Should Mortgage Interest be Deductible?

Continuing in the spirit of the tax season, this week saw at least two blogs, Weakonomics and Wallet Pop, asking if allowing taxpayers to deduct mortgage interest is really, after all, a good idea. Both wasted little time before concluding of course not.

In as much as this policy has any sincere defenders, the argument in favor is that it encourages home ownership. But why home ownership, of all things, is a worthwhile goal is generally left unexplored. I suppose a person might imagine some sort of Jeffersonian argument about how a nation of property owners makes for a more stable democracy. Alas, our leaders in Washington are rarely so philosophical.

When a politician says that he favors mortgage deductibility because it encourages home ownership it is a wink and/or nod in the direction of those who already own homes. It is an important bit of government largess for these voters because they get a nice tax break and, possibly more significantly, anybody they sell their house to will also get a nice tax break.

The history of this particular corner of the tax code is worth reviewing. As much as generations of politicians have defended it, it was never consciously enacted as policy. It just sorta happened.

In the late Nineteenth and early Twentieth Centuries American government relied principally on two income sources: property taxes and import duties and excise taxes. The duties and excises made many items more expensive for consumers, and so were a fairly regressive form of taxation. The property tax fell most heavily on big landowners, but missed entirely the newly emerging class of wealthy bankers, merchants, and other businessmen who made money from assets other than real estate.

The income tax was introduced to tax very high incomes so that these businessmen would pay their fair share. (See first 1040 form here.) The presumption was that any income at that level could only be due to the operation of a business of some kind, so it made sense to tax only net income. Thus, taxpayers could deduct from their inflow the assorted expenses they incurred in making money, including interest payments.

Oldsters like me remember that for most of the Twentieth Century all interest paid, credit cards and auto loans included, was deductible. That changed in 1986, when, in one of the few instances of tax reform worthy of the name, most consumer interest became no longer deductible. The main exception being, of course, interest on home mortgages. As much as getting rid of that too would have made sense, it was pretty clear to all involved that it would have been both politically impossible and disastrous for house prices.

And it really would have been a blow to house prices, just as it would be today if the deduction were simply repealed. How much of a blow is open to conjecture, but, according to Wallet Pop, doing away with it would raise about $100 billion a year for the government. You can’t raise that kind of money without meaningfully changing the economics of the thing you are taxing.

The flip side to the fact that pulling the rug out from under home mortgages would be bad for homeowners, and possibly a shock to the economy as a whole, is that the mortgage interest deduction must therefore be distorting the marketplace. I am not the kind that objects to such distortions on principle. But what we have here is a large, and I would argue largely accidental, subsidy for something not obviously in need of subsidy.

And it is not all that clear that this subsidy is as helpful to homeowners as it may at first appear. Yes, it makes mortgages less expensive. But it also increases what homeowners had to pay for the house to begin with.

The core challenge, obviously, is not in reaching consensus that this is bad policy but in finding a way out that is politically and economically feasible. It seems to me that the only course of action is to phase out mortgage deductibility over many years. That may not help reduce the deficit appreciably during the careers of the politicians who vote for it, but it will extract us from the mess we got ourselves into a hundred years ago.

In a small way, we have been phasing out mortgage interest deductions ever since 1986. One of the many new restrictions on interest deductibility introduced with tax reform that year was a $1 million maximum on the size of the deductible mortgage. That limit was not indexed to inflation and in the intervening 24 years has already shrunk by almost half in real terms.

Why not accelerate that process a bit? I propose that starting in 2012, the limit on the size of deductible mortgages be reduced by $50,000 a year, until it’s all gone in 2032. I think this is politically feasible, as the burden will fall on “the rich” first, and although it can only reduce house prices it will do so very gradually, almost imperceptibly, over many years and is unlikely to cause any big dislocations.

Government, Housing | Frank Curmudgeon | April 9, 2010 11:59 am

No Comments

By Adam, April 9, 2010 @ 12:15 pm

Here in Canada, mortgage interest is not deductible, but your primary residence is not considered for capital gains tax when you sell it either.
By Trent McBride, April 9, 2010 @ 12:23 pm

In the US, capital gains on the sale of a primary resident is not taxed either, iI am not mistaken.

Isn’t it also likely that that the mortgage interest deduction, while propping up home prices, also props up mortage rates as well?
By Steve, April 9, 2010 @ 12:35 pm

I still maintain my position that mortgage interest is and should be deductible to keep renting and owning on relatively equal footing. That is, if a landlord can deduct interest as a cost of doing business, and theoretically pass that decrease in costs on to the renter; then it seems like that interest should still be deductible to the same person living in the same home but without the middleman.

