Modifying the Mortgage Interest Deduction
State Legislative Analyst Proposes Modifying the Mortgage Interest Deduction to Increase Homeownership RatesDecember 21, 2007Taxation Committee
Housing Opportunity Committee
Legislative CommitteeThe following is for study only and has NOT been approved by the Taxation, Housing Opportunity, Legislative or Executive Committees or the Board of Directors.Issue
What is the Legislative Analyst’s Office (LAO) recommending in connection with the Mortgage Interest Deduction (MID)?Action
None required unless C.A.R. wishes to change it position on the MID.Options
Not Applicable.Status/Summary
The state legislature’s non-partisan LAO has recommended that the MID be modified because it doesn’t help achieve the policy goal of increasing homeownership.  Most of the benefit derived from use of the MID accrues to high-income taxpayers who would own a home regardless of the MID.  The LAO outlines a number of options for reformulating the MID so that the rate of homeownership is increased.  The LAO also suggests that replacing the MID with a mortgage tax credit.  By virtue of the tax assistance being a credit instead of a deduction, all homeowners would benefit.  Given the projected state budget deficit for next yearof approximately $14 billion, it is quite likely that the Legislature will be looking at tax expenditures such as the MID that may not be achieving their stated policy goals as a means of addressing the projected deficit.  In keeping with long standing C.A.R. policy, C.A.R. will oppose any changes restricting or otherwise limiting the MID.DiscussionThe MID allows homeowners to deduct interest payments on mortgages of up to $1 million for joint filers and $500,000 for single filers.  Also, the MID can be used for first and second homes.  Finally, the MID can be used on home equity loans of up to $100,000 for joint filers and $50,000 for single filers.  The rationale for the deduction is that increasing the rate of homeownership will result in better neighborhoods; however, individuals need help to buy a home.However, in November 2007 the state legislature’s non-partisan Legislative Analyst’s Office (LAO) released areport that concluded:[The MID] is poorly designed … for achieving the policy goal of increasing the rate of homeownership.  The structure of the MID directs most of its benefits to taxpayers who would own a home even if the MIDdid not exist, rather than to those whose rent-or-own decision may be influenced by the presence of the MID.The LAO’s report arrives at its conclusion by reviewing income tax data which reveals that most of the benefit derived from use of theMID accrues to high-income taxpayers. The top 20 percent of taxpayers by income constituted over half of the number of taxpayers who used the MID and these taxpayers received over three-fourths the dollar value of the deduction.  The LAO posits that these are taxpayers who would own a home regardless of the MID because they have the financial resources with which to purchase a home.  The LAO speculates that in actuality the MID allows these homeowners to purchase a larger home or to purchase other items such as vehicles, furniture, etc. High-income taxpayers benefit from the MID largely because (1) they generally itemize, and (2) as the income tax rates increase with income so, too, does the value of any deduction. The LAO also notes that several states (Connecticut, Illinois, Indiana, Massachusetts, Michigan, New Jersey, Ohio, Pennsylvania, and West Virginia) have personal income taxes but do not provide a MID and, yet, the homeownership rates in these states is higher than the national average.As a result of these findings, the LAO outlines a number of options for modifying the MID.  These include:
  • Allow the MID only for principal residences – as opposed to also allowing it for second homes.
  • Eliminate the MID for home equity loans.
  • Reduce the MID loan cap (currently, $1 million for joint filers).
  • Means test the MID – in other words, limit use of the MID to those who financially need assistance to buy a home.
  • Restrict the MID to first-time homebuyers.
  • Limit the number of years the MID canbe claimed.
  • Make the deduction “above the line” meaning that even taxpayers who claimed the standard deduction – instead of itemizing – would benefit.
In the alternative, the LAO also suggests that the Legislature could replace the MID with a mortgage tax credit.  Such a credit would be a specified percentage of the amount of mortgage interest paid.  By virtue of the tax assistance being a credit instead of a deduction,all homeowners would benefit and, moreover, the value of the credit would not be tied to the tax rate of the taxpayer.The LAO proposal to modify the MID is not new.  Two years ago, President Bush’s Advisory Panel on Federal Tax Reform also recommended new MID rules after finding that only 54 percent of taxpayers who pay mortgage interest receive an income tax benefit from the MID.  And, while it may be an open question as to whether the MID encourages individuals topurchase a home, it is becoming clear that there is an important distinction to be made between purchasing a home and owning a home.  Millions of people are purchasing their home.  However, the level of homeownership is declining.  In the third quarter of 2007, the percentage of a home’s market value minus mortgage-related debt fell to an average of 50.4 percent and some economists predict that home equity will drop below 50 percent by the end of 2008. In other words, people are buying homes but falling increasingly further behind with regard to actually owning their home.Given the $5 billion per year cost to the state of the MID and the projected state budget deficit for next year of approximately $14 billion, it is quite likely that the Legislature will be looking at tax expenditures such as the MID that may not be achieving their stated policy goals as a means of addressing the projected deficit.Unless directed otherwise, C.A.R. will maintain a position of opposition to any proposals restricting or limiting the MID
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