Options for Reforming the Mortgage Interest Deduction

The mortgage interest deduction has long been targeted as a tax expenditure by advocates of tax reform. In a new paper, the Tax Policy Center's Amanda Eng looks at four different options for replacing the deduction (and in one option the property tax deduction as well) with a credit. These options would all raise revenue while tailoring the subsidy toward lower-income taxpayers.

Under current law, taxpayers who itemize deductions can deduct up to $1 million in interest from a mortgage and $100,000 from a home equity loan. Like many other itemized deductions, it is regressive because higher-income taxpayers are more likely to own a home, more likely to itemize, and get a greater percentage benefit from the deduction due to their higher tax rate and higher average home value.

The four options Eng evaluates are:

  • Replacing the deduction with a 15 percent and 20 percent non-refundable credit (Options 1 and 2, respectively). Both options would reduce the maximum size of the mortgage on which interest could be deducted from $1.1 million to $500,000.
  • Replacing both the mortgage interest and property tax deductions with a 56 percent refundable credit up to $1,400 for single filers and $2,100 for couples (indexed for inflation). If phased in over five years, the change would raise the same amount of revenue with a 49.5 percent credit (Option 3).
  • Replacing the mortgage interest deduction with a flat refundable credit of $536 for all homeowners, indexed for inflation (Option 4).

Option 2 raises the least amount of revenue at $26 billion, or $38 billion if it is phased in over ten years. The other options raise in the range of $200-$300 billion, with Options 3 and 4 specifically designed to raise $300 billion.

In terms of the distributional effect, all of the options would raise taxes on people making at least six figures and lower taxes on people making less, although individual taxpayers at similar income levels may be affected very differently. The most progressive among them is Option 4, because it does not vary at all with the size of the taxpayer's mortgage, it is refundable, and it applies to homeowners who don't have a mortgage (benefiting elderly taxpayers who are more likely to not have a mortgage and be low-income). The graph below shows the distributional effect of all the options.

Distributional Effect for Options 1-4 (Percent Change in After-Tax Income)

Source: Tax Policy Center

We've made it clear that the tax code is in need of reform, particularly the large tax expenditures which could be better targeted to be more effective and go to those who need them. This paper provides options for policymakers looking to accomplish that.