Closing a Door for Homeowners

Changing the mortgage interest deduction could mean higher tax bills for some homeowners.

House Ways and Means Committee Chairman Dave Camp, R-Mich., recently unveiled a draft comprehensive tax reform plan that seeks to broaden the tax base while lowering corporate and individual income tax rates. The draft makes significant changes to federal tax rules connected to housing and homeowning. While most tax policy observers believe that the chances of a comprehensive tax reform plan being enacted in 2014 are slim, Camp’s proposal likely establishes the rough draft of future tax reform efforts in 2015 and thereafter.

Given the large scale of changes in any comprehensive tax reform proposal, it is important to review the plan its entirety. For example, the loss of deductions and credits that are law today may be offset by lower marginal income tax rates for some taxpayers. The plan effectively proposes a three-tier system for individuals (10 percent, 25 percent, and 35 percent), although the 10 percent rate phases out for high-income taxpayers. Additional phase-outs for items like the standard deduction or itemized deductions and changes to pass-through business income rules could also be classified as creating additional rates within the revised rate structure.

In total, the proposal is revenue and distributionally neutral, as evaluated by the nonpartisan Joint Committee on Taxation – the official tax policy scorekeeper on Capitol Hill. This means the proposal does not change the amount of revenue collected and there are effectively no changes in tax liabilities among income classes, at least as evaluated on a conventional scoring analysis.

However, revenue neutrality means that the sum of the changes will produce winners and losers within each income class. For homeowners and homebuyers, there are a number of proposals that would have direct and indirect impacts on how the nation’s tax code treats the costs associated with owning a home. And the indirect impacts are in some ways the largest potential effects that could come from this type of tax reform.

For example, the plan leaves most of the rules concerning the mortgage interest deduction intact. The deductions’s primary beneficiaries are middle class homeowners, with approximately two-thirds of the dollar benefit being collected by families with less than $200,000 in household economic income. The following map illustrates the share of mortgage interest deduction benefiting taxpayers with less than $200,000 in adjusted gross income using 2010 IRS data by state.

Under the draft proposal, the overall principal cap for the mortgage interest deduction would be lowered over a number of years to $500,000 (not indexed for inflation), but the second home rule would continue to apply under the new debt limit. The home equity loan interest deduction would be repealed, but loans taken out to improve an existing home via remodeling would continue to qualify under the new principal cap. The fact that most of the existing rules have been retained is a positive development for housing in terms of what may be kept in future tax reform drafts, although the lower cap limit would have negative impacts in high cost areas of the nation.

On the negative side, the deduction for property taxes paid in connection with an owner-occupied home would be repealed, along with all other individual taxpayer deductions for state and local income taxes. Furthermore, most of the other existing itemized deductions would be repealed, and the charitable giving deduction would be subject to a 2 percent floor of adjusted gross income (meaning you could not claim the charitable deduction unless your dollar value of giving exceeded 2 percent of adjusted gross income). These proposed changes would reduce the number of taxpayers who itemize their returns, thus reducing the direct tax benefit from homeownership and charity.

The draft proposal makes another significant change that would also alter the final distribution of tax liabilities. The standard deduction would be increased to $22,000 for married taxpayers filing joint returns ($11,000 for single returns). While touted as a change to improve simplicity with respect to tax filing, taxpayers who pay mortgage interest or engage in charitable giving would continue to need to tally those expenses to determine whether they itemize or not. Thus, the simplicity achieved here is one of outcome, not necessarily of process and administration.

The Ways and Means Committee summary indicates that these changes would reduce the number of taxpayers who itemize their returns, and who receive a direct tax benefit from homeownership or charitable giving, from 30 percent of all tax returns to approximately 5 percent. This is a significant step back from our current system which provides direct policy support for goals such as homeownership. It is worth recalling that numerous academic studies demonstrate a rich set of social and private benefits from homeownership.

Now some may argue that the increased standard deduction provides the same tax benefit as the current system for those who currently itemize. However, another change in the plan rules out this possibility. Under the draft plan, all personal exemptions are repealed. For present law, taxpayers in 2014 can claim a deduction in the amount of $3,950 per qualified family or household member. The increase in the standard deduction would help offset this change, along with a $500 increase in the child tax credit.

In contrast, under the proposed draft, the expanded standard deduction would stand in for a number of permissible adjustments under present law: the present law standard deduction, the present law personal exemptions, and certain itemized deductions like the mortgage interest deduction. However, the standard deduction simply does not increase enough to make up for all of these current tax rules.

Here are a few numbers to illustrate. Suppose a married couple with three children: Under present law, in 2014 the couple could claim a standard deduction of $12,400. They would also be allowed $19,750 in personal exemptions, raising their household deductions to $32,150 if they do not itemize. Finally, they would be able to claim three child tax credits in the amount of $3,000 total.

Under the new proposal, their standard deduction would increase from $12,400 to $22,000, but that benefit is completely offset by the loss of the personal exemptions. The approximate $10,150 loss in deductions is partially reduced by having the child credit total increase from $3,000 to $4,500 under the proposal.  Assuming a 25 percent tax rate, this boost in the child credit is equivalent to gaining another $6,000 in non-schedule A deductions, leaving the taxpayer with about $4,000 less in deductions, even before accounting for potentially lost Schedule A items due to not itemizing.

Thus, there is no ability for the increased standard deduction to make up for the loss of the charitable and mortgage interest deductions for those taxpayers who itemize under present law but who would not under the proposed reform. This example suggests that under this kind of revenue neutral tax reform, taxpayers who claim the mortgage interest deduction and the charitable giving deduction would likely find their taxes to be higher.

It is important to analyze any plan in its entirety, and the lower marginal rates of 10 percent and 25 percent offer a tax benefit to compensate for the broader tax base. But whether an individual family wins because of lower rates or loses because of changes to deductions depends a lot on family size and where you live.

Pro-growth tax reform that rewards investment, including housing, is clearly an important goal for the future. And the Ways and Means draft offers an important starting point that reflects a lot of work and difficult tradeoffs. But breaking the explicit link between tax policy and homeownership is the wrong path as the housing recovery continues.