Options to Reform the Deduction for Home Mortgage Interest

Page 1 of 22 Options to Reform the Deduction for Home Mortgage Interest Daniel Baneman, Hang Nguyen, Jeffrey Rohaly, and Eric Toder Urban-Brookings Tax Policy Center August 16, 2011 ABSTRACT Currently, 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. In addition, taxpayers can deduct interest on up to $100,000 in home equity loans or other loans secured by their properties regardless of the loans’ purpose. We consider a proposal that would limit the amount of deductible interest to the amount incurred on the first $500,000 of debt on a primary residence only, and would replace the itemized deduction with a nonrefundable tax credit equal to 15 percent of eligible home mortgage interest. This research was performed under a contract with the National Low Income Housing Coalition. Page 2 of 22 Options to Reform the Deduction for Home Mortgage Interest This analysis estimates the revenue and distributional implications of reforming the federal individual income tax treatment of home mortgage interest. Currently, taxpayers can claim an itemized deduction for interest on up to $1 million in acquisition debt used to buy, build, or improve their primary residence or a second designated residence. In addition, taxpayers can deduct the interest on up to $100,000 in home equity loans or other loans secured by their properties regardless of the purpose of the loans.1 The $1 million and $100,000 amounts are not indexed for inflation. We consider a proposal that: (a) would limit the amount of deductible interest to the amount incurred on the first $500,000 of debt on a primary residence only, not indexed for inflation; and (b) would replace the itemized deduction with a nonrefundable tax credit equal to 15 percent of eligible home mortgage interest.2 Under current law, the value of the itemized deduction for mortgage interest depends on a taxpayer's marginal tax rate. For example, a taxpayer in the top 35 percent tax bracket would save $35 from an additional $100 of mortgage interest whereas someone in the 15 percent bracket would save only $15.3 In addition, many lower-income taxpayers do not benefit directly from the mortgage interest deduction because they claim the standard deduction instead. In contrast, the proposed 15 percent nonrefundable credit for mortgage interest would provide the same percentage tax savings regardless of tax bracket and would be available in addition to the standard deduction. We examine five variants of this proposal. The first option would enact the full proposal, effective January 1, 2012. The other options would phase down the value of the current deduction over time before eliminating it entirely and would immediately provide taxpayers with a choice between the new credit and the phased-down deduction.4 Two of the other options would also gradually phase in the stricter limitation on the amount of deductible interest. We estimate the revenue and distributional effects of the proposals against two baselines: current law and current policy. ―Current law‖ is the standard baseline that official revenue estimators at the Joint Committee on Taxation use to score tax proposals. It assumes that tax law plays out as it is currently written. Most important, that means that the 2001–2010 income and estate tax cuts expire as scheduled at the end of 2012 and that temporary relief from the alternative minimum tax (AMT) expires at the end of 2011. 1 Interest on a home equity loan not used to buy, build, or improve a residence is not deductible for alternative minimum tax purposes. See "Present Law and Background on the Tax Treatment of Household Debt," Joint Committee on Taxation, July 11, 2011, available at http://www.jct.gov/publications.html?func=startdown&id=3802. 2 Because the deduction for home mortgage interest is not an alternative minimum tax (AMT) preference item, we assume that the new mortgage interest credit would not be limited by the AMT. 3 This simplified example ignores the various phase-ins and phase-outs in the tax code that can cause a taxpayer's effective marginal tax rate to differ from her statutory rate. 4 We assume that taxpayers respond optimally to the choice and pick whichever tax preference would give them the lowest tax liability. Page 3 of 22 The ―current policy‖ baseline assumes that Congress permanently extends all provisions in the 2011 tax code (except the 2 percent reduction in Social Security payroll tax) as well as AMT relief, indexed for inflation after 2011. Our revenue and distributional estimates assume that taxpayers optimally pay down their mortgage in response to a smaller tax preference for mortgage interest.5 In addition, our revenue estimates are microdynamic: they assume that reported taxable income responds to changes in a taxpayer's statutory marginal tax rate.6 W