The Mortgage Interest and Property Tax
Deductions: Analysis and Options
Mark P. Keightley
Analyst in Public Finance
January 18, 2011
Congressional Research Service
7-5700
www.crs.gov
R41596
CRS Report for Congress
Pr
epared for Members and Committees of Congress
The Mortgage Interest and Property Tax Deductions: Analysis and Options
Summary
Concern has increased over the size and sustainability of the United States’ recent budget deficits
and the country’s long-run budget outlook. This concern has brought the issues of the
government’s revenue needs and fundamental tax reform to the forefront of congressional
debates. Congress may choose to address these issues by reforming the set of tax benefits for
homeowners. According to the Joint Committee on Taxation, federally provided tax benefits for
homeowners will cost approximately $140.1 billion annually between 2010 and 2014. Reducing,
modifying, or eliminating all or some of the current tax benefits for homeowners could raise a
substantial amount of revenue, while simultaneously simplifying the tax code, increasing equity
among taxpayers, and promoting economic efficiency.
This report focuses on the two largest federal tax benefits available to homeowners—the
mortgage interest deduction and the deduction for state and local property taxes. While other tax
benefits for homeowners exist, these two particular benefits are the most expensive in terms of
forgone revenue to the federal government. Between 2010 and 2014 the mortgage interest
deduction and property tax deduction are estimated to cost around $96.8 billion and $24.2 billion
annually. Congress may therefore consider modifying these two tax benefits to raise revenue. The
mortgage interest deduction and property tax deduction are also the two tax benefits proponents
most often argue promote homeownership. Economists, however, have questioned this claim.
Some argue that the housing market is too fragile to modify federal homeownership policies at
this time. The market will, however, return to a more normal state eventually. Analyzing and
possibly deciding on policies now that are to be implemented at a more appropriate time may
reduce uncertainty faced by current and potential homeowners. A sustainable housing tax policy
would also be consistent with calls for a plan to address the government’s long-term fiscal
problems.
The analysis presented in this report is structured along two dimensions. First, the analysis
focuses on the rationales commonly offered for providing tax benefits for homeowners, mainly
that homeownership (1) bestows certain benefits on society as a whole such as higher property
values, lower crime, higher civic participation, among others; (2) is a means of promoting a more
even distribution of income and wealth; and (3) has a positive effect on living conditions, which
can lead to a healthier population. Although these benefits may exist, the analysis presented in
this report highlights the difficulties that economists have encountered in attempting to establish
their existence or magnitude.
The analysis then turns to examining the effect that the mortgage interest deduction and state and
local property tax deduction have on the homeownership rate, housing consumption, and the
economy. The analysis in this report suggests that these tax incentives may have a larger effect on
the size of homes purchased than on the decision to become a homeowner. The possibility that
attempting to promote homeownership via the tax code may distort the allocation of capital and
labor, which could hinder the performance of the economy in the short-run and long-run, is also
raised. In the process of conducting the analysis, this report briefly summarizes the historical
trends in homeownership and the more recent trends in foreclosures. The report concludes with
policy options that Congress may find useful as it moves forward, including proposals made by
President Obama’s Fiscal Commission, President George W. Bush’s Tax Reform Panel, and the
Congressional Budget Office.
Congressional Research Service
The Mortgage Interest and Property Tax Deductions: Analysis and Options
Contents
Introduction...................................................................................................................................... 1
Homeownership Trends ................................................................................................................... 1
What Tax Benefits Are Available..................................................................................................... 2
Mortgage Interest Deduction..................................................................................................... 3
Property Tax Deduction............................................................................................................. 6
Other Tax Benefits..................................................................................................................... 7
Non-Tax-Related Benefits ......................................................................................................... 8
Analysis of the Rationale for Subsidizing Homeownership ............................................................ 8
Positive Externalities ................................................................................................................. 8
Financial Benefits.................................................................................................................... 11
Psychological and Physical Health Benefits ........................................................................... 13
Economic Analysis of Current Tax Benefits for Homeowners...................................................... 14
Effect on Homeownership....................................................................................................... 14
Effect on Housing Consumption ............................................................................................. 16
Long-Term and Short-Term Effects......................................................................................... 17
Compulsory Tax Relief............................................................................................................ 18
Debt- and Equity-Financing Neutrality ................................................................................... 18
Potential Options for Change......................................................................................................... 19
Eliminate the Deductions ........................................................................................................ 19
Limit the Deductions ............................................................................................................... 20
Replace the Deductions with a Credit ..................................................................................... 21
Figures
Figure 1. Distribution of Homeowners in 2008 Claiming the Mortgage Interest Deduction
By Mortgage Status ...................................................................................................................... 5
Tables
Table 1. Estimated Budgetary Impact of Tax Benefits for Homeowners......................................... 3
Contacts
Author Contact Information........................................................................................................... 23
Acknowledgments ......................................................................................................................... 23
Congressional Research Service
The Mortgage Interest and Property Tax Deductions: Analysis and Options
Introduction
There has been increased concern over the size and sustainability of the United States’ recent
deficits and the country’s long-run budget outlook. This concern has brought the issues of the
federal government’s revenue needs and fundamental reform of the tax system to the forefront of
congressional debates. One place Congress may turn to address these issues is the set of tax
benefits for homeowners. The Joint Committee on Taxation (JCT) has estimated that the cost to
the federal government in terms of foregone revenue from these benefits will be approximately
$140.1 billion annually between 2010 and 2014.1 Economists have identified the set of tax
benefits for homeowners as one area in which reform may improve economic efficiency.
This report focuses on the two largest federal tax benefits available to homeowners—the
mortgage interest deduction and the deduction for state and local property taxes. The goals of this
report are five-fold: (1) briefly summarize the trends in homeownership; (2) provide an overview
of what tax benefits are available; (3) analyze the rationales commonly provided for offering such
benefits; (4) analyze the effect of the mortgage interest deduction and property tax deduction on
the homeownership rate, housing consumption, and the economy; and (5) present policy options.
Some may argue that the housing market is too fragile to modify federal homeownership policies
at this time. The housing market will, however, return to a more normal state. Analyzing and
possibly deciding on policies now to implement at a more appropriate time may reduce
uncertainty faced by current and potential homeowners. A sustainable housing tax policy change
would also be consistent with calls for a plan to address the government’s long-term fiscal
problems.
Homeownership Trends
Until recently, the homeownership rate in this
H o m e o w n e r s h i p a t a G l a n c e
country had generally increased over time. In
1900 only 46.5% of Americans owned the
Year
Homeownership
home that they lived in. By 1950, the
Rate
homeownership rate had increased to 55%, and
1900
46.5%
to 66.2% by 2000. Homeownership peaked in
1950
55.0%
2004 at 69%, and today hovers around 67%.
The most current data show that of 130.7
2000
66.2%
million homes in the United States, 74.9
2004
69.0%
million serve as principal residences. 2 Another
2010
66.9%
37.0 million homes are renter-occupied, and
the remaining 18.8 million are either for sale,
Source: U.S. Census Bureau
for rent, or for seasonal use.
1 Based on CRS calculations using estimates reported in U.S. Congress, Joint Committee on Taxation, Estimates of
Federal Tax For Fiscal Years 2009-2013, 111th Cong., 2nd sess., January 2010, JCS-1-10 (Washington: GPO, 2010).
The tax incentives included are listed in the table contained in this section.
2 U.S. Census Bureau, http://www.census.gov/hhes/www/housing/hvs/qtr310/q310ind.html.
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The Mortgage Interest and Property Tax Deductions: Analysis and Options
The size of homes that Americans own has also
H o m e a n d F a m i l y S i z e
generally trended upward over time, while
family size has trended downward. In 1970 the
Median New
Average
Year
House Size
median new home was around 1,385 square feet.
