Is it Time for Congress to Reconsider the Mortgage Interest Deduction?

Mortgage interest costs have risen sharply over the last two years, with the average 30-year fixed rate mortgage rate reaching 7.8% in October 2023, the highest in more than 23 years. While higher mortgage rates mean greater costs for potential buyers, many new homeowners could reduce more of their tax burden through the Mortgage Interest Deduction (MID).

The MID is one of the nation’s costliest federal tax expenditures, responsible for about $30 billion annually in foregone revenue for the federal government. This figure could more than double after key provisions in the Tax Cuts and Jobs Act expire in 2025, such as the increase in the size of the standard deduction which reduces the number of taxpayers who itemize each year, including those claiming the MID. Rising mortgage rates could further increase the cost of the MID to the government because homeowners are able to deduct these higher costs and limit their tax liability. As members of Congress from both parties work to reduce our national debt, the MID warrants scrutiny.

This explainer provides an overview of the MID, examines its effectiveness at encouraging homeownership, and highlights proposals to convert the MID to a tax credit.

Background

Today, homeowners who itemize deductions when filing taxes can deduct their annual mortgage interest payments from their taxable income, thereby lowering the total amount they owe in taxes.

Example: A married couple filing jointly with an annual gross income of $150,000 and annual mortgage interest payments of $10,000 would only be subject to income taxes on an annual gross income of $140,000. Because the marginal tax bracket for this income level is 22%, the tax savings for itemizing $10,000 in mortgage interest payments would be $2,200—which would translate to $2,200 less revenue for the government from that household.

In 2017, the TCJA doubled the standard deduction, leading more low- and moderate-income homeowners to claim the standard deduction as opposed to itemizing, reducing the total cost to the government of the MID. The TCJA also made changes to the level of mortgage debt subject to the MID: For mortgages incurred before December 15, 2017, the MID applies to the first $1 million of debt. However, for mortgage debt incurred on or after December 15, 2017, the MID is limited to interest incurred on the first $750,000 of debt on primary and secondary residences, meaning homeowners with newer mortgage loans have a lower limit to how much they can reduce their tax burden. In addition, the TCJA restricted the deduction of interest on home equity lines of credit (HELOCs) and home equity loans. Under the TCJA, mortgage debt up to $750,000 can include a HELOC or home equity loan, but it must be used for purposes related to purchasing, maintaining, or improving the home in order for the taxpayer to be able to deduct the interest on it. Prior to the passage of TCJA, interest on HELOC or home equity loans up to $100,000 was deductible regardless of what it was used to finance and was counted separately from the $1 million limit.

However, the TCJA’s provisions impacting the cost and utilization of the MID expire in 2025. Unless new legislation is passed, the size of the standard deduction will shrink by half and the amount of debt subject to the MID will revert back to $1 million. As the chart below demonstrates, the MID is expected to more than double in cost to the federal government once the TCJA limits expires, rising from about $30 billion annually to more than $80 billion (though when considering other TCJA provisions that will also expire, such as lower tax rates, the net effect of TCJA expiration would be to substantially increase federal revenue).

Does the MID promote homeownership?

The MID provides a tax benefit for homeownership not available to renters. Proponents of the MID posit the tax subsidy incentivizes homeownership, which is associated with a host of benefits for households, neighborhoods, the economy, and society, including wealth-building. However, as the Congressional Research Service has pointed out, there is no evidence that the MID was created with the purpose of incentivizing homeownership; rather, it has existed in some form since the creation of the tax code in 1913, when all interest payments were deductible.

Research also casts doubt on the MID’s effectiveness at encouraging homeownership. The ability to afford a downpayment is the primary barrier to homeownership for low- and moderate-income households, and the MID does nothing to address upfront costs. Studies have shown that the MID and similar policies in other countries have had little to no effect on homeownership rates. Critics of the MID claim that, instead of incentivizing potential homeowners who otherwise would not buy a home, the MID encourages larger and more expensive homes, as it allows households who can already afford a down payment to take out a larger mortgage than they otherwise would.

Who benefits most from the MID?

Higher-income households benefit more from the MID, as they are more likely to own their home rather than rent and more likely to itemize their deductions, which allows them to claim the MID. Just 7.5% of taxpayers making under $200,000 itemized in 2020, while 45% of taxpayers making over $200,000 itemized.

Among those who claim the MID, higher-income households enjoy a greater average reduction in their tax burden because they tend to have higher-value mortgages and belong to higher tax brackets, both of which translate to larger savings through the MID.

