Convert the Mortgage Interest Deduction to a 15 Percent Tax Credit

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 who file joint tax returns) when they sell their primary residence.

Under current law, the deduction for mortgage interest is restricted in two ways. First, the amount of mortgage debt that can be included when calculating the interest deduction is limited 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 debt for which the borrower's personal residence serves as security (such as a home-equity loan), regardless of the purpose of that loan. Second, the total value of certain itemized deductions—including the deduction for mortgage interest—is reduced if the taxpayer's adjusted gross income is above specified thresholds. (Adjusted gross income includes income from all sources not specifically excluded by the tax code, minus certain deductions.) Those thresholds are adjusted, or indexed, every year to include the effects of inflation. For 2016, the thresholds were set at $259,400 for taxpayers filing as single and $311,300 for married couples who file jointly.

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 2017. From 2017 through 2021, 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 2017, $900,000 in 2018, and so on, until it reached $600,000 in 2021. In 2022 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 home-equity lines of credit and mortgages for second homes, 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 $105 billion in revenues from 2017 through 2026, according to estimates by the staff of the Joint Committee on Taxation.

One argument in favor of the option is that it would make the tax system more progressive by distributing the mortgage interest subsidy more evenly across households with different amounts of income. 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.)

Another argument in favor of the option is that it would increase the tax incentive for home ownership for lower- and middle-income taxpayers who might otherwise rent. Research indicates that when people own rather than rent their homes, they maintain their properties better and participate more in civic affairs. However, because people are unlikely to consider those benefits to the community when deciding whether to buy or rent a personal residence, a subsidy that encourages home ownership can help align their choices with the community's interest. Increased home ownership can also put people in a better position for retirement because they can tap into their home equity for any unexpected expenses. In addition, expenses associated with home ownership remain relatively stable, which matches well with retirees' typically fixed income.

A further rationale 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 higher-income taxpayers 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 probably redirect some capital, which would moderate that effect. In principle, this option could induce low- and middle-income taxpayers to spend more on housing, which could create an offsetting reduction in business investment.

However, on net, the option probably would increase investment in businesses for two reasons. First, the total mortgage interest subsidy would be lower under the option, which would most likely result in lower aggregate spending on housing. Second, a larger fraction of increases in spending on housing by low- and middle-income taxpayers would probably be financed by a reduction in other expenditures rather than by a reduction in business investment. Because investment in owner-occupied housing is boosted by the current 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, indicating a better allocation of resources.

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 assume. Principal residences tend to be the largest asset that people own and the source of their largest debt. When housing prices rise, homeowners' wealth can rise significantly. However, when prices drop, people can lose their homes and much of their wealth, especially if their income falls at the same time and they cannot keep up with their mortgage payments. The collapse of the housing market during the late 2000s demonstrated 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 assumption 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 assumption 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 that 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 new construction. Over time, as the supply of housing declined, 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.