Family Size
(sq. ft.)
By 2008, the median new home was roughly
2,227 square feet—an increase of 61%. Over this
1970
1,385
3.58
same time period the average family size
decreased. In 1970 the average family size was
1980
1,595
3.29
3.58 persons, while in 2008 the average family
1990
1,905
3.19
size was 3.15 persons. Thus, the increase in
home size has been even larger after adjusting
2000
2,057
3.17
for family size. The fact is that Americans have
tended to build bigger and bigger homes while
2008
2,219
3.15
tending to have smaller and smaller families.
This trend can have important ramifications in
Source: Statistical Abstract of The United States
terms of land use, energy use, transportation, and
affordability.
These long-term trends in homeownership
Foreclosure Rates
behavior may be overshadowed by more recent
trends in foreclosures. At the beginning of 2001,
Year
All Loans (%)
Subprime
near the start of the housing boom, the national
(%)
foreclosure rate on all mortgage loans was
2001 Q1
1.24
3.58
1.24%. The foreclosure rate among riskier
subprime borrowers was slightly higher at
2007 Q1
1,28
5.10
3.58%. Foreclosures began to increase between
2008 Q1
2.47
10.74
2007 and 2008, shortly after the turning point in
the housing market. By the first quarter of 2010
2009 Q1
3.85
14.34
the foreclosure rate on all loans stood at 4.63%,
2010 Q1
4.63
15.39
with the greatest increase in foreclosures
occurring among subprime borrowers, 15.39% of
Source: MBA National Delinquency Surveys
which were in foreclosure.
What Tax Benefits Are Available
In 2010, there were at least eight tax incentives that directly or indirectly benefit homeowner-
occupiers. The Joint Committee on Taxation (JCT) estimates these benefits will cost the federal
government an average of $140.1 billion in foregone revenue annually between 2010 and 2014.34
These tax benefits and their associated budget impacts are listed in Table 1. The three most
expensive tax incentives in the JCT’s estimate are the mortgage interest deduction ($96.8 billion
annually), the itemized state and local property tax deduction ($24.2 billion annually), and the
exclusion of capital gains on the sale of a principal residence ($17.3 billion annually).5
3 Other tax benefits that benefit investors in housing exist, but are beyond the scope of this paper.
4 Based on CRS calculations using estimates reported in U.S. Congress, Joint Committee on Taxation, Estimates of
Federal Tax For Fiscal Years 2010-2014, 111th Cong., 2nd sess., December 2010, JCS-3-10 (Washington: GPO, 2010).
The tax incentives included are listed in the table contained in this section.
5 The figures reported in parentheses are the average annual estimates over the 2010-2014 period.
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The Mortgage Interest and Property Tax Deductions: Analysis and Options
Table 1. Estimated Budgetary Impact of Tax Benefits for Homeowners
(Billions of dollars)
Tax
Benefit
2010 2011 2012 2013 2014 Total
Mortgage Interest Deduction
90.8 93.8 94.1 98.5 106.8 484
State and Local Property Tax Deduction
15.0
22.8
26.5
27.6
29.1
120.9
Capital Gains Exclusion
15.0
16.5
17.5
18.2
19.0
86.3
Mortgage Revenue Bonds
1.0
1.1
1.1
1.3
1.4
5.9
Homebuyer Tax Credit
8.7
-2.4
-2.5
-1.6
-0.8
1.5
Canceled Mortgage Debt Exclusion
0.8
0.7
0.5
-
-
1.0
Mortgage Insurance Premium Deduction
0.3
0.1
-
-
-
0.4
Increased Standard Deduction for Property Taxes
0.5
-
-
-
-
0.5
Total
132.1 132.6 137.2 144.0 155.5 700.5
Source: Joint Committee on Taxation, Estimates of Federal Tax For Fiscal Years 2010-2014.
Notes: A positive estimate corresponds to a federal revenue cost. The estimates show that the homebuyer tax
credit increases revenue after 2011. This is due to the fact that homebuyers in 2008 who claimed the credit are
required to repay it over a 15-year period.
Some argue that another tax expenditure not included in official costs estimates—the exclusion of
imputed rental income—should be included. Unofficial cost estimates place the foregone revenue
generated by this exclusion at between $20 billion and $30 billion annually.6 The following
overview focuses on the mortgage interest and property tax deductions. The exclusion of capital
gains is not reviewed in detail because its effects on the housing decisions of taxpayers is
fundamentally different than the effects of the deductions for mortgage interest and property
taxes.7 A brief summary of the capital gains exclusions, as well as the other tax benefits, is
provided at the end of this section.
Mortgage Interest Deduction
The largest and most well-known tax benefit that homeowners can take advantage of is the
mortgage interest deduction. Specifically, homeowners are allowed to deduct the interest they pay
on a mortgage that finances a primary or secondary residence as long as they itemize their tax
deductions.8 For example, an itemizing homeowner who pays $10,000 in mortgage interest in a
given year can deduct $10,000 from his or her adjusted gross income. If this individual is in the
25% marginal tax bracket, a $10,000 tax deduction reduces his or her income taxes by $2,500
($10,000 multiplied by 25%).
6 The Tax Policy Center estimated the cost in 2005 of excluded imputed rental income to be $28.6 billion. See, Adam
Carasso, C. Eugene Steuerle , and Elizabeth Bell, “The Trend in Federal Housing Tax Expenditures,” Tax Notes,
February 28, 2005, p. 1081. Extrapolating their estimate to 2009 is made difficult by the current state of the housing
market. Therefore, providing a estimated range for the cost is more appropriate.
7 For more detail on the capital gains exclusion for principal residences, see CRS Report RL32978, The Exclusion of
Capital Gains for Owner-Occupied Housing, by Jane G. Gravelle and Pamela J. Jackson.
8See CRS Report RL33025, Fundamental Tax Reform: Options for the Mortgage Interest Deduction, by Pamela J.
Jackson.
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The Mortgage Interest and Property Tax Deductions: Analysis and Options
The value of the deduction generally
Distribution of Mortgage Interest Claimed
increases with taxpayer income for two
by Income Class in 2008 ($ in thousands)
reasons. First, the marginal tax rate a
Total $
Share of Total
homeowner faces increases with income.
Income Class
Amount
$ Amount
So an individual in the 35% marginal tax
Deducted
Deducted
bracket, paying $10,000 in mortgage
Below $30k
$37,378,818
8%
interest, would realize a reduction in taxes
of $3,500 in comparison to a $2,500
$30k to $40k
$25,732,689
5%
reduction for someone in the 25% tax
$40k to $50k
$29,709,973
6%
bracket. Second, higher-income individuals
$50k to $75k
$80,945,061
17%
tend to purchase more expensive homes,
$75k to $100k
$77,607,378
16%
which results in larger mortgage interest
payments, and hence, a larger deduction.
$100k to $200k
$142,679,352
30%
This relationship explains why most of the
$200k and over
$76,354,560
16%
total dollar amount of mortgage interest
Total
$470,407,831
100%
claimed is done so by middle- and upper-
income households.
Source: CRS calculations using 2008 IRS SOI
There are limits to the amount of mortgage
interest that may be deducted. Only the interest paid on the first $1 million of mortgage debt that
is incurred in the purchase, construction, or substantial improvement of a residence, and only the
interest paid on up to $100,000 of home equity debt may be deducted. Home equity indebtedness
is debt that is not incurred in the purchase, construction, or substantial improvement of a
residence, but that is secured by the residence. Home equity debt may be used to finance personal
expenditures (college education, vacations, etc.) unrelated to the home.
