The Mortgage Interest Deduction and Negative Equity

The President’s Commission on Fiscal Responsibility and Reform recommended changing the mortgage interest deduction. Under current law, taxpayers can deduct the interest payments on up to $1 million of mortgage debt for principal and second residences, and they can deduct the interest payments on an additional $100,000 of a home equity loan. In 2009, these deductions lowered tax revenue by about $86 billion and are expected to lower tax revenues by nearly $500 billion from 2010 through 2013. The deduction lowers the tax burden by more for those in the higher tax brackets. Of the nearly $86 billion of reduced tax payments stemming from the deduction, roughly 75 percent accrued to those making more than $100,000.

The Commission proposes to change this deduction (currently available only to those who itemize their taxes) to a non-refundable credit available to all taxpayers. The credit will equal 12 percent of interest payments on up to $500,000 of mortgage debt for principal residences. No tax credit will be given for interest paid on mortgages for second residences or for home equity loans. These changes will increase government tax revenue and will re-distribute the mortgage tax benefits from higher-income tax filers toward lower-income tax filers.

If our tax system aimed to tax the money value of the net increase in a household’s power to consume during the year, then taxes would be levied on the net income stemming from owning a home. This would mean taxing the imputed rental value of the home and the annual appreciation of its value, but would also mean allowing the deduction from taxation of the operating expenses on the home, including the mortgage interest payments. Given the administrative difficulty (to say nothing of the political difficulty) of taxing the imputed rental value of homes, the current system of allowing mortgage interest deductions amounts to a substantial subsidy to mortgage holders. This subsidy provides inefficient incentives to buying a home over renting and toward borrowing to fund a greater proportion of the home purchase.

The most common defense of the mortgage interest deduction is that it promotes homeownership. Both the National Association of Home Builders and the National Association of Realtors have cited increased homeownership in their opposition to the Commission’s proposal to reform the mortgage interest deduction. Figure 1 shows that the homeownership rate has increased dramatically since 1965. How much of this is due to the mortgage interest deduction is difficult to say, although many studies support the claim that tax considerations have played an important part in the growth of homeownership.

The recent experience of the housing bubble has led to a drop in the homeownership rate from a peak of 69.2 percent in 2004 to the current rate of 66.9 percent. The homeownership rate is currently comparable to the rate in Canada (68.7 percent in 2009), which has housing policies that differ in a number of ways from the U.S., including not having a mortgage interest deduction. Another thing to consider is what constitutes “homeownership.” According to the Census definition used to compute the numbers in Figure 1, people are considered “homeowners” even if they are in negative equity, meaning owing more on their mortgages than their homes are currently worth.

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The prevalence of negative equity was made apparent by Monday’s release of third quarter 2010 estimates by CoreLogic. Corelogic reported that 22.5 percent of all residential properties with mortgages are in negative equity. Nearly 10 percent are in severe negative equity, meaning their loan values are greater than their house values by 25 percent or more. If one excludes the severely negative equity households from the Census definition of homeownership, the rate drops from 66.9 percent to 62.4 percent. (Removing all negative equity households drops the rate to 56.6 percent.)

It seems semantically incorrect to call someone who owes more on an asset than it’s worth an “owner.” And although one must be cautious in identifying the mortgage interest deduction as the main culprit for the negative equity problem, the disconcertingly high number of people with negative equity highlights a potential risk involved in subsidizing mortgage borrowing through the tax code. A policy goal solely in pursuit of maximizing homeownership risks leaving many people in the unfortunate position of owing more on their home than their home is worth.