The Much Loved, Little Used Mortgage Deduction

The Much Loved, Little Used Mortgage Deduction
April 25, 2011

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 although 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 may deduct from their income taxes mortgage interest on up to $1.1 million in borrowing. Although 66.9 percent of Americans are homeowners, fewer than one-third of taxpayers receive the mortgage interest deduction.

$11,400 Needed
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. A married couple has 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, there were 48.2 million individual tax returns with itemized deductions. This works out to just 33.8 percent of the total number of returns filed. Of all returns with itemized deductions, 38.7 million took a mortgage interest deduction. The total amount deducted was $470 billion, an average about of $12,000 per filing.

Shrinking Value
In other words, 27 percent 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 percent tax bracket with $12,000 in mortgage interest would receive savings of $3,000. And those savings shrink over time because most mortgage payments include both principal and income, and the amount of interest owed goes down each year. That, in turn, reduces the value of the tax deduction.

The Congressional Budget Office estimates the mortgage deduction will reduce government revenues 9.3 percent between 2009 and 2013, or a total of $573 billion. Using that ratio, the 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. 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 on loans.

None in Canada
In any case, the mortgage interest deduction isn't responsible for rising homeownership. In 2006, 68.4 percent of Canadians owned their own house, according to Statistics Canada, with 24.9 percent of Canadian households spending 30 percent 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 interest deduction.

For the same year in the United States, with a mortgage interest deduction, the Census Bureau reported homeownership at the end of 2006 was 68.9 percent. (It's down to 66.9 percent at the end of the third quarter 2010.) Ninety-six billion dollars 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 from Americans. They pay off their mortgages so they have less financial risk. In fact, Canada stood out in the world financial crisis by not having much of a crisis.

Deduction Distortions
The tax deduction creates another distortion in the market by making 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 would cause some house prices to fall—but not all. The houses that would be affected are those expensive enough that buyers are likely use a lot of debt. It wouldn’t affect prices in markets that are already relatively cheap. And, of course, the lower prices would represent a big benefit to buyers, whether they are first-time buyers or people changing residences. The drop in prices would be a transfer of wealth; it would not eliminate it.

In fact, the tax deduction itself represents a transfer of wealth. It is a transfer from future taxpayers to those 27 percent of current taxpayers who have enough debt to take the deduction.

Ann C. Logue (annielogue@gmail.com) writes from Chicago about business and technology issues. Her latest book is Emerging Markets for Dummies.