Although many contend that the purpose of the mortgage interest deduction is to promote
homeownership, this was not the deduction’s original purpose. When laying the framework for
the modern federal income tax code in 1913, Congress recognized the importance of allowing for
the deduction of expenses incurred in the generation of income, which is consistent with
traditional economic theories of income taxation. 9 As a result, all interest payments were made
deductible with no distinction made for business, personal, living, or family expenses.10 It is
likely that no distinction was made because most interest payments were business related
expenses at the time and, compared to today, households generally had very little debt on which
interest payments were required—credit cards had not yet come into existence and the mortgage
finance industry was in its infancy. Among those that did hold a mortgage, the majority were
business farmers.
For more than 70 years there was no limit on the amount of home mortgage interest that could be
deducted. The Tax Reform Act of 1986 (TRA86; P.L. 99-514) eventually restricted the amount of
mortgage interest that could be deducted and limited the number of homes for which the
deduction could be claimed to two. Mortgage interest deductibility was limited to the purchase
price of the home, plus any improvements, and on debt secured by the home but used for
9 Sen. William Borah, Congressional Record, August 28, 1913, p. S3832.
10 U.S. Congress, Senate Committee on the Budget, Tax Expenditures: Compendium of Background Material on
Individual Provisions, committee print, prepared by Congressional Research Service, 110th Cong., 2nd sess., December
2008, S. Prt. 110-667 (Washington: GPO, 2008), p. 330.
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The Mortgage Interest and Property Tax Deductions: Analysis and Options
qualified medical and educational expenses.11 Subsequently, the Omnibus Budget Reconciliation
Act of 1987 (P.L. 100-203) resulted in the basic deduction limits that exist today.
Figure 1. Distribution of Homeowners in 2008 Claiming the Mortgage Interest
Deduction By Mortgage Status
Source: Author’s estimates using 2008 American Community Survey and the 2008 IRS SOI Data
Not all homeowners claim the mortgage interest deduction.12 Some homeowners have no
mortgage, and hence no interest to deduct. The most recent data (2008) show that this group
accounts for 32% of homeowners. Among the 68% of homeowners with a mortgage, 75% claim
the deduction. This implies that around 51% of all homeowners claim the mortgage interest
deduction. The remaining 25% of mortgage holders (or 17% of homeowners) who do not claim
the deduction are likely either (1) toward the end of their mortgage payments so that the
deduction is not worth much, (2) live in a state with low state and local taxes and thus claim the
standard deduction, or (3) live in a low-cost area and therefore have a relatively small mortgage.13
In terms of tax returns filed, the deduction is claimed on about 27% of all federal income tax
returns and 80% of itemized returns.
11 Ibid.
12 The figures reported here are based on the author’s calculations using data from the 2008 American Community
Survey (AHS) and the 2008 IRS SOI Data, Tables 1.1 and 2.2.
13 State and local taxes are a major determinate of whether taxpayers itemize their federal tax returns.
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The Mortgage Interest and Property Tax Deductions: Analysis and Options
Property Tax Deduction
Homeowners also benefit from the ability to deduct state and local property taxes. In general,
homeowners are allowed to claim an itemized deduction equal to the full amount of state and
local property taxes paid.14 For example, an itemizing homeowner who pays $1,000 in property
taxes can deduct $1,000 from his or her adjusted gross income. If this individual is in the 25%
marginal tax bracket, a $1,000 tax deduction reduces his or her income taxes by $250 ($1,000
multiplied by 25%).
As with the mortgage interest deduction, the value of the property tax deduction generally
increases with taxpayer income for two reasons. First, the marginal tax rates that a homeowner
faces increase with income, so an individual in the 35% marginal tax bracket paying $1,000 in
property taxes would realize a tax savings of $350. Second, higher-income individuals tend to
purchase more expensive homes, which results in higher property taxes, and therefore a larger
deduction. Because there is no limit on the amount of property taxes that can be deducted—as
there is with the mortgage interest deduction—the majority of property taxes claimed is done so
by upper-middle- and upper-income households.
The deduction for state and local property
taxes was never intended to encourage
Distribution of Real Estate Taxes Claimed
homeownership. When the modern federal
by Income Class in 2008 ($ in thousands)
income tax code was created in 1913 almost
Total $
Share of Total
all state and local taxes were deductible.15 A
Income Class
Amount
$ Amount
major rationale for providing the deduction
Deducted
Deducted
was that the payment of the state and local
Below $30k
$12,362,815
7%
taxes was compulsory and thus should be
deducted when determining a taxpayer’s
$30k to $40k
$7,837,642
5%
ability to pay the federal income tax.16 Over
$40k to $50k
$8,853,315
5%
the years Congress has gradually restricted
$50k to $75k
$24,782,429
15%
the types of state and local taxes that could
be deducted. Today, deductible taxes
$75k to $100k
$24,870,397
15%
include real estate taxes, personal property
$100k to $200k
$50,974,540
30%
taxes, income taxes, and sales taxes. The
$200k and over
$38,223,572
23%
deduction for state and local sales taxes is
only available through 2011, and may only
Total
$167,904,710
100%
be taken in lieu of the deduction for income
Source: CRS calculations using 2008 IRS SOI
taxes.17
14 Because a taxpayer must itemize to claim the deduction, those taxpayers that claim the standard deduction
historically have not been allowed to claim a deduction for property taxes. This has changed temporarily, however. The
American Recovery and Reinvestment Act of 2009 (ARRA, P.L. 111-5) includes a temporary provision that allows
non-itemizing homeowners to claim an additional standard deduction for property taxes in an amount up to $500
($1,000 for married couples filing jointly) for 2008 and 2009. This additional standard deduction may be extended,
however. As with the mortgage interest deduction, the property tax deduction lowers the cost of homeownership
relative to what it otherwise would be.
15 State and local taxes assessed against local benefits were not deductible.
16 U.S. Congress, Senate Committee on the Budget, Tax Expenditures: Compendium of Background Material on
Individual Provisions, committee print, prepared by Congressional Research Service, 110th Cong., 2nd sess., December
2008, S. Prt. 110-667 (Washington: GPO, 2008), p. 336.
17 The Tax Reform Act of 1986 (TRA86, P.L. 99-514) limited deductibility of taxes to the first three classes of taxes.
(continued...)
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In 2008, 55% of all homeowners claimed the deduction for state and local property taxes. 18 The
deduction was claimed on slightly over 29% of all federal income tax returns.19 Approximately
86% of those taxpayers who itemized their federal return claimed the property tax deduction—
higher than the fraction of itemizers who claimed the mortgage interest deduction (see previous
section).
Other Tax Benefits
Following the mortgage interest deduction and property tax deduction, the next largest tax benefit
is the exclusion of capital gains from the sale of a principal residence. A capital gain is realized
when the sales price of a home exceeds the original cost of the home plus improvements. In
general, a capital gain on the sale of a principal residence of up to $250,000 for single taxpayers,
and $500,000 for married taxpayers filing jointly, may be excluded from taxable income. The
capital gains exclusion probably has a rather small effect on the homeownership rate. This is
likely due to the fact that the benefit of the exclusion cannot be realized until a taxpayer sells a
house, while, as discussed later, the main barrier to homeownership is the upfront down payment.
The tax treatment of capital gains on housing does have important effects on other aspects of the
economy.20
A rather abstract tax benefit that homeowners receive, but one which is well-known in the
academic community, is the exclusion of imputed rental income. To understand imputed rental
income, consider that a homeowner is effectively both a rental property owner and a tenant
(renter)—they own a home which they choose to rent to themselves instead of to someone else.
