The Mortgage Interest Deduction

(1) If I buy a property and rent it out, then my income is equal to the rent that I get, minus expenses, including interest payments on a mortgage. Thus, I get to deduct mortgage interest.

(2) If homeowners could not deduct mortgage interest, then landlords would have an advantage. That is, the landlord could deduct mortgage interest, but the homeowner could not.

(3) As a homeowner, I do not count as income the “rent” that I earn on the house. This gives me an advantage over a landlord.

(4) Also, I do not count as income a capital gain from selling the house. This is another advantage over a landlord.

One can argue that the main distortions in the tax code are (3) and (4), rather than the mortgage interest deduction. If you took away (3) and (4), then I think one could argue that you want to keep the mortgage interest deduction.

Of course, the main reason we have the mortgage interest deduction is that the mortgage industry loves it. Yes, it is popular with people who currently use the deduction. But even if you “grandfathered” the deduction for everyone currently using it, you could never get a repeal past the housing lobby.

12 thoughts on “The Mortgage Interest Deduction

  1. I am not a tax expert, but I believe that:

    1) the owner of investment real property may depreciate the property over a span of years, which consequentially lowers the cost basis incrementally, which when the property is sold should increase the capital gain, presuming net proceeds. Also, I believe that it is (or was?) quite common for a real estate investor to roll the proceeds from his investment via a non-taxable “1031 exchange” into a subsequent investment. I don’t know whether that subsequent investment has to be real property or not — and my recollection may be quite wrong or outdated….. 🙂

    2) a homeowner must pay capital gain on the net proceeds from the sale of his home, BUT the first $250,000 (individual, $500k for married couple) is excluded, if it meets certain minimum requirements. I believe the law used to be that the proceeds up to a certain amount were excluded IF rolled into the purchase of a home of greater value, but in the age of Boomers downsizing, maybe that precluded them cashing out their equity in order to retire?

    There are so many moving parts to a homeowner v. renter v. landlord comparison that it may prove impossible unless one sets up specific scenarios as examples & explicates each vis-à-vis the tax code.

  2. The main reason we still have a mortgage interest deduction is that everyone includes it when budgeting a home purchase, and depend on its continuance to keep that budget as expected. Ending the deduction would represent a significant “taking” from recent home buyers. So right behind the evil mortgage industry are millions of individuals.

    There are many expenses landlords can deduct that homeowners cannot. And the previous poster is correct that landlords can depreciate properties. It is also not guaranteed that the net imputed income from home ownership is always positive. It would be difficult to calculate an imputed profit/loss and perhaps more difficult to audit.

  3. I should have said that 1031 exchanges are tax deferred: they are taxable when finally closed out, I think.

    If the mortgage interest deduction were phased out over a period of time, perhaps that would allow for owners/sellers to adjust their expectations & for the market to adjust pricing. IIRC, back ~1986, the income tax deduction for all other types of interest (personal loan, credit card, etc.) was taken away, while at the same time the AGI % floors for medical & a few other deductions were created. Granted, purchase of a home is one of the largest personal investments that someone will make in his life, but given some time to filter it through, the residential real estate market would adjust to the new reality. Perhaps the mortgage interest deduction could be withdrawn as a deductible expense for investment real estate as well. …I can hear the screams now…. LOL

  4. Taxing #3, a non-cash or monetary, gain would be among the most intrusive and abused taxes in the land.

    Yes, some people gain substantial wealth over time through #3, but I still see no way to tax it without many opportunities for abuse.

  5. Let’s go out a lot further into the grasses of the wetlands and join the muskrats:

    Keeping in mind that these issues are economic, political and social. The social drives the political, and the two together trump the economic. Otherwise –

    we would begin these taxation issues by regarding them as transactional, in which what we call “income” results from transactions of exchanges of services or exchanges of goods attained through the accumulation of the exchanges of services.

