Effects of Reforms of the Home Mortgage Interest Deduction by Income Group and by State

Effects of Reforms of the Home Mortgage Interest Deduction by Income Group and by State Chenxi Lu, Eric Toder December 6, 2016 ABSTRACT This report considers three options for restructuring the home mortgage interest deduction – replacing the deduction with a 15 percent non-refundable interest credit, reducing the ceiling on debt eligible for an interest subsidy to $500,000, and combining the substitution of the credit for the deduction with the reduced limit on the interest subsidy. All three options would raise federal tax revenue and make the tax system more progressive. Distributional effects would differ by state of residence and, within states by income group. We display distributional effects by income group in California, Kentucky, Illinois, Michigan, New York, Oregon, Texas, Utah, and Wisconsin. This report was funded by The National Low Income Housing Coalition. We thank our funders, who make it possible for the Urban-Brookings Tax Policy Center and the Urban Institute to advance their mission. The authors are grateful to Frank Sammartino, Surachai Khitatrakun, Joseph Rosenberg, Gordon Mermin and Elena Ramirez for helpful comments and Yifan Zhang for preparing the draft for publication. The findings and conclusions contained within are those of the authors and do not necessarily reflect positions or policies of the Tax Policy Center or its funders. TAX POLICY CENTER | URBAN INSTITUTE & BROOKINGS INSTITUTION 1 CURRENT LAW AND REFORM OPTIONS About 30 percent of individual taxpayers itemize deductions to their federal income tax returns, and 75 percent of those who do so claim a deduction for home mortgage interest. Under current law, taxpayers can deduct interest on up to $1 million in acquisition debt used to buy, build, or improve their primary residence or a second designated residence. They can also deduct interest on up to $100,000 in home equity loans or other loans secured by their properties, regardless of the purpose of loans.1 The value of the deduction differs across taxpayers because of their different marginal tax rates. A taxpayer in the top tax bracket of 39.6 percent would save $39.60 whereas someone in the 15 percent bracket would save only $15 from $100 additional interest deductions. Four out of five taxpayers do not claim the mortgage interest deduction, many of whom are lower-income taxpayers. Most of them instead claim the standard deduction because it is larger than the sum of all their potential itemized deductions. Others are itemizers who either do not own a home or have paid off their home mortgage loans. We consider three options to reform the deduction for home mortgage interest: Option 1: Replace the mortgage interest deduction with a 15 percent non-refundable tax credit that can be claimed by both itemizers and non-itemizers, while maintaining the $1 million cap on the eligible debt. Option 2: Reduce the maximum amount of debt eligible for the mortgage interest deduction to $500,000. Option 3: Replace the deduction with a 15 percent non-refundable credit, and reduce the cap on the size of the mortgage eligible for the tax preference from $1 million to $500,000. For each of the three options, we present federal-level revenue and distributional effects: we display (1) revenue effects for fiscal years 2017 through 2026, (2) distributional effects of beneficiaries and benefits from the mortgage interest subsidy in 2016, and (3) distributional effects of federal tax changes under different options compared with current law. In addition, using a method the Tax Policy Center (TPC) developed of imputing state weights to samples of federal taxpayers, we analyze the effects of the options by state of residence and by income within selected states. Specifically, we display: (4) federal income tax changes by state of residence, and (5) the distributional effects of federal income tax changes by income group within each of nine selected states. 1 The amounts of $1 million and $100,000 are not indexed for inflation. In 2010, an IRS ruling allowed taxpayers with acquisition debt over $1 million to re-characterize the debt in excess of $1 million as a home equity loan. This effectively raised the ceiling on acquisition debt that is deductible to $1.1 million, which remains the allowable maximum on the sum of acquisition debt and home equity loans that are deductible. TAX POLICY CENTER | URBAN INSTITUTE & BROOKINGS INSTITUTION 2 Here are five key takeaways (one for each section):  All three options would raise federal tax revenue, and Option 3 would raise the most.  More taxpayers would benefit from the credit than from the deduction, but the average benefit per recipient from the credit would be substantially lower than that from the deduction.  Under Options 1 and 3, the biggest winners are the lower-and-middle-income taxpayers while the biggest losers are high-income people who