Economic theories of taxation suggest that homeowners and rental property owners should
therefore be taxed similarly. Currently, they are not. Rental property owners are taxed on their net
rental income, which is their rental income after deducting the costs they incur in generating this
income—mainly mortgage interest, taxes, insurance, maintenance, and depreciation.
Homeowners, however, are allowed to deduct mortgage interest and taxes without having to pay
taxes on the “rent” they pay themselves. Therefore, owner-occupied housing is subsidized relative
to rental housing.
There are a number of other smaller tax benefits that are currently available to homeowners. The
interest on mortgage revenue bonds (MRBs) is tax exempt, which allows MRBs to finance
below-market rate mortgages for potential homebuyers that meet certain criteria. Through 2011,
certain homeowners who itemize their tax returns may deduct from their taxable income
premiums paid for qualified mortgage insurance. Through 2012, homeowners whose mortgage
debt is forgiven (wholly or partially) may be able to exclude from taxable income the amount of
forgiven debt. Historically, when a individual is granted debt forgiveness by a lender—be it credit
card debt, a car loan, etc.—they must include the forgiven debt as taxable income.
(...continued)
The American Jobs Creation Act of 2004 (AJCA, P.L. 108-357) provided the temporary deduction for sales taxes. This
provision has been extended several times, most recently by the Tax Relief, Unemployment Insurance Reauthorization,
and Job Creation Act of 2010 (P.L. 111-312).
18 This figure was computed by combining tax information from the 2008 SOI data with homeownership information
from the 2008 AHS.
19 2008 IRS SOI Data, http://www.irs.gov/taxstats/indtaxstats/article/0,,id=96981,00.html, Tables 1.1 and 2.2 .
20 See CRS Report RL32978, The Exclusion of Capital Gains for Owner-Occupied Housing, by Jane G. Gravelle and
Pamela J. Jackson.
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There have also been several other temporary tax benefits that recently expired. For 2008 and
2009, non-itemizing homeowners were allowed to claim a $500 to $1,000 additional standard
deduction for property taxes. From the spring of 2008 through the fall of 2010, qualified
homebuyers were eligible to claim a tax credit for their home purchase.21
Non-Tax-Related Benefits
In addition to the numerous tax benefits that exist for homeowners, there are also a number of
non-tax-related programs that either directly or indirectly assist homeowners. For example,
homeownership is also subsidized by the favorable treatment of lending institutions that make
home loans (federal home loan banks); by federal programs that insure lenders against losses on
home loans which lowers the down payment homebuyers must make (FHA and VA); by federal
programs that provide favorable loan terms to farmers (USDA); by guaranteeing certain federally
charted financial institutions that assist in maintaining a viable secondary market for mortgages
which enables mortgage financing to be more readily available (Fannie Mae, Freddie Mac, and
Ginnie Mae); by establishing programs within HUD and USDA that fund agencies that counsel
prospective homebuyers on obtaining and maintaining homeownership; and by funding grant
programs that provide down payment and closing cost assistance to some homebuyers.22
Analysis of the Rationale for Subsidizing
Homeownership
A number of possible rationales for subsidizing homeownership have been put forth. First, a high
homeownership rates may bestow certain benefits to society as a whole such as higher property
values, lower crime, and higher civic participation, among others. Second, homeownership may
promote a more even distribution of income and wealth, as well as establish greater individual
financial security. And lastly, homeownership may have a positive effect on living conditions,
which can lead to a healthier population. This section provides a review and analysis of these
rationales. The analysis presented here is distinct from the analysis of the economic effects of the
mortgage interest and property tax deductions, which is presented in the next section.
Positive Externalities
Tax benefits for homeowners are most often rationalized on the basis that homeownership
generates positive externalities. Positive externalities, also known as spillover benefits, occur
when the actions of one individual benefit others in society. Because a given individual will tend
to only consider his or her own (private) benefit from an activity, and not the total benefit to
21 For more information about the homebuyer tax credit, see CRS Report R40955, An Economic Analysis of the
Homebuyer Tax Credit, by Mark P. Keightley.
22 For more information about these programs, see the following reports: CRS Report RL32815, Federal Home Loan
Bank System: Policy Issues, by Edward V. Murphy; CRS Report RS20530, FHA-Insured Home Loans: An Overview,
by Bruce E. Foote and Katie Jones; CRS Report RS20533, VA-Home Loan Guaranty Program: An Overview, by Bruce
E. Foote; CRS Report RL33421, USDA Rural Housing Programs: An Overview, by Bruce E. Foote; CRS Report
RL34661, Fannie Mae’s and Freddie Mac’s Financial Problems, by N. Eric Weiss; and CRS Report RL34591,
Overview of Federal Housing Assistance Programs and Policy, by Maggie McCarty et al.
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society, too little of the positive-externality-generating activity is undertaken from society’s
perspective. Governments, however, may intervene through the use of taxes and subsidies to align
the interests of individuals with the interests of society to achieve a more economically efficient
outcome.
A concrete example of a positive externality, often cited by homeownership advocates, is the
positive effect ownership is believed to have on property values in a community. The theory is
that since homeowners have a larger financial stake in their homes than renters, they are more
likely to make investments that raise surrounding property values. For example, a homeowner
may be more inclined than a renter to paint the exterior of his or her home, fix a hanging gutter,
or remove street debris outside his or her house. While the owner may be only seeking to improve
the appearance and resale value of the house, he or she is also positively influencing the values of
surrounding properties (the spillover effect).
There is a long list of other externalities that proponents claim homeownership generates.23
Homeownership is believed by some to create neighborhood stability since owners are more
inclined to remain in the community for a longer period of time than renters. Proponents also
associate homeownership with a greater degree of social and political involvement due to the
concern about one’s property value. Homeownership is also believed by some to lead to lower
neighborhood crime. It has also been suggested that homeownership fosters more responsible
behavior among youths in the community, such as higher academic achievement and lower teen
pregnancy rates, due to the monitoring mechanism put in place to maintain the attractiveness of a
community.
Economists have been able to establish that a correlation between homeownership and these
positive neighborhood effects does exist. For example, Denise DiPasquale and Edward Glaeser
found that homeowners are more likely than renters to belong to more non-professional
organizations, know the head of their local school board and U.S. House Representative, vote in
local elections, and garden.24 In separate investigations into the effects of homeownership on the
academic performance of children, Richard Green and Michelle White, and later Donald Haurin,
Toby Parcel, and R. Jean Haurin, reported statistical evidence that there is a positive relationship
between homeownership and the educational performance of owners’ children.25 And William
Rohe and Leslie Stewart found that every one percentage point increase in an area’s
homeownership rate was correlated with an $800 increase in home values over a 10-year period.26
At the same time economists have found it difficult to establish causality (i.e., homeownership
causes these positive effects).27 There are a number of reasons for this. First, there may be
23 See William Rohe, Shannon Van Zandt, and George McCarthy, “Social Benefits and Costs of Homeownership,” in
Low-Income Homeownership, ed. Nicolas P. Retsinas and Eric S. Belsky (Washington , DC: Brookings Institution
Press, 2002), pp. 381-406.
24 Denise DiPasquale and Edward Glaeser, “Incentive and Social Capital: Are Homeowners Better Citizens?” Journal
of Urban Economics, vol. 45, no. 2 (1999), pp. 354-384.