    In that light, taxation on transactions has a fundamental impact comparable to tariffs on imports and exports. The factor of impedance of transactions, thereby reducing the base for transaction taxes (as has been seen by excise taxes) is one of the floods that constantly sweeps through these marshlands of taxation, taking the muskrats out to the sea beyond their swimming abilities.

    “Pure” transaction taxation (of the income variety) would auger for “Gross Income” as the proper measure of all transactions; principally because it is the measure of the transactions between the participants.

    So long as we tend to regard “Income Taxation” as something other than transaction taxation we will continue with the vulnerabilities of the muskrats in the marshlands of taxation policy.

    This is not intended as propaganda for “Flat Tax.” Merely a call for realism.

  6. Of course no one has seriously suggested it, but if the “revenue expenditure” of the Mortgage Interest Deduction is eliminated, should it not be balanced by excluding its receipt from the “income” of the creditor?

  7. Laws vary across states as well. In regards to 3, landlords can deduct expenses including interest against their wage income, not only against rents, up to an amount if they are active managers, which is one more in their favor. In regards to 4, landlords defer taxes indefinitely, often forever, passing to their heirs at full market value, only being taxed under estate taxes if that sizable. The benefits are outsized for landlords as a result.

  8. Taxing personal interest expense but not business interest expense already skews individual behavior. Many wealthy people are “employed” by some kind of closely held corporation because that creates lots of avenues for tax avoidance. There’d be ways to work around losing the MID too, like having your corporation buy the house and lease it to you.

  9. I think many people overestimate the value of the mortgage interest deduction. It’s only an “absolute” tax deduction if you have a reasonably high income and are in a high-tax state, so you can itemize without it (as state and local taxes are itemizable). If you’re in a lower-tax state, particularly one with lower RE prices, the “shadow” of the standard deduction may well cover much of the mortgage interest deduction. For instance, if you’re in TX and your property taxes are $7K/year (and have no state income tax – ignore other itemized deductions for the sake of argument), you’d need to pay $5.2K of mortgage interest to cover the 12.2K standard deduction (for 2012, married, filing jointly) before you actually “win” a tax decrease because of your mortgage interest.

    Unfortunately, few people actually do their taxes without software, so they don’t realize this, and think their mortgage interest is saving them a bundle on taxes.

  10. In Australia, mortgage interest on one’s home is non-tax deductible for the homeowner but is taxable in the hands of the lender.

    Seems to work O.K.

  11. Deductibility of interest is a matter of horizontal tax equity. I paid cash for my house, reducing my income by the interest I would have earned on the money. Someone who borrows to buy a house or anything else should be able to reduce his income by the interest he pays. Incidentally, for decades Britain taxed imputed income on owner occupied houses.

  12. Going out on a legal limb …

    Many states have progressive-populist-era ‘homestead exemption from attachment in suit or bankruptcy’ laws where the equity in one’s residence lies beyond the reach of creditors. Some even exempt homesteads from criminal fines. The most generous, IIRC, are Florida, Iowa, Kansas, Oklahoma, South Dakota, and Texas – with protections perhaps rising into the 7 figures.

    The incentive structure is clear. A nice way to make oneself judgment-proof is to put every dime of equity you have into as much single-residence value as it can buy you. You lose that protection the minute you sell, so there is probably some small, inefficient effect on transferability and alienability. It would also distort the market slightly towards home-ownership instead of renting, and tend to bid up house prices slightly higher than they would otherwise be – a strange form of personal ‘rent-seeking’, paying for the extra legal benefit.

    One of the advantages of the mortgage interest-rate deduction is that it nudges this calculus in the direction of allocating one’s assets more towards attachable-equity, which could facilitate even more lending at lower rates and more economic activity in general.

    Ok – I admit I’m out on the very reaches of plausible argumentation here, but I can imagine a lawyer-lobbyist talking to a lawyer-legislator (or his staff, also often lawyers), and seeming very persuasive on this point – one I haven’t heard expressed anywhere else before.

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