Mortgage Interest Deduction in Jeopardy


The  mortgage interest deduction, which has long been an untouchable pillar of the tax code for homeowners, is on the chopping block in President Obama’s 2010 budget proposal. mortgage interest calcuationThe President wants to reform our healthcare system here in America and is proposing the mortgage interest deduction be capped at 28%. This would affect homeowners making $208,850 over the 2009 married filing jointly tax bracket income calculations.  The mortgage interest deduction has been in place since we had an income tax code. All interest used to be deductible but over the years, congress has whittled down interest deductions for non-businesses to only the mortgage interest deduction. That was done with the Tax Reform Act of 1986.  Several groups are up in arms about this proposal as the mortgage deduction is seen as a help for lower income folks to buy a home. Many economists however disagree that the home mortgage interest is all it is cracked up to be. In a recent blog post in the New York Times Economix Blog,  Harvard University Economics Professor Edward Glazer makes some salient points about the flaws of the mortgage deduction. He outlines 5 problems with the “conventional wisdom” of the deduction as a savior of the working class hero:

Problem #1: Subsidizing interest payments encourages people to leverage themselves to the hilt to bet on housing markets. The size of the tax benefit is proportional to your debt. The deduction essentially encourages us to make leveraged bets on the swings of the housing market. That leverage means that housing price swings can easily wipe people out. We are currently experiencing the consequences of subsidizing gambles on housing.

Problem #2: The deduction pushes up prices in places where the supply of new homes is constrained, as it is in many coastal markets. Economics 101 teaches us that if we subsidize demand where supply is inelastic then the only effect is to make prices go up. Housing supply is pretty constrained in places like New York City because of land-use restrictions and lack of land. In these places, the deduction doesn’t make housing more affordable. It just transfers money from buyers to sellers, and that makes little sense.

Problem #3: The deduction is wildly regressive. The tax savings for households earning more than $250,000 is 10 times the tax savings for households earning between $40,000 and $75,000 a year, according to recent research by James Poterba and Todd Sinai.

If there ever was a case for small-government egalitarianism, then this is it. Eliminating the home mortgage deduction and replacing it with an across-the-board tax cut would equalize after-tax incomes without a single new government program.

Problem #4: The deduction encourages people to buy larger, single-family detached homes, and that increases carbon emissions and pushes people out of cities. The deduction encourages people to buy more expensive homes, which are generally bigger homes.

Bigger homes use more energy. The deduction is therefore implicitly urging Americans to run higher electricity bills and spend more on home heating. If global warming is a serious problem, then the government should be encouraging us to live in smaller, not bigger, dwellings.

Problem #5: The home mortgage interest deduction is poorly designed to encourage homeownership, which is, after all, the alleged desideratum. Much of the interest deduction’s benefits go to richer Americans who are likely to own homes in any case.

Poorer people who are on the margin of buying and renting often don’t even itemize. My own research in this area found that when the value of the interest deduction rose, during periods of high inflation, there was no observable increase in the homeownership rate.

If the goal of the deduction is just to increase homeownership, then it would make far more sense just to give a flat tax credit to people who buy homes. If the credit was independent of home value, then this would eliminate the incentive to buy bigger homes. If the credit was independent of borrowing, then this would decrease the incentive to over-borrow.

I would like to hear from the BiggerPockets community about their feelings on the mortgage deduction.What do you think?  Is it truly something we can’t live without?

(Image Courtesy of: Arizona Mortgage News)

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  1. Alex Aguirre on

    While there are some great valid points. We have to remember one thing. Income levels. Income levels have not increased significantly to keep up even with the Depressed( previously over inflated)home prices.

    Simple economics – Lower demand + over supply= Lower house prices.

    In essence, by removing the ability to leverage a home purchase, and removing the incentive of a tax deduction base on the size of the purchase creates the opposite affect.

    There is a way to maximize the “FLAT” Credit that will offered. For Example: A 10,00 tax credit for a 100,000 purchase(10%) is much better than a 10,000 tax credit(5%) for 200,000 home. Why would anyone NOT want to maximize their tax credit? This could potentially stagnate an place a CAP on home prices. Is this what we need?