25 Richard Green and Michelle White, “Measuring the Benefits of Homeowning: Effects on Children,” Journal of
Urban Economics, vol. 41, no. 3 (1997), pp. 441-461. Donald R. Haurin, Toby L. Parcel, and R. Jean Haurin, “Impact
of Homeownership on Child Outcomes,” in Low Income Homeownership: Examining the Unexamined Goal, ed.
Nicholas P. Retsinas and Eric S. Belsky (Washington, DC: Brookings Institution Press, 2002), pp. 427-446.
26 William Rohe and Leslie Stewart, “Homeownership and Neighborhood Stability,” Housing Policy Debate, vol. 7,
no. 1 (1996), pp. 37-81.
27 For a very accessible review of the literature on the topic see Donald R. Haurin, Robert D. Dietz, and Bruce A.
(continued...)
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observable differences between owners and renters, that when not accounted for, may lead
researchers to false conclusions. For example, Green and White (discussed above) did not
account for differences in net worth, mobility, and home location when studying the effect of
homeownership on a child’s educational outcome. But these factors are likely strongly correlated
with homeownership. Thus, by not accounting for these observable difference the authors may
have been attributing the influence of these other factors on a child’s educational outcome to
homeownership.28
Second, there may be unobservable differences that exist between homeowners and renters that
researchers may not be able to account for, which leads them to infer causality when it is not
present. For example, certain traits or attitudes may lead some people both to homeownership and
community activism. Statistical methods can be employed to overcome the problem of
unobservable differences. These methods, however, are typically only reliable if particular
assumptions hold. This limitation generates a great deal of debate among researchers as to
whether the assumptions hold, and therefore whether the reported results are reliable.
A third problem that researchers commonly face in determining causality is the possible existence
of an interaction between homeownership and the positive outcome policymakers wish to
promote. Take for example the claim that increased homeownership rates boost neighborhood
property values. Determining causality is difficult because homeowners may prefer to purchase
homes in neighborhoods where home values are rising. Statistical methods have been developed
to determine causation when such interdependence exists. Again, however, particular assumptions
must hold for these methods to produce reliable results, generating debate among researchers
about findings.
Because of these difficulties, a definitive answer to whether homeownership produces the
purported externalities has eluded economists. This limitation, however, does not mean that
homeownership does not result in positive externalities that justify housing subsidies. But one
could argue that determining whether to provide subsidies for homeownership depends on
establishing cause and effect. If homeownership does not generate the positive effects some
believe it does, then the economic justification for subsidization is diminished.
It has been even more difficult for researchers to determine the magnitude of the purported
benefits of homeownership. Without accurate estimates of how large the social benefits are from
homeownership, it is difficult to determine the amount of subsidization homeownership should
receive. If the social benefits associated with homeownership are small then the current amount
of subsidization, which some economists view as substantial, could have the unintended
consequence of decreasing, not increasing, economic efficiency. This outcome is especially true if
the social return to investment in other activities in the economy, such as education and other
non-housing capital, are higher than the return to homeownership. In such a situation, reducing
housing subsidies would free up resources for these more socially valuable investments.
(...continued)
Weinberg, “The Impact of Neighborhood Homeownership Rates: A Review of the Theoretical and Empirical
Literature,” Journal of Housing Research, vol. 13, no. 2 (2003), pp. 119-151.
28 The statistical terminology that is used for this type of estimation error is “omitted variable bias.” When important
variables are omitted from an analysis the estimates of the importance of the variables that are included in the analysis
may be biased or over/understated.
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Often absent from the debate over the existence of positive externalities is the possibility that
homeownership results in negative externalities. Negative externalities occur when the actions of
one individual impose a cost on others in society. On the one hand, a higher concentration of
homeowners may result in increased property values. On the other hand, the opposite may be true
at times. If enough homeowners in a given community default and are foreclosed upon, the effect
could be to reduce the value of surrounding properties in the neighborhood. This, in turn, could
lead to more defaults and foreclosures, which reinforces the downward pressure on surrounding
home values. In effect, the community’s “portfolio” of homeowners and renters is undiversified,
so that a negative economic shock to a small group of homeowners can be transmitted to a larger
group.
Homeownership may also result in less than desirable social and community involvement.29 The
same incentive that is believed to lead homeowners to make investments that raise surrounding
property values—mainly homeowners’ financial stake in their property—may also lead
homeowners to push for local initiatives that exclude certain groups of people from their
communities. Zoning restrictions, for example, may be supported by homeowners if it prevents
the construction of low-income rental housing that they fear could impact their property values.
If the positive externalities outweigh the negative externalities, economic theory still suggests that
subsidizing homeownership to generate socially desirable outcomes may not be the most efficient
remedy. If landscaping, painting, and other exterior investments increase surrounding properties’
values, it is not clear why subsidizing homeownership to generate this result is the ideal method.
Theories of public finance and externalities suggest that a more efficient policy would be to
subsidize the externality-generating activity directly. The government could offer a tax credit,
deduction, or voucher for painting or landscaping one’s house, for example. Renters and owners
alike could then benefit from the incentive while producing the desired result—higher property
values from more aesthetically pleasing neighborhoods. Directly subsidizing socially beneficial
investment in one’s home could also be more cost effective than indirect subsidization via
homeownership incentives.
Financial Benefits
Some contend that homeownership promotes economic equality. Data reveal that homeowners on
average earn higher incomes and have higher savings than renters.30 In general, homeowners also
have greater access to wealth via their home’s equity which can be used to finance discretionary
and emergency spending. In addition, homeowners may have greater access to credit to borrow
for such things as a child’s education, which can increase the child’s income, and, in turn,
increase his or her ability to become homeowners. Thus, because of these positive correlations,
promoting ownership may be a tool used to achieve a more even distribution of income and
wealth within and across generations.
Again, economists confront the issue of distinguishing causation from correlation. Does
homeownership positively influence one’s income and wealth, or is the relationship reversed, and
29 See William Rohe, Shannon Van Zandt, and George McCarthy, “Social Benefits and Costs of Homeownership,” in
Low-Income Homeownership, ed. Nicolas P. Retsinas and Eric S. Belsky (Washington , DC: Brookings Institution
Press, 2002), pp. 394-396.
30 See for example the American Housing Survey: http://content.knowledgeplex.org/kp2/img/cache/documents/
1373.pdf
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higher income and wealthier households are more inclined to become homeowners? Likewise,
there may be some intergenerational wealth transmission mechanism that homeownership helps
facilitate, but it could also have something to do with the general ability of higher-income
households to invest in their children. If this is the case, more effective investment in education
may be a more economically efficient way to achieve an equitable distribution of wealth.
Homeownership is also often viewed as way to promote the accumulation of an individual nest
egg. This argument has become more prominent over the past decade as personal saving rates in
the United States have decreased. As long as home prices are stable or increasing, a homeowner,
as opposed to a renter, automatically builds his or her net wealth (equity) with each successive
mortgage payment. Home equity can be used to make improvements to the house, finance college
expenses, or be converted into income for retirement later in life, among other things.31 Being a
homeowner also allows individuals to build or improve their credit scores. As a result, a
homeowner may have access to cheaper credit than a renter.
Encouraging homeownership as a means of saving carries with it certain risks that policy makers
and potential homeowners may want to consider. First, it is not clear that the financial return to
homeownership is as high or as predictable as some believe. When viewed as an investment
vehicle, there appears to be differences across income groups and regional markets that should be
taken into account with a home that are not present with other assets. For example, there is
evidence that lower-income households are less likely than higher-income households to claim
the mortgage interest and property tax deductions, are more likely to pay higher “sub-prime”
mortgage rates, and spend less on maintaining their homes—all behaviors which should lower
their return to homeownership.32 At the same time, there is some evidence that homes in lower-
income markets may experience greater home appreciation relative to homes in the higher-
income markets.33 In addition, like all other investments, the financial return to homeownership
depends on market conditions at the time the home is bought and sold and the expected return
from alternative investments. Instead of purchasing a home, an individual could invest down-
payment funds in financial instruments, such as stocks and bonds.
