The Case For (and Against) Killing the Mortgage Interest Deduction

In our Flashcard series, The Atlantic aims to decode the concepts and terms readers encounter every day but seldom see explained. Today's installment: the plan by the chairmen of the deficit commission to change the mortgage interest deduction.

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The News

The chairmen of the president's deficit commission skewered a number of sacred cows in their widely discussed, and widely criticized, report. But few ideas have received more outrage than the plan to limit the mortgage interest deduction -- the costliest tax giveaway in the United States. What is the mortgage interest deduction and why should we want to reduce it?

The Gist

Here's the rule: Every year, most homeowners are still paying interest on their house. But the IRS helps them out by letting them keep an amount equal to their mortgage interest multiplied by their tax rate. This amount is "deducted" or subtracted from their taxable income, reducing their tax bill.

With this benefit in 2012, the federal government will give homeowners more than $130 billion -- more than two and a half times the entire Department of Housing and Urban Development.*

Who benefits? Homeowners benefit because they get a subsidy, and renters don't. Rich folks who choose to itemize their deductions benefit, and lower-income families who take the standard deduction don't. Americans living in high-income, high-home value areas like Maryland and California benefit, while only one in seven North Dakotans take the deduction. High-income earners are in higher tax brackets and can deduct a higher portion of their interest. Most importantly, people who take out bigger loans benefit from having more interest to deduct.

The last point is key, because if the mortgage interest deduction is a poor way to encourage homeownership. Canada has similar homeownership with no subsidy. Instead, it's an effective way to give eventual homeowners more money to take on more debt. It says: Hey taxpayer! If you buy a big house, make a small down-payment, and borrow lots of money, we'll reward that debt with a yearly $10,000 gift, courtesy of the American taxpayer. Does that sound like sound budgeting to you?

MORE ON The Debt Report:

Derek Thompson: How to Fix the Budget FAQ

Center for a Responsible Federal Budget:
A 50/50 Plan to Stabilize the Debt

Derek Thompson: How I Balanced the Budget

The Debate

What should we do? The answer breaks three ways: (1) Do nothing; (2) Kill the deduction; or (3) Make like Goldilocks and find middle ground.

The case for doing nothing is that we will punish current homeowners who bought their homes expecting that the government would help them pay back the mortgage. Millions of homeowners tax bills will go up, and the value of their houses might decline. After all, without government subsidies, there might be less demand for expensive homes.

The case for killing the mortgage interest deduction is cold-hearted economics. The deduction is a regressive transfer of money from renters to buyers, from the low-income who need cash to the upper-middle class that doesn't need welfare. Our nation is approaching a debt crisis and this is an upper-middle class handout with three out of four dollars going to filers with incomes over $100,000.

The case for limiting the deduction is the most sensible. Currently taxpayers can claim the deduction if their mortgage is under $1 million. One easy change would be to lower that ceiling to $500,000 so that we're no longer subsidizing folks with million-dollar mortgages.

A more creative solution would turn the deduction into a credit. In simple terms, that means we let all homeowners keep exactly 20 percent of their yearly interest, no matter what tax bracket they're in. That plan would leave most homeowners better off while raising effective tax rates on the rich. And isn't that the point of the deficit plan in the first place: raising government revenue while protecting the middle and lower class?

*As this great Tax Policy Center paper points out, "Homeowners also benefit from other federal tax preferences, including deductibility of residential property taxes on owner-occupied homes ($31 billion), and exclusion of tax on the first $250,000 ($500,000 for joint returns) of capital gains on housing ($50 billion)."