On The Much Loved, Little Used, Mortgage Deduction

by Ann C. Logue on January 13, 2011

photo by Sean Dreilinger/Flickr, used under a Creative Commons license

One of the most treasured myths about prosperity in the United States may have finally been killed off: the myth that homeownership is a guaranteed route to wealth for the middle class. To many people, a house magically combined tax savings, investment returns, a place to live, and the memories of magical Christmases; the logic, therefore, was that it made sense to borrow as much as possible to maximize tax savings, investment returns, living space, and family memories.

By now, it should be clear that while it’s awfully nice to be able to paint the walls any color you want, homeownership has been a path to ruin for some people. They can’t afford their houses, and they can’t afford to move to places offering better economic opportunities.

In the United States, homeowners can deduct mortgage interest on up to $1.1 million in borrowing from their income when calculating taxes.  But although 66.9% of Americans are homeowners, fewer than a third of taxpayers receive the mortgage interest deduction.

Too many people have interpreted the mortgage interest deduction as the government paying the mortgage. They believe it is a tax break given to homeowners when, in fact, homeowners have to pay a lot of interest before they can get it. And a married couple would have to pay $11,400 in interest and other deductible expenses before being able to itemize them on their income tax return. In 2008, the IRS reports that there were 48.2 million individual tax returns with itemized deductions. This works out to just 33.8% of the total number of returns filed. And of those returns with itemized deductions, 38.7 million took a mortgage interest deduction. The total amount deducted was $470 billion, or an average about of $12,000 per filing.

In other words, 27% of taxpayers receive a mortgage deduction. And how much is that deduction worth? Not $12,000. A tax deduction reduces the amount of income being taxed, not the amount of tax paid. So, someone in the 25% tax bracket with $12,000 in mortgage interest would receive savings of $3000. Those savings would shrink over time; because most mortgage payments include both principal and income, the amount of interest owed goes down each year. That, in turn, reduces the value of the tax deduction.

The Congressional Budget Office estimates that the mortgage deduction will cost us 9.3% of government revenues between 2009 and 2013, or a total of $573 billion. Using that ratio, then mortgage deduction would have cost $96 billion in 2008, for an average tax savings of about $2481, hardly the equivalent of the government paying anyone’s mortgage.

Part of the American myth of homeownership is that owning a house is so wonderful in every way that the government wants to encourage homeownership through the mortgage deduction. Besides the unfortunate housing bust that followed George W. Bush’s dream of an “ownership society,” the mortgage deduction was never part of a set housing policy. It’s an artifact of earlier tax regulations that allowed people to deduct all interest paid.

And the mortgage deduction isn’t responsible for homeownership, anyway. In 2006, 68.4% of Canadians owned their own house, according to Statistics Canada, with 24.9% of Canadian households spending 30% or more of their income on shelter – and most of those were homeowners, not renters. The Canadians managed to do this without a home mortgage deduction.

For the same year in the United States, with a mortgage interest deduction, the Census Bureau reported that homeownership at the end of 2006 was 68.9%. (It’s down to 66.9% at the end of the third quarter 2010.) $96 billion seems like a lot of money to pay to encourage an additional half a percent of the population to buy a house.

Because they can’t deduct mortgage interest, Canadians seem to approach financial planning a bit differently. They pay off their mortgages, so they have less financial risk. And, in fact, Canada stood out in the world financial crisis by not having much of a crisis.

The tax deduction also creates a distortion in the market. It makes the cost of borrowing money cheaper for those who will borrow enough to be able to take the deduction. Because the sellers know this, they are able to charge more. Eliminating the deduction will cause some house prices to fall – but not all. The houses that will be affected are those expensive enough that buyers are likely to be using a lot of debt. It’s not going to affect prices in those markets that are already cheap.

And, of course, the lower prices will represent a big benefit to the buyers, whether they are first-time buyers or people changing residences. The drop in prices will be a transfer of wealth; it won’t eliminate it.

In fact, the tax deduction itself represents a transfer of wealth; it is a transfer from future taxpayers to those 27% of current taxpayers who have enough debt to take the deduction.  As much as I like saving money on taxes, that doesn’t seem right.

Plus renting isn’t that bad. Right now, I wish I could call a landlord about the leaking icemaker in our freezer, because I don’t want to deal with it myself.

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