Of course, someone living in the home can’t depreciate the property, so it’s not a perfect correlation. Also there’s the whole issue of the standard deduction (which Weakonomics, for one, totally messed up. And there is no such thing as the 30% tax bracket BTW.)

I say this as a renter, though I do plan to buy eventually. At the same time – rents are already lower than mortgage payments in the area I live in, so there’s a lot more at work here.
By Chuck, April 9, 2010 @ 12:44 pm

If you take the position that tax policy should be logical, or that there should be parity between business and individual tax policy, then you haven’t even started down this rabbit hole.
By Steve, April 9, 2010 @ 12:47 pm

Fair enough!
By jim, April 9, 2010 @ 1:59 pm

Owning a home is often considered synonymous with The American Dream. So supporting home ownership is natural political policy. From that perspective it makes sense for home interest to be deductible. Is it best to incentivize home buying and is this the best way to give tax breaks? *shrug* Most of the tax code makes no real logical sense standing on its own. The tax system is a convoluted mess.

That original 1913 tax form is neat. I am amused that they use the term “super tax” in there.
By ctreit, April 9, 2010 @ 3:09 pm

International studies have shown that there is a relationship between homeownership rates and government subsidies. For example, there are no subsidies in Germany and their homeownership rate is in the 40s while it is in the high 60s in the US. At the same time, Germany has also very good and extensive social housing for the rental market. When rents are subsidized renters have little incentive to lay out the money to buy a house. German policies seem to be supporting renting rather than owning while we do the opposite.
By Hibryd, April 9, 2010 @ 3:58 pm

I, for one, support ending the mortgage tax deduction SOLELY on the grounds that it will stop real estate agents from saying “It’s a great tax deduction!” when they push homeownership in general and expensive homes in particular.

Seriously, though, I think backing down the amount that can be deducted while letting inflation eat it up from the other side is a great idea.
By the weakonomist, April 11, 2010 @ 10:42 am

That’s why I love this guy!

I try not to waste time before drawing conclusions in my posts, but I appreciate your expansion on the subject and policy suggestions. You da man Frank.
By kitty, April 11, 2010 @ 3:55 pm

“In the US, capital gains on the sale of a primary resident is not taxed either, iI am not mistaken.”

I believe it’s only up to 250K, but I could be wrong.
By FactScanner, April 17, 2010 @ 9:10 pm

Steve is a bit wrong, the current policy favors homeowners and not renters or even landlords, a landlord cannot deduct interest the same way a homeowner deducts interest, landlords deduct interest as a “business expense” on top of the tax they pay as a rental income, for instance if a landlord is has a tenant paying $10,000 a year and a portion of that goes to interest say $2,000, the landlord is TAXED at the same $10,000 minus $2,000 but still has to pay taxes on any profits, in contrast a homeowner is deducting his or her personal residence while a renter cannot do so. The purpose of deducting business expenses is to avoid double taxation, and to prevent a loss, for instance if a small business has expenses and part of the profit goes towards paying those expenses , the profit before expenses should not be taxed only the net.

Personal expenses are not normally deductible, but the home mortgage interest us, of course businesses sometimes flaunt the rules but IRS crackdowns, and the law itself is not that issue there.

Kitty, it is 250k and 500k for couples, that amount is not indexed for inflation which is both good and bad(if a $2 million dollar home is now worth $3 million over 10 years but at 33% inflation the homeowner would not make any profit but will have a loss since he or she is being taxed not a $0 but at $1 million)
By Steve, October 1, 2010 @ 6:28 pm

It has taken months for me to wrap my head around why I was incorrect. FactScanner has it right. Landlords deduct mortgage interest as a business expense offsetting the business income (rent received) they must pay taxes on. So in fact the mortgage interest deduction is simply a benefit for homeowners.
By sanjeeb, December 2, 2010 @ 8:45 am

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By Puzzled in DC, September 10, 2012 @ 8:16 pm

I am with Steve’s original position. To see the logic of it, imagine that one could buy a house and rent it to oneself. A 100K house with, say, a monthly mortgage of $500 would have a tax offset of, say, 100 dollars, making the net cost 400 dollars. If the interest deduction is eliminated (and housing prices do not adjust), the cost would increase to $500. Suppose that the owner sets up a shell company which owns the house and rents it to himself for 400 dollars, which is the net of expenses cost of the house (no profit to tax). His cost is the same as before. Similarly, if instead he rents an identical house from someone else, he will pay $400 or more, but the difference will be taxed as profit. Nonetheless, the profit is above and beyond expenses, which are taxed. The rental will be cheaper than owner occupation for the same house, unless the housing stock is segmented. So more people will rent with the elimination of the deduction, few people will own those that they live in, and more rental units will be claiming interest as an expense. The revenue savings will not be as high as those who estimate the revenue increase based on current static tax deduction amount would suggest.
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