Wednesday, June 15, 2011

The Misunderstood Mortgage Interest Deduction

Copyright, The New York Times Company

The home-mortgage interest deduction does not by itself significantly distort housing markets. Too much owner-occupied housing has been built because housing is excluded from sales and other taxes owed by businesses.

The housing boom and bust of the last decade, and government revenue shortfalls, have brought back the topic of whether the government excessively encourages home building. Those discussions invariably mention the elimination of the home-mortgage interest deduction.

This deduction allows taxpayers who own a home, have a mortgage and itemize deductions to reduce their personal income tax by including home-mortgage interest payments in their tax deductions. Homeowners rightly consider this when considering whether and how much to invest in a home and how much they should borrow.

A homeowner who pays, say, one-third of his taxable income in federal and state personal income taxes will recognize that a $3,000 monthly mortgage-interest payment really only costs $2,000, because the mortgage interest reduces his taxable income by $3,000 and thus the personal income tax owed by $1,000 a month. It’s as if he paid $2,000 and the federal and state government treasuries paid the other $1,000.


At first glance, the home-mortgage interest deduction would seem to cause homeowners to borrow excessively for home ownership, and thereby deplete government treasuries. But that ignores the fact that one person’s mortgage interest payment produces interest income for another person or a business. The lender may well owe taxes on the interest income.

More home-mortgage borrowing means more home-mortgage lending, and the latter means more interest income that can be taxed. In theory, home-mortgage borrowing could even add revenue to the Treasury if the lender is in a higher tax bracket than the borrower (or if the borrower is not itemizing her tax deductions).

Interest deductions are present in the business sector, too, and have the same essential properties as the home-mortgage interest deduction. A corporation that borrows to finance an investment project can deduct its interest payments from its taxable income, and that borrowing will generate interest income for whoever made the loan.

Landlords can also take out mortgages on their properties and deduct the interest payments from their taxable income (that benefit may, in turn, affect the rent they set). In that sense, the possibility of deducting mortgage-interest payments from income taxes does not by itself discourage renting rather owning.

In contrast, consumer durable goods do not enjoy the interest deductions that housing and business capital do. Someone who takes out a car loan to purchase an personal automobile cannot deduct the interest payments from her taxable income, even while the Internal Revenue Service may be collecting taxes on the interest income of the lender. In this regard, tax policy discourages investment in consumer durable goods relative to investment in housing and businesses.

This is not to say that housing investment has been efficient. Earlier this year I explained how housing is much less profitable than business capital before taxes, largely because of the host of taxes — like sales taxes and income taxes on profits — that are owed by owners of businesses but not
by owners of homes.

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