Home Mortgage Interest Deduction History

Home mortgage interest is interest a homeowner pays on a loan secured by their home (a main home or a second home). The loan can be a mortgage to buy your home, a second mortgage, a line of credit, or a home equity loan.

The home mortgage interest deduction is a very old tax deduction in the income tax law. Shortly after the 16th Amendment was ratified in 1913, the modern federal income tax was enacted. At that time all interest payments were made deductible.

In 1986, the Tax Reform Act eliminated many tax deductions in the federal income tax, but it left the home mortgage interest deduction largely intact. It eliminated the deductibility of all consumer interest, including deductions for credit card debt and loans to finance cars, furniture, and other consumer durable items, but it retained a one million dollar limit on home mortgage interest deductions.

Again in the 1990s, there were proposals to replace the income tax system with a system based on taxing consumption, and these plans proposed eliminating the home mortgage interest deduction.  These plans died out, however, over arguments about how the removal of the tax deduction on mortgage interest would affect the housing market.

Now, with the federal government strapped for cash and congressmen and women looking for ways to reduce the federal deficit, proposals are again being put forward to reduce the one million dollar limit or to completely remove the tax deduction on home mortgage interest. According to the Tax Policy Center:

“In 2012, the MID [mortgage interest deduction] will cost the federal Treasury an estimated $131 billion, much more than the total of all outlays by the Department of Housing and Urban Development ($48 billion). 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).”

Many economists believe that the United States encourages people to borrow money by offering the tax deduction of home mortgage interest. The home mortgage interest deduction helps promote home ownership, but many economists feel that a system that encourages people to take on more debt and discourages saving is not a good thing.

How Would the Removal of the Tax Deduction on Mortgage Interest Affect the Housing Market?

In a rapidly growing economy, asset prices, such as the value of a home, increase. This makes the expected return from owning a home higher than if the economy is not growing as we’ve seen in recent years where housing prices have decreased dramatically.

The tax deduction on home mortgage interest makes the cost of owning a home lower. The removal of the tax deduction on mortgage interest would affect the housing market by causing the demand for homes to decrease and therefore housing prices to fall even more.

For example, most people base the decision to buy a house primarily on the monthly cost of owning versus renting. You calculate the rental equivalence that combines after-tax mortgage payments, property taxes, insurance, maintenance, and the cost of your down payment. Ginnie Mae offers a Buying vs. Renting Calculator just for this purpose. For a given mortgage interest rate, removal of the tax deduction on mortgage interest increases the after-tax cost, leading to a higher monthly payment and, therefore, a decline in demand for owner-occupied housing. This reduction in demand ultimately reduces housing prices, but it is interesting to note that some countries not offering a mortgage interest deduction, like England for example, have a similar number homeowners as the U.S. Housing prices, however, tend to be lower. An interesting question to consider is whether or not borrowers would have bought homes during the recent housing bubble if there had been no home mortgage interest deduction.

Mortgage Interest Deductions and Non-itemizers

The effect that removing the tax deduction for home mortgage interest has on housing prices differs across income levels. Most of the benefits of the home mortgage interest deduction are accrued to higher-income households. This is mainly because lower-income households do not tend to itemize their tax returns, so mortgage interest deduction does not benefit non-itemizers to the same degree as wealthy homeowners.

Recent Proposals to Change the Mortgage Interest Deduction

In November 2010, the co-chairs of the National Commission of Fiscal Responsibility and Reform issued a draft report containing a suggestion to reform the home mortgage interest tax deduction. The debt reduction draft report contains a modest change in the mortgage interest tax deduction. The proposal scales back mortgage interest deductions to eliminate interest on home equity loans and second homes, and it reduces the one million dollar limit on home mortgage interest deductions to $500,000.

In response to the above debt reduction draft report, House Resolution 25 was created on Jan. 6, 2011 by California Republican Representative Gary Miller, seeking to extend the mortgage interest deduction. The extension was drafted with American homeowners in mind.  Approximately 67 percent of Americans are homeowners. The home mortgage interest deduction is one of their biggest deductions and saves taxpayers thousands of dollars every year.  In addition to the tax saving, many feel that now is not the time to remove the tax deduction on mortgage interest because of how it would affect the already fragile housing market.