Chart of the day: Where does the mortgage-interest deduction go?

By Felix Salmon
July 12, 2011
report on the way that household debt is treated for tax purposes.

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Check out page 44 of the Joint Committee on Taxation report on the way that household debt is treated for tax purposes. I’ve put the table into chart form, to make it easier to see what’s going on. Apologies for the rather weird y-axis on the chart: it’s serving a double purpose, counting total returns for the left-hand column and dollars for the right hand column. I would have done a dual axis, but I was having difficulty making that work in Excel.

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In any event, the big picture here is clear. Households earning more than $200,000 a year account for less than 10% of the returns, but get 30% of all the benefits. And households earning more than $100,000 a year get 69% of all the benefit. The mortgage-interest deduction might be a middle-class tax break, but realistically it’s an upper-middle-class tax break.

The JCT is also very clear on the two separate ways in which it’s fundamentally unfair, benefiting owners at the expense of renters:

The deduction for home mortgage interest reduces the after-tax cost of financing and maintaining a home. Because the Federal income tax allows taxpayers to deduct mortgage interest from their taxable income, but does not allow them to deduct rental payments, there is a financial incentive to buy rather than rent a home. Taxpayers are also allowed to exclude gains from the sale of their principal residences of up to $500,000 from gross income. There is no such exclusion for other types of investments, further reinforcing the financial incentive to buy rather than rent a home.

Homeowners also receive preferential treatment under U.S. tax law because the imputed rental income on owner-occupied housing (that is, the cost of rent which the taxpayer avoids by owning and occupying a home) is not taxed. Consider two taxpayers: one rents a home at a $1,000 monthly rate, and the other owns a home which carries a $1,000 monthly mortgage. All else equal, a renter pays taxes on a measure of income that includes the $1,000 used to pay rent and the homeowner pays taxes on a measure of income that does not include that same $1,000. If imputed rental income were included in income, it would be appropriate to allow a deduction for mortgage interest, property taxes, and depreciation as costs of earning that income. Because tax law allows taxpayers to deduct mortgage interest and property taxes to determine their taxable income but does not tax imputed rental income or allow them to deduct rental payment, it creates the incentive to buy rather than rent a home and to finance the acquisition with debt.

The mortgage-interest deduction should be abolished, of course — it’s a dreadful piece of public policy. Homeownership, especially during times of high unemployment, does more harm than good, and there’s not even any real evidence that the deduction actually increases homeownership, rather than just artificially making houses more expensive to buy.

But if we’re not going to abolish the mortgage-interest deduction, I like the idea that homeowners should be taxed on their imputed rental income. Think about it this way: I can give you a house, or I can give you the money to buy that house, or I can give you an income stream to pay the rent on that house. The tax consequences of the three are very different, and the last one is the worst: you have to pay income tax on the income stream, leaving you with less money for rent. But if you own a house, and get lots of valuable benefit from it every month, you don’t need to pay any tax on that benefit at all.

More realistically, however, we should just look at the $80 billion a year we’re spending on the mortgage-interest deduction and ask ourselves (a) whether we can afford it, and (b) whether it’s really the best possible way in which we could be spending $80 billion a year. The answer to both questions is clearly no. Especially since that money is going overwhelmingly to the richest households in America.

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Comments
24 comments so far

Well, if the deduction has inflated home prices by, say 10% (not a bad estimate considering an 80% mortgage and a 15% tax bracket), then doing away with the deduction will reduce home prices by, say, 10%.
There’s good policy!
Unfortunately, the deduction is the Qwerty keyboard of the tax code.

Posted by RZ0 | Report as abusive

“we should just look at the $80 billion a year we’re spending on the mortgage-interest deduction”

I hate this new idiotic form of logic people are using with the tax code.

If you change the mortgage interest tax deduction, you are not going to miraculously “find” $80B of new revenue because you have radically changed the rent vs. buy economics. This applies any deduction that is erroneously called “spending”. Ignoring behavioral changes make logic like this like chasing a mirage.

Posted by dis737 | Report as abusive

“I like the idea that homeowners should be taxed on their imputed rental income.”

How are you going to tax somebody on a fictional measure? Will the IRS be inspecting each property every five years to determine “fair market rental”? Abolishing or limiting the mortgage-interest deduction makes plenty of sense, but your alternative sounds awful.

