Understanding the Mortgage Interest Deduction

Homeowners get a tax advantage relative to rents. But those with mortgage are not at an advantage relative to those who finance with equity. From an article I wrote for the Encyclopedia of Tax Policy (Cordes and Gravelle, eds.):

In the popular press, the mortgage interest deduction
is often characterized as being the principal tax
benefit accruing to homeowners. This is certainly
not correct. First, fewer than 50 percent of homeowners
itemize on their tax returns; the remainder
use the standard deduction. This is because the value
of itemized deductions for low- to moderate-income
homeowners in states with low marginal tax rates
will almost certainly be less than the value of the
standard deduction, which in 2003 was $9,500 for
married couples filing jointly. Also, according to tabulations from
the Survey of Consumer Finances, many households
with elderly heads own their homes entirely with
equity (i.e., do not have mortgages), and for these
households, the mortgage interest deduction has no
value.

Second, even for those who do itemize, the
mortgage interest deduction does not necessarily
produce the largest tax benefit arising from owning.
The imputed rent that households earn from their
owner-occupied housing (i.e., the rents that households
are not required to pay anyone else because
they own) goes untaxed. This rent is therefore
favored relative to most other types of income,
including ordinary income, taxable bond income,
dividend income, and capital gains income, which,
while favored and deferrable, is still generally taxed.
The average loan-to-value ratio in the United States
is less than 50 percent. Thus, even if all owners with
mortgages itemized on their tax returns, the value of
the nontaxation of imputed rent would be larger than
that of the mortgage interest deduction.

Effect of the benefit on choice of financing

One could argue that the effect of the mortgage interest
deduction is to put debt on a level playing
field with equity as a way to finance housing. This
contrasts with the tax treatment of corporate income,
where interest is deductible and the opportunity cost
of equity capital is not. Many analysts have shown
that the U.S. tax system encourages corporations to
take on debt. Capozza et al. (1996) have shown
how the combination of nontaxation of imputed rent
and the absence of a mortgage interest deduction
would discourage households from financing housing
with debt. In Australia, imputed rent is not taxed
and mortgage interest is not deductible, and households
there generally pay off their mortgages more quickly than in the United States.