Second, policies that promote homeownership may result in households holding relatively
undiversified portfolios. To minimize risk, households should hold a portfolio containing a wide
range of assets. Returns should not be too closely related so that if some assets in the portfolio
fall, others may rise. But a home is an inherently large and practically indivisible asset. In fact,
for those who are homeowners, their house is typically the largest asset in their portfolio.
Committing such a large fraction of one’s portfolio can complicate diversification. Also
complicating diversification is the combination of a home with an individual’s other largest asset,
his or her human capital, the return to which is labor income. The recent housing boom and bust
showed that the return to housing and the labor income of some workers in certain industries or
certain age groups may be closely related. Areas with high unemployment also suffered high
foreclosure rates which had a downward reinforcing effect. Thus, from a portfolio perspective,
homeownership may not be a financially prudent decision for all Americans.
31 The conversion of equity to income for retirement is often carried out using a “reverse mortgage.” For more
information, see CRS Report RL33843, Reverse Mortgages: Background and Issues, by Bruce E. Foote.
32 Eric S. Belsky, Nicolas P. Retsinas, and Mark Duda, The Financial Returns to Low-Income Homeownership, Joint
Center for Housing Studies of Harvard University, Cambridge, MA, September 2005, http://www.jchs.harvard.edu/
publications/finance/w05-9.pdf.
33 See for example Low-Income Homeownership: Examining the Unexamined Goal, ed. Nicolas P. Retsinas and Eric
S. Belsky (Brookings Institution Press, 2002), pp. 208-256.
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Third, unlike most other assets in the typical household’s portfolio, a home purchase is often
financed using a substantial amount of debt. The use of mortgage debt to acquire a home
increases the homeowner’s exposure to fluctuations in home prices. Specifically, more mortgage
debt causes greater changes in an owner’s equity—the difference between a home’s value and
what is owed on the house—in response to a given price change. If prices fall enough, an
individual can end up owing more on the house than it is worth—a scenario referred to as having
negative equity, or being “underwater” on the mortgage. Selling a house also requires the owner
to incur significant transaction costs, implying that a house is an “illiquid” asset, which further
increases risk.
Psychological and Physical Health Benefits
Some believe homeownership bestows certain benefits exclusively to individual homeowners,
including improved psychological wellbeing. The pride associated with owning one’s home could
lead to higher levels of self-esteem and overall life satisfaction. Self-esteem and satisfaction could
also be lifted by the pleasure one takes in maintaining and improving his or her property.
Homeownership could also promote a sense of individual security, stability, and control leading
to less stress than being a renter. As the current economic environment has made clear, however,
homeownership can also produce the opposite feelings if it becomes a struggle to make mortgage
payments.
In addition to the psychological benefits, some also point to the possible physical health benefits
associated with homeownership.34 Homeownership may provide higher-quality living conditions
which lead owners to be, in general, physically healthier than renters. Homeownership may also
allow households to better cope with unforeseen health events by drawing on equity in the home
and thus affecting the outcome of certain illnesses.
Researchers studying the psychological and health benefits of homeownership have encountered
the same problems as those studying homeownership externalities—primarily, distinguishing
causation from correlation.35 Some economists have also noted that if these benefits of
homeownership accrue to the individual and not to society, then widespread homeownership
subsidy programs may be unwarranted. Economic theory generally predicts that when only
private benefits exist (i.e., there are no externalities), the market will tend to allocate resources
most efficiently. At the same time, one could argue that individual health and well being are
fundamental features of a prosperous society, and if owning a home contributes to one’s health,
society should subsidize homeownership.
34 See William Rohe, Shannon Van Zandt, and George McCarthy, “Social Benefits and Costs of Homeownership,” in
Low-Income Homeownership, ed. Nicolas P. Retsinas and Eric S. Belsky (Washington , DC: Brookings Institution
Press, 2002), pp. 388-390, and National Association of Realtors, Social Benefits of Homeownership and Stable
Housing, August 2010, http://www.realtor.org/Research.nsf/files/
05%20Social%20Benefits%20of%20Stable%20Housing.pdf/$FILE/
05%20Social%20Benefits%20of%20Stable%20Housing.pdf.
35 Peter H. Rossi and Eleanor Weber, “The Social Benefits of Homeownerships: Empirical Evidence from National
Surveyrs,” Housing Policy Debate, vol. 7, no. 1 (1996), pp. 1-35.
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Economic Analysis of Current Tax Benefits for
Homeowners
While some policy makers may or may not want to promote homeownership based on the reasons
just discussed, a separate issue that arises is—what are the effects of the mortgage interest
deduction and property tax deduction? In particular, do these two tax provisions actually increase
homeownership as some argue? How do they affect other dimensions of homeownership, such as
the quality and size of homes taxpayers purchase? And how does subsidizing owner-occupied
housing affect the performance of the overall economy? This section analyzes these questions in
turn.
Effect on Homeownership
In order to have an effect on the homeownership rate, tax incentives must address the barriers that
households on the verge of homeownership face. Economists have identified the high transaction
costs associated with a home purchase—mostly resulting from the down payment requirement,
but also closing costs—as the primary barrier to homeownership.36 Household income has also
been found to influence the home-buying decision, although its effect on the decision to become a
homeowner is smaller than the ability to finance a down payment. This finding is likely because
those seriously considering making the transition from renter to owner already have sufficient
income to rent.
The effects of the mortgage interest deduction and property tax deduction on the homeownership
rate are likely to be small because they are not well targeted toward lowering the down payment
barrier. While the deductions lower the annual cost of homeownership, they do not provide any
upfront benefit that can assist in completing a home purchase. Instead the deductions enable
homeowners to have a greater after-tax income than they otherwise would. This may have an
important effect on another aspect of homeownership—the size of home taxpayers purchase, or
housing consumption. The next section elaborates on this issue.
The deductions’ effect on homeownership is also limited because the deductions are not well
targeted toward the group of potential homebuyers most in need of assistance—lower-income
households, which includes younger potential first-time buyers. The mortgage interest deduction
and property tax deduction are not well targeted toward this group because homeowners must
itemize their tax return to benefit, but lower-income households itemize their tax returns at a very
low rate. Thus, very few lower-income households benefit from the mortgage interest deduction
or property tax deduction.
The academic community has debated the virtues of the mortgage interest deduction as a tool for
promoting homeownership for some time. In the early 1980s two economics professors, Harvey
36 See for example, Peter D. Linneman and Susan M. Wachter, “The Impacts of Borrowing Constraints,” Journal of
the American Real Estate and Urban Economics Association, vol. 17, no. 4 (Winter 1989), pp. 389-402; Donald R.
Haurin, Patrick H. Hendershott, and Susan M. Wachter, “Borrowing Constraints and the Tenure Choice of Young
Households,” Journal of Housing Research, vol. 8, no. 2 (1997), pp. 137-154; and Mathew Chambers, Carlos Garriga,
and Donald Schlagenhauf, “Accounting for Changes in the Homeownership Rate,” International Economic Review,
vol. 50, no. 3 (August 2009), pp. 677-726.
