Convert the Mortgage Interest Deduction to a 15 Percent Tax Credit

CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.

(Billions of dollars) 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2014-2018 2014-2023
Change in Revenues 0.2 0.9 1.4 2.2 3.4 5.5 8.4 9.1 9.9 10.8 8.1 51.7

Source: Staff of the Joint Committee on Taxation.

Note: This option would take effect in January 2014. The estimates include the effects on outlays resulting from changes in refundable tax credits.

The tax code treats investments in owner-occupied housing more favorably than it does other types of investments. For example, landlords can deduct certain expenses—such as mortgage interest, property taxes, depreciation, and maintenance—from their income, but they have to pay taxes on rental income, net of those expenses, and on any capital gain realized when their property is sold. In contrast, homeowners can deduct mortgage interest and property taxes if they itemize deductions, even though they do not pay tax on the net rental value of their home. (Other housing-related expenses, however, cannot be deducted from homeowners’ income.) In addition, in most circumstances, homeowners can exclude from taxation capital gains of up to $250,000 ($500,000 for married couples filing joint tax returns) when they sell their primary residence.

Under current law, the deduction for mortgage interest is restricted in two ways. First, the tax code limits the amount of mortgage debt that can be included in calculating the interest deduction to $1.1 million: $1 million for debt that a homeowner incurs to buy, build, or improve a first or second home; and $100,000 for other debt (such as a home-equity loan) for which the owner uses the personal residence as security, regardless of the purpose of that loan. Second, beginning in 2013, the total value of certain itemized deductions—including the deduction for mortgage interest—is reduced if the taxpayer’s adjusted gross income is above a specified threshold. (Adjusted gross income includes income from all sources not specifically excluded by the tax code, minus certain deductions.)

This option would gradually convert the tax deduction for mortgage interest to a 15 percent nonrefundable tax credit. The option would be phased in over six years, beginning in 2014. From 2014 through 2018, the deduction would still be available, but the maximum amount of the mortgage deduction would be reduced by $100,000 each year—to $1 million in 2014, $900,000 in 2015, and so on, until it reached $600,000 in 2018. In 2019 and later years, the deduction would be replaced by a 15 percent credit, the maximum amount of mortgage debt that could be included in the credit calculation would be $500,000, and the credit could be applied only to interest on debt incurred to buy, build, or improve a first home. (Other types of loans, such as those incurred to buy second homes and those using homes as security, would be excluded.) Because the credit would be nonrefundable, people with no income tax liability before the credit was taken into account would not receive any credit, and people whose precredit income tax liability was less than the full amount of the credit would receive only the portion of the credit that offset the amount of taxes they otherwise would owe. The option would raise $52 billion from 2014 through 2023, according to estimates by the staff of the Joint Committee on Taxation.

Relative to other taxpayers, lower-income people receive the least benefit from the current itemized deduction, for three reasons. First, lower-income people are less likely than higher-income people to have sufficient deductions to make itemizing worthwhile; for taxpayers with only small amounts of deductions that can be itemized, the standard deduction—which is a flat dollar amount—provides a larger tax benefit. Second, the value of itemized deductions is greater for people in higher income tax brackets. And third, the value of the mortgage interest deduction is greater for people who have larger mortgages.

Unlike the current mortgage interest deduction, a credit would be available to taxpayers who do not itemize and would provide the same subsidy rate to all recipients, regardless of income; however, taxpayers with larger mortgages—up to the $500,000 limit specified in this option—would still receive a greater benefit from the credit than would households with smaller mortgages. Altogether, many higher-income people would receive a smaller tax benefit for housing than under current law, and many lower- and middle-income people would receive a larger tax benefit. (The credit could be made available to more households by making it refundable, although doing so would significantly reduce the revenue gain.)

One argument, then, in favor of the option is that it would distribute the mortgage interest tax subsidy more evenly across households with different amounts of income. Another argument in favor of the option is that it would increase the tax incentive for homeownership for lower- and middle-income taxpayers who might otherwise rent. Research indicates that when people own their homes rather than rent, they maintain their properties better and participate more in civic affairs. However, because individuals are unlikely to consider those benefits to the community when deciding whether to buy or rent a personal residence, a subsidy that encourages homeownership can help align individuals’ choices with the community’s interest.

Another argument for such a change is that it probably would improve the overall allocation of resources in the economy. With its higher subsidy rates for taxpayers in higher tax brackets and its high $1.1 million limit on loans, the current mortgage interest deduction encourages people who would buy houses anyway to purchase more expensive dwellings than they otherwise might. That reduces the savings available for productive investment in businesses. Reducing the tax subsidy for owner-occupied housing would moderate that effect. And because investment in owner-occupied housing is boosted by the tax subsidy, and investment in many businesses is held down by taxes on their profits, the before-tax return on the additional business investment that would occur under this option would generally be higher than the forgone return from housing.

One disadvantage of the option is that, by providing a larger tax benefit to lower- and middle-income people than they receive under current law and thereby encouraging more of them to buy houses and to buy more expensive houses than they otherwise would, the option would increase the risk that some people take on. Principal residences tend to be the largest asset that people own and the source of their largest debt. When home prices rise, homeowners’ wealth can rise significantly. However, when prices drop, people can lose their homes and much of their wealth, especially if their incomes fall at the same time and they cannot keep up with their mortgage payments. The experience of the past half-dozen years demonstrates that risk vividly.

Another disadvantage of the option is that it would adversely affect the housing industry and people who currently own their own homes—especially in the short term. Many homeowners have taken out long-term mortgages under the presumption that they would be able to deduct the interest on their loans. Many financial institutions have been willing to lend homebuyers higher amounts than they otherwise might have under the presumption that the mortgage interest deduction would help those buyers repay their loans. Reducing the tax subsidy for housing would make it more difficult for some homeowners to meet their mortgage obligations. Such a change would also reduce the amount new homebuyers would be willing to pay, which would lower the prices of homes, on average. Lower housing prices would create further stress on the finances of existing owners and lead to reduced housing construction. Over time, as the supply of housing declined, housing prices would rise again, but probably not to the levels they would reach under current law. Most of those hardships could be eased by phasing in restrictions on the mortgage interest deduction. Because of the lengthy terms of mortgages, however, and the slowness with which the stock of housing changes, substantial adjustment costs would still occur even with a six-year phase-in period.