It is the mother of all deductions.
An analysis of IRS data by Reason.com found that out of the $1.26 trillion in income that was excluded from 2008 tax base, the largest deduction — accounting for some 36 percent of all deductions — was the mortgage interest deduction.
The Congressional Joint Committee on Taxation said the deduction cost about $90 billion in 2010.
Is it any wonder that such a large potential source of revenue regularly draws attention?
Over the years, the mortgage interest deduction has been targeted for reduction and elimination. Most recently President Barack Obama's (Simpson-Bowles) deficit reduction commission were considering taking it out in attempts to balance the budget.
Change, however, has the deck stacked against it. The deduction is certainly popular — with about half of mortgage holders taking advantage of it and, no doubt, wanting to hold onto it. Today mortgage interest deduction's main justification is it is a great incentive for creating more homeowners — making it more affordable to buy a home. Its critics are saying that it is an ineffective policy and other incentives would help people better to get into homes. Both sides worry, however, that any changes in today's fragile housing market could have negative consequences.
BEGINNINGS AND REASONS
Richard K. Green, director of the Lusk Center for Real Estate at the University of Southern California, said the mortgage interest deduction wasn't created to encourage home ownership. But as time went on, helping people afford homes became the battle cry to keep it.
The original 1913 income tax code allowed people to deduct all interest from their income when figuring out their income tax. All the way until the Reagan era, credit card interest, car loan interest, student loan interest and more were all tax deductable — with some limitations. "There was a worry that this was encouraging people to take on too much debt," Green said, "which is sort of funny if you look at how much debt people had then compared to today."
Initially the proposals in the mid 1980s would have eliminated all interest deductibility. But in a speech in 1984 to the National Association of Realtors, President Ronald Reagan carved out an exception. "I strongly agreed with the home mortgage interest deduction, which is so vital to millions of hard-working Americans. And in case there's still any doubt, I want you to know we will preserve that part of the American dream," he said. "Well, that is the thing, that deduction, that symbolizes, I think, that American dream."
The Tax Reform Act of 1986, in the end kept the deduction — but the elimination of other deductions allowed the top marginal tax rate to drop from 50 percent to 28 percent. It did, however, limit the deduction to mortgage debt from a principal residence and a second home. It was capped at $1 million and not much has changed since then (except $1 million can't buy what it used to).
The Realtors were relatively happy then and still fight today to keep the mortgage interest deduction from falling to any new tax proposals. "NAR firmly believes that the mortgage interest deduction is vital to the stability of the American housing market and economy," NAR president Ron Phipps, said in a statement. "NAR will remain vigilant in opposing any plan that modifies or excludes the deductibility of mortgage interest."
"I don't blame them for taking this position," Green said. "If I'm representing their members, it is the policy that is in the best interest of their members."
But is the deduction in the best interest of all Americans — and does it really encourage home ownership?
INCENTIVES FOR HOME OWNERSHIP
Unlike Green, Robert Dietz, an economist and assistant vice president for the National Association of Home Builders, thinks the deduction does encourage home ownership. He testified last month along with Green and other experts before the U.S. Senate Committee on Finance (Senator Orin Hatch, R-Utah, is the ranking member). Dietz said a NAHB survey found 71 percent of voters oppose eliminating the deduction. "Since most homeowners benefit from the mortgage interest deduction, and most of that benefit flows to younger, middle class families, making homeownership less accessible is likely to diminish the financial success of future generations," Dietz told Congress. "Without the mortgage interest deduction, NAHB believes that disparity in economic income would increase, and the middle class would continue to shrink."
Green, however, said for those trying to decide whether to buy a home or not, the deduction has little or no impact. "We spend an awful lot of money on it to get very little amount of bang from the standpoint of home ownership, which is what its proponents are advertising," Green said.
Green said that for a lot of people, even if they have a home, they are going to take the standard deduction on their income tax because it will be more than the deduction they would get through itemizing and including the mortgage interest tax deduction. He said only about 30 percent of taxpayers use the mortgage interest deduction, which is almost half of homeowners.
But what about the people who are on the edge of deciding to buy a home?
He said the people who earn about $40,000 to $50,000 a year are not likely to pay any income taxes anyway — leaving the value of a tax deduction at nil. "If you think of the people who are at the cusp of buying a home, … they don't pay taxes," Green said.
BIGGER HOMES AND MORTGAGES
So what does it do?
Green said it helps wealthier people to buy bigger homes. And instead of encouraging people to buy bigger homes, as the deduction does, it would be better for the overall economy if they diversified and bought other investments. "If you invest in the stock market, for example, that's money that is available to help build a warehouse or build a factory," Green said.
Data from the NAR shows that in places where smaller numbers of people own their homes free and clear, a much greater percentage of people will use the deduction. In the District of Columbia, where 22.4 percent own their homes outright, 75 percent of homeowners use the deduction. In Utah, 62 percent of homeowners use the deduction. On the other end of the scale is West Virginia where 47.6 percent of homeowners are free and clear and only 21.6 percent use the deduction.
Green points to other countries that do not have a mortgage interest deduction at all — such as Canada, the United Kingdom or Australia. In Australia, he said, they get mortgages about the same size as Americans do. "But they pay off their mortgages faster than we do," he said. "The difference is quite striking. There is no benefit to having a mortgage, but there is a benefit to owning a home with equity."
Phipps with the NAR, however, doesn't see things this way — and thinks doing something in this housing market would be a disaster. "Recent progress has been made in bringing stability to the housing market, it is not recovering at the rate it should be and is far too fragile to sustain any tax increases," Phipps said. "Congress must do no harm and preserve the mortgage interest deduction so that the nation's 75 million home owners continue to receive this important tax benefit, which primarily helps middle- and lower income families."
Dietz's testimony to the Senate Committee on Finance also claimed broader benefits to the deduction. He said it particularly helped younger buyers in high-cost areas and it was primarily a "middle-class tax break."
Green also agrees to do anything in the current housing market would be a bad idea. Implementing any changes now would reduce prices even further, putting more mortgages underwater and leading to more foreclosures. "Until the market stabilizes, I wouldn't do this. I'm a practical person," Green said.
A good sign of when the market is stable is when house prices are rising at the same rate as inflation or more. "That means we have finally gotten rid of our oversupply of housing," he said.
Then changes should be slowly phased in, he said, perhaps over a decade.
In place of the mortgage interest deduction as an incentive for home ownership, Green would recommend using a credit. He also would like to see that credit begin to be phased out for people with around $100 thousand a year incomes. "With that much income they are going to be homeowners anyway," he said.
Dietz, however, said credits are "just a means of reducing the benefits going to homeowners."
"If you give people a credit it would be there even if they took the standard deduction on their income tax. That would encourage people on the margins to become homeowners," Green said. "If that is really what you want to do."
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Dietz told the Senate committee there were many reasons why homeownership should be encouraged: "These include increased wealth accumulation, improved labor market outcomes, better mental and physical health, increased financial and physical health for seniors, reduced rates of divorce, and improved school performance and development of children. These beneficial financial and social outcomes are due to the stability offered by homeownership, as well as the incentives created by the process and responsibilities of becoming and remaining a homeowner."
Green, however, isn't sure about encouraging homeownership. "If you had asked me five years ago I would have said absolutely," Green said. "What has happened in the last three or four years has rocked my world. So my answer right now is I don't know. I'm not going to say absolutely not either, but I really don't know."