“I can give you a house, or I can give you the money to buy that house, or I can give you an income stream to pay the rent on that house.”

Not within my expertise, but I believe the tax consequences of all three are identical. If you give me an income stream, or a valuable property, then gift taxes apply. Right? Because of the gift tax exemption, the last one is the BEST because the first $10k per person per year is tax-free.

My parents didn’t exactly GIVE me the money to buy a house, but they did buy our mortgage (at a rate that was at the low end of “fair market” for the times). We deduct the mortgage interest that we pay them. They report and pay taxes on that mortgage interest. Net benefit to the IRS, since their tax rate is higher than ours. Net benefit to both us and them, because we don’t have a bank as an intermediary skimming profits.

If you eliminate the mortgage interest deduction, you’ll strongly encourage people to pay off their mortgages BEFORE building their savings. This would have some benefits, to be sure, but could further compromise attempts to encourage 401k participation.

Posted by TFF | Report as abusive

Does the “benefit” incorporate the impact of AMT? Specifically, the “households earning more than $100,000 a year get 69% of all the benefit” bit would seem even crazier after realizing that AMT hits a good portion of HHs earning that much. Something like 50% of the Bush tax cuts are swallowed up by the AMT anyway – I would expect something similar on the mortgage deduction.

Posted by brad_o | Report as abusive

You are forgetting that homeowners also have to pay property taxes, which while also deductible, are not exactly chump change.

The amount of money most homeowners save from the mortgage interest and property tax deductions are usually substantially exceeded by what they have to pay in property taxes. Likewise, homeowners also have to insure their homes and pay for their upkeep, which are not insignificant costs.

So comparing renting vs. owning is never quite as simple as it looks.

Posted by mfw13 | Report as abusive

Felix,

As I’m among your most loyal readers and I tell a dozen people a month about your amazingly awesome blog I beg you to forgive me for being fresh… but it sounds like you spent some of your valuable time to illistrate that one of the largest tax break goes to… ahem… tax payers.

Next lets explore what group benefits most from the 15% rate on capital gains and dividend income… I’m betting the rich come out ahead on that one as well no?

There are lots of good reasons to advocate the goverment end the favorable tax treatment for homeowners:

#1 it costs the goverment much needed revenue when we are running deficits so large that they threaten our entire economy.

#2 by so strongly encouraging home ownership it constains worker mobility. People can’t leave detroit’s 15% unemployment to move to North Dakota’s 4% unemployment because they are chained to their underwater homes.

All the big tax expendatures like the mortgage interest deduction, retirement savings (401k & IRAs,) and favorable rates for investment income, cost Treasury huge dollars. All the benifit go exclusively to the upper middle class and outright rich.

Consider though, that goverment has even more imporntant reasons to offer the citizenry every possible incentive to build wealth through homeownership, business ownership, or via tax defered savings… PEOPLE WHO OWN HOMES DON’T MARTCH DOWN STREETS THROWING ROCKS AT COPS… only unemployed people who are 2 months behind on their rent do that. The images I see out of Greece (like the ones from Egypt earlier in the year) simply terrify me.

Lets find some common ground… cap your hated deduction at $500,000 and limit it to one primary residence. Those two simple measures probably cut the cost by half and ALL the savings comes out of the pockets of the most affluent benificaries. Fair?

Posted by y2kurtus | Report as abusive

How much does the 250k/500k capital gains exemption cost in terms of lost taxes?

Posted by josiek | Report as abusive

“How much does the 250k/500k capital gains exemption cost in terms of lost taxes?”

Not sure, but it dramatically reduces the number of households that need to file an extremely messy capital gains calculation on their house.

Posted by TFF | Report as abusive

Jul 12, 2011
7:53 pm EDTYou are forgetting that homeowners also have to pay property taxes, which while also deductible, are not exactly chump change.

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DUH…people who RENT also pay property taxes. it comes out of the rent. Where else do you think the landlord gets the money to pay their porperty taxes? From the leprauchauns?

Stupid fallacy that somehow rent does not cover the property taxes on the property!

Posted by onthelake | Report as abusive

It seems to me that the comparison between renting and buying would be easier if the properties were comparable. It may seem so to Felix, living in the one location in America where you can’t tell the difference between apartment, co-op, or condo by visual inspection, but in the vast majority of America you can’t rent a standalone house except as a one-off that you are likely to lose when it’s sold.