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Rosen and Kenneth Rosen, presented research that suggested that when taken together, the
mortgage interest deduction, the deduction of property taxes, and the exclusion of imputed rental
income explained one-fourth of the increase in the post-World War II homeownership rate.37
Their results suggest that if these three tax benefits were repealed, the homeownership rate in this
country would fall about four percentage points. In the long term, the effect on the
homeownership rate would depend on interaction between the supply and demand for rental
housing and the supply and demand for owner-occupied housing.
There are at least two problems with the researchers’ approach. First, their results do not separate
out the effect of each individual tax benefit, so it is not possible to determine, for instance, what
would be the effect of only repealing the mortgage interest deduction, or only the property tax
deduction. Second, and arguably more important, the model employed does not allow for changes
in the rental market following the repeal of the tax benefits. As a result, their model may be
overestimating the effect of repealing the tax benefits since in their model a lower
homeownership rate would imply more renters. But in the short term, more renters would
increase rental rates, providing an offsetting disincentive to become a renter. Over time increased
rental rates would encourage the development of more rental housing, which should lower the
cost of renting. The long-term effects of repeal may be uncertain.
Economists Edward Glaeser and Jesse Shapiro have compiled research that partially refutes the
findings of Rosen and Rosen. Glaeser and Shapiro undertook an empirical investigation
concerning the effect of the mortgage interest deduction on the homeownership rate.38 The pair
looked first at the relationship between inflation and the homeownership rate. The value of the
mortgage interest deduction is positively related to inflation—when inflation is high, the value of
the deduction correspondingly increases. Thus, if the mortgage interest deduction affects the
homeownership rate, one should see homeownership change as inflation changes. But the
inflation rate fluctuated considerably between 1965 and 2000 while the homeownership rate was
relatively stable. Next the authors looked at the relationship between the itemization rate and the
homeownership rate. If the mortgage interest deduction influences home buying, changes to the
itemization rate should also result in changes in the homeownership rate. Again, no such
relationship was found. Glaeser and Shapiro conclude,
… the home mortgage interest deduction is really not a pro-homeownership policy in any
meaningful sense. It subsidizes housing consumption, but its impact on the homeownership
rate appears to be minimal.
More recently, economists Matthew Chambers, Carlos Garriga, and Don Schlagenhauf examined
the factors that best explain the increase in homeownership over the last decade. In a series of
papers the authors present both empirical and theoretical evidence that suggests that the most
influential factor was innovation in the mortgage markets, not tax policy. Mortgage market
innovations reduced—sometimes to zero—the down payment requirement for constrained
households, allowing more households to purchase a home. Tax policy, however, may have
interacted with some of the innovative financial products to increase the attractiveness of using
37 Harvey S. Rosen and Kenneth T. Rosen, “Federal Taxes and Homeownership: Evidence from Time Series,” The
Journal of Political Economy, vol. 88, no. 1 (February 1980), pp. 59-75.
38 Edward Glaeser and Jesse Sharpiro, “The Benefits of the Home Mortgage Interest Deduction,” Tax Policy and the
Economy, vol. 17 (2003), pp. 37-82.
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them—for example, the ability to deduct mortgage interest may have led some households to rely
on interest-only mortgage products.39
Effect on Housing Consumption
Some economists have argued that the mortgage interest deduction and property tax deduction
exert a non-trivial influence on the size of homes that taxpayers purchase. As was discussed
above, the main factor that prevents renters from transitioning to homeownership is the down-
payment barrier. But tax benefits—particularly the mortgage interest deduction and property tax
deduction—increase the after-tax income of those households that are able to take advantage of
them. And because the value of these benefits increase with taxpayer income and mortgage size,
it is argued that they tend to encourage larger home purchases among higher-income households.
In essence, they lower the effective annual price of homeownership. Individuals tend to consume
more of a good or service when its price falls.
The mortgage interest and property tax deductions could be capitalized into home prices, which
would limit their effect on housing consumption. Because the deductions increase the after-tax
income of homeowners, they may lead to home prices being bid-up higher than they otherwise
would be. In theory, the disincentive provided by higher prices to purchase more home could be
such that it exactly offsets the incentive provided by the deductions. In this case, there would be
no effect on housing consumption.
If tax policy does affect home size, it may also affect land use, energy use, and transportation.
Larger homes generally require more land on which to be built, which, in densely populated
areas, is typically found the furthest away from employment opportunities. The increased
commuting distance may lead to greater carbon emissions. Traffic congestion may also increase if
the transportation infrastructure is not enhanced to support the transition outward. And if
taxpayers are building homes larger than they would otherwise, energy use may also increase as
larger homes generally require more energy to heat and cool.
The mortgage interest deduction may have exerted a larger effect on housing consumption during
the recent housing boom than it historically has. Some homebuyers used mortgage products that
required very low or interest-only payments, such as an interest-only adjustable rate mortgage
(ARM). When home prices are rising and interest rates are low, these products can be attractive
because the homeowner can refinance into a more traditional mortgage before the interest-only
period is over. They are also attractive because the whole interest payment can be deducted due to
the mortgage interest deduction, which frees up income for a larger mortgage payment. Of
course, as is clear now, home prices do not always rise. Some of these borrowers were unable to
refinance because prices fell to the point that their home was worth less than what they owed in
mortgage debt.
39 See Matthew Chambers, Carlos Garriga, and Don Schlagenhauf, “The Loan Structure and Housing Tenure Decisions
in an Equilibrium Model of Mortgage Choice,” Review of Economic Dynamics, vol. 12, no. 3 (July 2009), pp. 444-468;
Matthew Chambers, Carlos Garriga, and Don Schlagenhauf, “Accounting for Changes in the Homeownership Rate,”
International Economic Review, vol. 50, no. 3 (August 2009), pp. 677-726; Matthew Chambers, Carlos Garriga, and
Don Schlagenhauf, “Mortgage Innovation, Mortgage Choice, and Housing Decisions,” Federal Reserve Bank of St.
Louis Review, vol. 90, no. 6 (November/December 2008), pp. 585-608. In addition, see Carlos Garriga, William Gavin,
and Don Schlagenhauf, “Recent Trends in Homeownership,” Federal Reserve Bank of St. Louis Review, vol. 88, no. 5
(September/October 2006), pp. 397-411.
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Long-Term and Short-Term Effects
The mortgage interest deduction and property tax deduction can improve the long-term
performance of the U.S. economy if the tax preferences promote homeownership, and if
homeownership produces positive externalities or if other market failures exist. When
externalities or market failures do exist, the free-market outcome will result in capital and labor
being employed in sectors of economy where they generate relatively low returns compared to
housing. Economic output and well-being will be below its potential. Providing preferential tax
treatment for homeowners can improve the long-run performance of the economy by encouraging
capital and labor to flow to the higher return producing housing sector.
It is also true that providing homeowners with preferential tax treatment can also harm the long-
run performance of the U.S. economy. If there are no externalities or market failures associated
with homeownership, then providing preferential tax treatment to homeowners causes capital and
labor to be diverted away from more productive employment in the non-housing sectors of the
economy. The same result occurs if homeownership produces externalities, but the level of
subsidization is greater than the external benefits produced. Although homeownership is often
claimed to generate positive externalities, such benefits have not generally been measured; nor is
there reason to believe that they justify such significant subsidies. Reducing the amount of tax
preferences available to homeowners could also improve the long-run budgetary situation of the
United States as federal tax revenues would increase, implying less reliance on deficits to finance
spending.
Housing tax policy can also exert an influence on the economy in the short term. Most
economists agree that a combination of mortgage market innovations, loose lending standards,
and low interest rates were the primary drivers of the run-up in home prices over the last decade.
