Tax reform and the mortgage interest deduction

A "review and outlook" article in the 8/21/12 Wall Street Journal - "Tax Reform Skirmish" points out an event that may indicate some possibility of comprehensive tax reform in the near future. The paper reports that drafters of the Republican Party platform did not act on the request of the real estate lobby to protect the mortgage interest deduction. Per the paper, the drafters "managed to beat back an attempt by the real-estate lobby to put an endorsement of the mortgage-interest deduction into the 2012 Republican Party platform."

The mortgage interest deduction is in the top three of "tax expenditures" in terms of cost - about $90 billion per year. That is a lot of money!  It is a lot of money in terms of the few people who benefit from it.  The deduction is only claimed by those who itemized.  Only about 1/3 of individuals itemize their deductions and not all of them have mortgage interest.

The deduction is an upside-down subsidy because the higher your tax bracket (and your income), the more tax savings the deduction produces. Addition inequitable aspects of the deduction is that it also allows an interest deduction for a mortgage on your vacation home (not something everyone can even afford a downpayment for). And, if you have equity in your home, you can borrow up to $100,000 and deduct the interest (but not for AMT purposes). That's a much better deal then borrowing on your credit cards or getting a personal loan where the interest is not deductible.

And - research shows that the deduction doesn't even improve home ownership.  Home ownership rates in the US are about the same as in countries without these subsidies.

The WSJ notes: "As an economic matter, the mortgage deduction has long done more harm than good, misallocating capital to housing at the expense of other industries that might create more national wealth. The economy would be stronger, and might have avoided the trauma of the last five years, if housing demand hadn't been artificially inflated by years of policy favoritism."

That's right - the deduction lowers the tax rate on investment in homes, so we overinvest.

To keep lower tax rates, remove inequities, remove economic distortions, simplify the law and reduce the debt and deficit, I recommend:

1. Phase-out the home equity interest deduction over 5 years.
2. Phase-out the deduction for interest on a vacation home over 5 years.
3. Phase-out the $1 million debt limit on acquisition debt over 5 years. Drop it to $500,000 adjusted annually for inflation.
4. Convert the deduction to a tax credit.

Some will argue that it will hinder the housing market.  But, it may just bring it into equivalent treatment to other types of investments.  Also, it frees up money that could be used to provide assistance for low-income individuals to purchase a home.

For research from the Tax Policy Center that points out problems with the deduction, click here.

What do you think?