I would like to see single family housing developments specifically developed as mid-range and higher rental properties, so that the middle class has a real choice between renting and buying that is not dependent upon whether it comes with a front yard.

Posted by Curmudgeon | Report as abusive

Nit picking dept: In the quotation from JCT, only the portion of the $1000 mortgage payment that is interest would be deductible. Granted, that portion could be near 100% early in the life of the mortgage, or exactly 100% for an interest-only mortgage.

Posted by engineer27 | Report as abusive

Curmudgeon, stand-alone properties take a lot of care. That isn’t a big deal for a homeowner who does 90% of the work himself, but it is economically prohibitive for the rental market. Even with the most basic lawn-and-shrubbery landscaping, your typical .25 acre property can take 10 hours a month to maintain properly.

Put the tenants in charge of property maintenance? That is the usual arrangement on our street, with several rental properties (both 1 family and 2 family). Bet you could drive down the street and correctly identify every single rental property instantly.

Pay a property manager to do it for you? Now you’ve increased the rent by $200-$300/month above and beyond the cost of the structure itself. The economics simply don’t work!

Moreover, landlords need to be able to make a profit. At the very least, they need the properties to generate sufficient cash flow to pay the bills. They need to do this WITHOUT the benefit of the mortgage-interest deduction, with less favorable mortgage rates, and with higher insurance costs.

Begin with the cost of owning/maintaining the property. Add additional costs. Subtract tax benefits. Add a profit margin. Your ultimate cost WILL end up higher than you started.

Those who would choose to pay an extra $200-$300 a month to rent are most likely content with a multi-family building of some kind. There is simply no interest in the market you suggest, either from landlords or from tenants. Not at prices that are sustainable.

Posted by TFF | Report as abusive

Sir,

I for one would argue that interest rates and tax brakes have no impact on affordability.

For example, imagine interest rates go down, you would think that must be great for new home owners, alas, all the benefit goes to existing owners, who sensing that higher mortgage can be sustained, jack up the principal (the price of what is for sale).

Similarly for the tax brakes. These brakes permit higher principal to be undertaken by the home owners. Again, this is reflected in higher house price.

petar marinov
(san francisco, ca)

Posted by rootis0 | Report as abusive

The largest impact of the deduction is not on income or taxes but on asset prices and how is changing asset prices fair to those who made their decisions based on them? Comparing $1000 rent to a $1000 mortgage is anything but equal since no one would rent if renting were equal to ownership.

Property taxes are a close substitute for taxing imputed rental income, and suffer from the same problem, imputation does not provide the cash flow with which to pay taxes. I would not mind paying income taxes on imputed income if I did not also have to pay property taxes. Historically property taxes were associated with services for the property, but they are probably even better associated with incomes.

Landlords do not actually pay tax on rental income because income property is financed to operate at a loss and they can deduct $25k of losses against their other income if they manage it themselves. This deduction is half as large as the ownership deduction but is still substantial and allows for many other deductions as well. Owners would quickly shift to becoming landlords of one.

In the end, property is an investment and deserves equal treatment as such. Eliminate the deductibility of all debt or allow all.

Posted by MyLord | Report as abusive

“Comparing $1000 rent to a $1000 mortgage is anything but equal since no one would rent if renting were equal to ownership.”

If the cost of renting were equal to the cost of ownership, then most people would be better off renting. There are heavy transaction costs when you buy/sell real estate that do not apply when you move from one rental to another.

But if the income from renting were merely equal to the cost of ownership, then landlords would make no profit at all (and would lose money any time they have a vacancy). Why would anybody want to be a landlord in that situation?

Historically, the cost of ownership is LESS than the cost of renting. That is why people in stable situations who can afford to do so choose to own. That is why landlords are able to make a profit.

This may have been temporarily reversed over the past decade, but it logically cannot be a stable situation.

In my opinion the biggest reason why renting *seems* cheaper than owning is that the properties that are being rented are much shabbier than those which are owner-occupied. Apples and oranges.

Posted by TFF | Report as abusive

Aren’t these the same folks paying all the property taxes for schools, roads, etc!

Posted by DrJJJJ | Report as abusive

Tax deductions and exclusions are public policy. I see no reason to change public policy so drastically. The bubble was in securitization driving inflated values, really awful lending practices, and lack of regulation, not because owning a home became a bad thing for society. Some people should rent, more than the GWBush administration believed but that was not the bubble, as your analysis of actual mortgage statistics clearly says.

