How an ostensibly universal deduction excludes lower income taxpayers

Some tax subsidies survive by dividing the population into those who benefit from the subsidy and those who have never heard of it. The mortgage interest deduction survives by going in the opposite direction: it benefits so many people that it is largely impossible to eliminate.

It doesn’t benefit everybody: you clearly can’t take the mortgage interest deduction (MID) if you don’t have a mortgage. And people who get a smaller mortgage may have such a small MID that the deduction provides no benefit. As you may recall from filling in your 1040, taxpayers have a choice of either itemizing deductions (including the MID) or taking a standard deduction, which is $6,300 for a single person with no kids and twice that ($12,600) for a married couple. So if you’re married and you have $12,000 in mortgage interest that you want to deduct and nothing else to itemize, then you’re better off eschewing the MID and taking the standard deduction. Total MID benefit: $0 reduction in taxable income. If you have $12,700 in interest to deduct, you’re now an itemizer taking the MID, but you can only itemize if you give up your $12,600 standard deduction. Total MID benefit relative to not having a mortgage at all: $100 reduction in taxable income (0.8% of the interest paid).

Conversely, consider a family that has large business expensess, or already has an existing mortgage on their first house, so that they started itemizing deductions long ago and the standard deduction is a distant memory. If they take out a new mortgage with $12,700 in interest, then their taxable income falls by $12,700 (100% of the interest paid).

In practice, few people making under $50k/year take the deduction to any great effect. This is a tax subsidy primarily for people who can afford expensive houses and have good enough credit to get large mortgages.

A chart of MID benefits claimed by income. Very little is claimed by those under $50k. Conversely, most of the people with severe housing cost burdens have incomes below $50k.

The mortgage interest deduction primarily benefits those who can afford more expensive houses.

In fact, in terms of encouraging home ownership among those making less money, consider a situation where one family wants to bid on a house, but knows that, as above, the extra $1,000/month in mortgage interest won’t be worth deducting. For another family bidding on this house, the purchase would be their second mortgage, so they will take the full MID, and on the bottom line of the tax form save $3,000 on their taxes every year for the next thirty years. Given that subsidy, they decide to raise their bid by $10,000. Thanks to the mortgage interest deduction, the lower-income family stands that much less of a chance of achieving homeownership.

The price of comparable houses is probably the foremost factor in how home prices are valued. So after this house sold for $10k more than it would have without the MID, expect the neighbors to tick up their asking prices—even in situations where none of the bidders are expected to use the MID. Soon every house will be more expensive than in the world without the MID subsidy, meaning that it will be that much more difficult to buy a house without some sort of subsidy.

There are proposals to solve some of the asymmetry between the two families by making the mortgage interest deduction a credit. There are different ways to put a credit on the tax form, but for now we’ll just assume that it is a separate space from the standard deduction, allowing people to take both. This article (the one I copied the above bar chart from) goes into great detail on many variants of the deduction-to-credit option. In each, the family with $12,700 in mortgage interest payments would first deduct the $12,600 standard deduction, then deduct the full $12,700 as well, not just the sliver past the standard deduction.

The deduction-to-credit trick could be done with any deduction, by the way, so you’ll often find politicians propose to give a tax cut to the poor by shifting something or other from the list of deductions to the list of credits.

Entrenchment

Even if you own your house mortgage-free, or you got over the hump and bought with no tax benefits, the price of your most valuable asset is bolstered by the mortgage interest deduction. If the deduction were eliminated, your house price would suffer. [If your plan is to sell your house and buy a more expensive home, it would basically be a wash, but people tend to not be so subtle in their thinking, and there can be complications.]

The National Association of REALTORs, which represents a group of people whose pay is calculated as a percentage of house price, has this official position: “The mortgage interest deduction (MID) is a remarkably effective tool that facilitates homeownership. NAR opposes any changes that would limit or undermine current law.”

So there are people who indirectly benefit from the subsidy, and people who directly benefit from the subsidy. And on the other side, the only people who wouldn’t see an immediate loss from the elimination of this subsidy are renters who for some reason never want to be home owners [let me tell you about my ritzy Velux skylights that leak every time it rains…].

There are two points to take away from this. First, order matters deeply in the design of tax incentives. The one-sentence version of the subsidy (you can deduct mortgage interest from your taxes!) sounds equitable and potentially beneficial to families at the bottom end of homebuying. But because of the exact positioning of the deduction on the tax flowchart, low-income families and those with smaller mortgages get almost no benefit from this subsidy.

Second, regardless of the original motivation, regardless of whether the mortgage interest deduction actually improves homeownership rates despite its complete ineffectiveness among the lower-income people most on the homebuying fence, regardless of whether home ownership is even something the federal government should spend billions of dollars encouraging, the deduction exists and is self-sustaining. The price of every house or condo in the United States takes into account the subsidy on the mortgage virtually every buyer will take out, and it is difficult to eliminate in direct proportion to its upward distortion of prices.

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