. Only 4% will accrue to households in the middle income quintile.

The deduction has always been regressive, and the 2017 tax changes made it more so.

While the economics of the deduction have always been suspect, the 2017 tax law changed the politics of the subsidy, too. By cutting the use of the deduction and further concentrating the benefits onto high-income households, the tax overhaul makes clear that current mortgage subsidies aren’t meant to help the middle-class or new homeowners.

The next step should be to eliminate the deduction altogether. The phase out should be gradual but complete. One approach would be to reduce the maximum principal against which interest can be deducted by $75,000 a year—10% of the current limit—for the next 10 years.

The mortgage-interest deduction has been expensive, reducing federal revenues by about $60 billion a year before the tax overhaul. That figure is now down to around $30 billion.

Axing the deduction would provide more than enough resources to give each first-time home buyer a one-time refundable tax credit of $10,000. That would be more progressive and less expensive than current policy and, most important, would actually help some middle-class families become homeowners.