I would rather see more cutting off the deduction for higher incomes. I would rather have homes not taxed at all on sale because I think society should reward long-term home ownership. I mean specifically that over time the exemption should phase in until it reaches 100%. We could also tie the exemption amount to local real estate values because $500k is not that much in NYC, CA, MA, and a number of other places.

Remember: taxation is supposed to reflect our values, not merely the most convenient ways to raise or not raise money.

Posted by jomiku | Report as abusive

This is a slanted analysis… you are missing one bar in your graph… percentage of total homeowners in each $return category. I am certain this would show limited home-ownership in the under $30k.

Posted by 20-20 | Report as abusive

Felix, I agree that no asset class should be given a preferential tax treatment whether it is real estate, stocks, bonds, venture capital, oil, mining, etc. However, before we hit the middle class with another tax increase, we should look at the tax give aways in the real estate investment property treatment.

Right now under the US tax code, when an investment property is sold (this excludes any home used by the owner as his/her residence) the capital gains tax is avoided 100% if the proceeds are reinvested within six months into another piece of real estate!! This is absurd. Can you imagine what would happen to the stocks if you told traders that they could avoid cap gains taxes if the put the money right back into the stock market?

Plus the favorable tax treatments on REITS, real estate partnerships and all the state and local tax rebates to real estate develops account for $billions of lost tax revenues while distorting the US Economy.

The US economy is in such a bad state right now because for 5 decades it has relied on real estate development and its related construction sector to prop up its economy after each recession. Even with historical low interest rates, the game is over and policy makers have no more tools. That’s what happens when the tax code unfairly supports one economic sector over the other (Hedge Funds, derivatives, oil & gas, and mining are all distortions as well with their favorable tax codes).

Posted by Acetracy | Report as abusive

sure Felix. Get rid of mortgage interest deduction and watch underwater homeowners run for the exits (as if many have not already)! Why not focus on the 2nd home deduction, the boat with a john deduction, the rv deduction. Those toys should not be a factor in the interest deduction part of a tax return.

Posted by clc123 | Report as abusive

If it’s true that the mortgage interest deduction has inflated home prices, then doing away with the deduction should deflate home prices.

Why would people stay in their homes if their mortgages are underwater, the value plummets even more, and the only remaining benefit for staying there (the mortgage interest deduction) is removed?

Conversely, highly profitably corporations like General Electric not only avoid paying taxes, but have a net gain at tax time. Corporate farms get huge tax benefits, Exxon get tax subsidies to explore for oil and people who earn modest hourly wages pay higher tax rates than those who make their money through investments.

If America wants to be altruistic about tax burdens, then the effort shouldn’t stop with expecting middle class homeowners to make a greater contribution.

One more thing… I recall paying 10 5/8% on a mortgage during the Carter administration. The real estate industry was almost at a dead stop at that time. If there had been no mortgage interest deduction, no one would have been buying during those years. We can be sure that interest rates will not remain the way they are now.

Posted by breezinthru | Report as abusive

There used to an deduction for other types of investment, indeed for all personal interest, until 1986. And there still is a deduction for margin interest. Nobody talks about that one.

Renters get a deduction in lieu of mortgage and property tax deductions. It’s called the standard deduction. If the standard deduction is a minimum estimate of the itemized deductions, which are primarily composed of mortgage and property taxes, then why should renters get the standard deduction at all? And if the standard deduction is for something else, why should homeowners not claim it too? “Unfairness” goes both ways.

As a homeowner I’d have no problem paying tax on imputed rental profit, meaning that I’d be able to deduct the other expenses landlords can deduct besides mortgage interest. Of course, there’s a fair chance that my property operates at a loss…

Posted by DavidN | Report as abusive

Just let the folks choose one deduction for homes. Don’t include second homes or boats with johns. Forget yachts, those folks can buy them overseas and register them there to avoid any US or State sales taxes and licensing fees.

Posted by rogersw | Report as abusive

Whoops didn’t get to finish.
Allow only one home deduction and require it to be a house or condo – forget the houseboat, yacht or big sailing vessel interest deduction. If they can afford those they can afford not having the deduction. Some folks buy fishing boats that cost more than some of the boats with a bunk, a kerosene stove and a chemical john and they cannot deduct the interest on them.

Posted by rogersw | Report as abusive
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