As mentioned, the TCJA doubled the standard deduction, resulting in more low- and moderate-income homeowners claiming the standard deduction as opposed to itemizing. Consequently, the existing MID benefits higher-income homeowners to an even greater degree relative to low- and moderate-income homeowners.

White households also disproportionately benefit from the MID compared to Black and Hispanic households, in part because Black and Hispanic households at every income level are less likely to own their home than their white counterparts, who tend to have greater intergenerational wealth to help them afford a downpayment.

States with higher home prices, incomes, and taxes—such as California and Washington—also see more benefits from the MID, as people in those states are more likely to itemize and have larger mortgages.

Converting the Mortgage Interest Deduction to a Tax Credit

Critics of the MID have promoted replacing it with a new tax credit for mortgage interest payments. Under this proposal, homeowners could claim a tax credit worth a percentage of their annual mortgage interest payments. A new tax credit could better support moderate- and lower-income homeowners in two ways:

1. A tax credit could be claimed by all mortgage holders regardless of whether they itemize or not, as moderate- and lower-income households are less likely to itemize than higher-income ones.
2. Since the MID lowers one’s taxable income (and therefore indirectly reduces the amount of taxes they owe), homeowners in higher tax brackets benefit more. By contrast, a tax credit would go directly towards reducing a taxpayer’s final tax liability by a fixed percentage of the household’s mortgage interest payments.

A new tax credit could distribute the benefits of mortgage interest relief more directly to homeowners in need of it, rather than concentrating the value to those in the highest income brackets. The impact of a new tax credit to replace the MID would depend on several factors:

• Size of the tax credit: The percentage of a taxpayer’s mortgage interest that can be claimed as a tax credit.
• Refundable or non-refundable: Whether the credit would be refundable, which would allow a taxpayer to collect the amount of the credit left after fully eliminating the tax liability, or non–refundable, meaning the most a taxpayer can receive from the credit is the amount that brings their income tax liability to zero.
• Maximum eligible mortgage interest: As the table below shows, some proposals limit the amount of mortgage interest that can be applied to the credit directly, while others set a limit for the maximum value of the total mortgage for which interest can qualify. Most proposals would lower the amount of interest a credit covers relative to the current deduction.
• Number of eligible residences: Whether the tax credit is restricted to mortgages for primary residences only. Currently secondary residences qualify.

Three high-level bipartisan commissions have proposed converting the MID to a tax credit: BPC’s Domenici-Rivlin Debt Reduction Task Force, the National Commission on Fiscal Responsibility and Reform (Bowles-Simpson), and the President’s Advisory Panel on Federal Tax Reform (Mack-Breaux). The main components of the three proposals are compared in the table below.

Example: If the MID were replaced with a 15% tax credit, a married couple filing jointly with annual mortgage interest payments of $10,000 could claim 15% of their mortgage interest as a credit. Therefore, they would receive a $1,500 tax credit.

Several organizations, including the National Association of Home Builders (NAHB), have endorsed similar proposals. NAHB also suggests pairing a tax credit targeted to lower- and middle-income households with a permanent, first-time home buyer tax credit to help households with the challenge of accumulating a down payment.

Supporters of replacing the MID with a new tax credit argue it would reduce federal deficits by substantially increasing revenue, though the exact budgetary effect is unclear and would depend on the specifics of the new credit. In 2016, the Congressional Budget Office (CBO) and the Tax Policy Center estimated that replacing the MID with a 15% non-refundable tax credit phased in over several years would increase federal revenue by over $100 billion (and potentially more than $200 billion) over a decade. A new CBO analysis, accounting for the changes in the TCJA and today’s economy, would provide a better understanding of the budgetary implications of replacing the MID with a tax credit.

A portion of the increased federal revenue that would likely result from replacing the MID with a tax credit could be allocated to support increasing the supply of affordable homes. Several organizations estimated that the U.S. has “underbuilt” housing by millions of homes over the past 15 years, resulting in a mismatch between supply and demand that has contributed to today’s housing affordability crisis.

Conclusion

Addressing our nation’s housing affordability crisis will require enhancing—and in some cases expanding—federal housing investments in housing supply and assistance to families. In a budget-constrained environment, lawmakers should question whether the existing MID is the most equitable, effective, and fiscally responsible way to support homeowners. BPC and BPC Action put forth a comprehensive housing legislative proposal—the American Housing Act—including a provision to convert the MID to a non-refundable tax credit, with the acquisition debt limit adjusted for inflation.