    The real population that will be affected will be the upper middle class. They make enough money to be penalized for making more money. The wealthy know how to conduct their purchases as a business, write off the business expense, and show very little income, and thereby very little taxes.

    Last point, if we are going to limit the tax deduction for homeowners to a flat tax credit, does it not also seem fair and equitable that we LIMIT property taxes to a flat rate rather than based on their value? There has to be a give an take.

    just my two cents – love the post, just wanted to give another vantage point

  2. I find some very fundamental flaws in Edward’s logic and his “5 Problems”. First and foremost, being involved in the real estate industry in many different positions for over a decade, I have yet to run across a buyer that makes the statement, “lets get a bigger house and bigger mortgage payment so that we can have a bigger tax deduction.” My experience has shown me that the consumer is more concerned with finding a property that meets their needs (beds, baths, etc.) as well as it being located in the desired geographic area. While the interest tax deduction is used a an incentive for first time homebuyers or a benefit of homeownership, my experience has shown that it barely, if at all, is part of the decision making process on how much to spend or how leveraged to be on a home purchase.
    Secondly, as outlined in Problem #3, Edward’s argument is wildly misleading. While his statement that the tax savings for incomes above the $250,000 is 10 times greater than that of the earners between $40,000 – $75,000 may be accurate he neglects to mention that the interest payments made by these same high income earners will mirror that multiplier. Also keep in mind that according to IRS data the top 25% of income earners in the US pay nearly 83% of all the income tax. This figure INCLUDES the interest deduction. A flat tax credit would only make this percentage grow.
    The removal of the tax deduction for interest on a mortgage is a poor idea and will hurt the real estate industry even further. Especially if it is restricted to income earners identified in the proposal. Pride of ownership will stimulate consumer spending especially in a newly purchased home. Rarely is the case when a home is purchased and it includes everything the new owners want. Think rugs, blinds, appliances, landscaping, etc. The larger and more expensive the house the higher the price tag on these items and the more spending that will be required.
    As it has been said many times, “The housing industry lead us into this recession and it will be up to them to lead us out.” If that is the case why would we want to place additional obstacles in the way of making that happen?

  3. His plans are really beginning to scare me, it is obvious to me he is not well versed in economic theory. Eliminating this tax deduction would only serve to fuel a further down-turn in the housing market. I would be interested to hear how his plan is based on sound economic theory and facts. Please tell me how Obama believes this plan will work.

  4. This is the worst idea that I have ever heard out of the Washington think tank. Only a genius from the government could come up with such a gem.
    Thank goodness for the new administration. The negative feedback loop was running out of bad news.

  5. Voodoo economics makes a return, this time on the other end of the spectrum. Removing the deduction makes no sense – just increases gov’t revenues and will lead to even more failed loans!!

    As a lender, few folks look at the deduction as making a larger home or loan more affordable, because such is not seen as real money.

    We got where we are due to the removal of the Glass-Steagall Act of 1933 as a barrier between depository institutions and investment institutions, which occurred in 1999 – see Citigroup/Travelers merger.

    After that we got all the “sophisticated” investment instruments which led us to the abyss on the edge of which we now teeter.

  6. The mortgage interest deduction is a subsidy to the lenders rather than an effective incentive for home ownership. It provides an incentive for home owners to avoid paying off their mortgage ahead of time. A one time credit or deduction for buying a home based on a percentage of the price would make more sense because it provides the proper incentive… I think you people need to see past your own self interest here… Sarah – have you ever picked up a book on economic theory? hmmm….

  7. I think the professor has earned his title. His 5 problems list sums up the situation concisely. My vote is for the “flat tax credit” if we are going to have a tax based incentive for potential buyers. I do also like Alex’s point about the other side of that coin, if we have a flat tax incentive to purchase, wouldn’t it make sense to have a flat property tax? Great views…

  8. Some individuals invest a large number of dollars on mortgage interest each and every year it is really a excellent tax advantage; that’s why numerous individuals say it’s much more advantageous to personal a house as opposed to renting. Thanks for the post.

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