But housing tax policy may have reinforced these factors, making the economic expansion and
subsequent contraction more acute than it otherwise would have been. The ability to deduct the
interest on exotic mortgage products may have reinforced these products’ influence on expensive
home purchases. The ability to deduct interest on home equity loans may have reinforced the
ability to withdraw equity to increase housing-related and non-housing-related consumption.
More homeowners and larger home purchases required increasing levels of capital and labor from
other areas of the economy. In 2005, The Economist estimated that “over two-fifths of all private-
sector jobs created since 2001 have been in housing-related sectors, such as construction, real
estate, and mortgage brokering.” 40
Attempting to encourage homeownership may also have the adverse consequence of slowing the
economy’s recover when it does fall into a recession. Most economic recoveries are characterized
by an elevated unemployment rate. The more quickly workers can transition from the weaker
sectors of the economy to the stronger sectors, the more quickly the economy can recover.
Homeownership can slow this transition because it reduces the ability of workers to move. For
example, an unemployed auto worker in Michigan may have to first sell his or her house to accept
a job somewhere else in the country. This may be infeasible if the worker is unable or unwilling
to sell his or her home. A renter, however, would at most be required to pay the remaining rent on
their lease before moving and could therefore be expected to transition to another form of
employment or location more quickly than a homeowner.
40 “The Global Housing Boom,” The Economist, June 18, 2005, p. 66.
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Compulsory Tax Relief
As mentioned previously, a major rationale for providing the deduction for state and local
property taxes is that such payments are compulsory and thus should be deducted when
determining a taxpayer’s ability to pay the federal income tax. In actuality, whether or not
compulsory taxes should be deductible depends on what the taxpayer receives in exchange. If a
taxpayer receives a benefit in exchange for paying local property taxes, deductibility may not be
justified. Consider a homeowner who pays a private company for trash collection services every
year. This homeowner would not be permitted to deduct such payment for tax purposes because
the payments were to a private company in exchange for a benefit. But if the taxpayer’s locality
handled trash collection in exchange for property taxes, the homeowner would be permitted to
deduct the taxes. Both homeowners are paying for trash collection, but one homeowner is better
off simply because the service was provided by the local government. Therefore, one could argue
that when property taxes are used to finance government services, the property tax deduction is
not justified.
It could still be argued that property taxes should be deductible even if a taxpayer receives a
service because it is the local government, and not the taxpayer, that determines which services
are provided. Thus, a taxpayer could be paying property taxes in exchange for services that he or
she does not value at all—a childless homeowner who pays taxes in exchange for a public school
system may be an example. Taxpayers, however, can still “vote with their feet” and choose a
locality and state that provides services that are more consistent with their preferences. In reality,
even when homeowners can vote with their feet they probably receive a mix of services that they
do and do not desire in exchange for paying property taxes. Therefore, it may still be justified to
provide at least a partial deduction for property taxes.
Debt- and Equity-Financing Neutrality
One justification that has been offered for the mortgage interest deduction is that it promotes
neutrality between homeowners who rely primarily on debt financing (borrowing) and
homeowners who rely primarily on equity financing (one’s own financial assets). Without the
mortgage interest deduction, equity financing would be tax preferred. Since those who have
enough assets to rely more on equity financing tend to earn higher income, the mortgage interest
deduction promotes financing neutrality among homeowners of different income levels.41
Because equity would be tax preferred, absent the mortgage interest deduction, it could be
expected that borrowers would tend to finance more of their home purchases with larger down
payments (equity contributions).
41 To understand how the mortgage interest deduction promotes neutrality between debt and equity financing, consider
the cost of each option. The cost of equity financing is the after-tax return that could be earned if the taxpayer invested
the funds elsewhere (stocks, bonds, etc.). The cost of debt financing is the after-tax interest that the homeowner must
pay on his or her mortgage. For example, if a taxpayer chooses to withdraw $250,000 from an investment account to
purchase a home, the cost of this option is the forgone investment earnings after taxes. Assuming a 6% return on the
investment account and a marginal tax rate of 28%, the annual pre-tax earnings would have been $15,000 (6%
multiplied by $250,000), which would have yielded a return of $10,800 ($15,000 minus $4,200 in taxes) after taxes.
Alternatively, if the taxpayer finances the purchase by borrowing $250,000 at an interest rate of 6% they would pay
$15,000 in interest before taxes. Assuming a marginal tax rate of 28% the after-tax interest cost would be $10,800
($15,000 minus $4,200 in tax deductions). Thus, the two financing options are neutral with respect to taxation.
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In light of the recent housing boom and subsequent bust, it could be argued that debt/equity
neutrality is not necessarily a desired policy objective. Debt financing—also known as
leveraging—increases a homeowner’s exposure to home price fluctuations. When a taxpayer is
highly leveraged, a relatively small decrease in home price can lead to owing more on his or her
house then the house is worth. This can cause problems should the taxpayer need to move or sell
their house unexpectedly. As was previously discussed, increased leveraging can also lead to
costs being imposed on surrounding property owners if it increases the risk of foreclosure, which
can negatively impact the value of neighboring homes. To the extent that this negative externality
exists, economic theory suggests that debt/equity neutrality may be suboptimal.
Potential Options for Change
If Congress chooses to do so, there are a number of options at its disposal for changing the
mortgage interest deduction and the state and local property tax deduction. This section discusses
several of these options. Actual implementation of any of the options presented here would
require careful consideration about how specifically to modify the parameters of the tax benefit(s)
of interest. It appears that the two options that have generally received the most attention so far
are converting the mortgage interest deduction into a credit, and limiting the deductibility of state
and local property taxes. The list of options presented here is by no means exhaustive.
Eliminate the Deductions
One possible option would be to eliminate the mortgage interest and property tax deductions.
Elimination of the deductions could be justified as a second-best policy alternative to taxing net
imputed rental income. It was discussed earlier in this report that net imputed rental income is
currently excluded from taxation. This is due in part to limited acceptance by non-economists of
the idea that owning a home provides owners with implicit income that should be taxed, and in
part to the practical difficulty of taxing such income. Little is known, for example, about the
probable rental value of individual owner-occupied homes and available data on rental rates is of
limited use because of the differences in size and quality of rental units as compared to owner-
occupied properties.42
The impact on the economy and housing market would depend on how quickly the elimination of
the deductions were phased in. Sudden elimination of the deductions could cause home purchases
to decrease, leading to a decrease in home prices. The decrease in home prices would be more
severe if the deductions are capitalized to some degree into current home prices. The decrease in
home prices would impose capital losses on current owners and perhaps produce a lock-in
effect—current homeowners could be reluctant to sell at a loss. In addition, the decrease in home
prices could lead to a reduction in new home construction, a reduction in homeowner wealth, and
the possibility of higher defaults since some homeowners could find themselves underwater on
their mortgages. These three events could lead to the broader economy being negatively impacted
in the short term.
42 The government does compute the imputed rental value of owner-occupied housing when calculating gross domestic
product (GDP). GDP is a measure of all income earned in an economy in a given year. As a result, individual estimates
of imputed rental income for purposes of GDP likely do not need to be as precise as would be required for tax purposes
since errors in the estimation of individual imputed rental values likely aggregate out.
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If elimination of the deductions were gradually phased in over time it could help mitigate the
negative consequences for the economy and housing market. Researchers Steven Bourassa and
William Grigsby propose eliminating the deductions over a 15- to 20-year period with a fixed
date after which the deductions would no longer be available.43 For example, if January 1, 2031,
were chosen as the cut-off date, taxpayers who buy a home in 2011 could claim the deductions
for 20 years, buyers in 2012 could claim the deduction for 19 years, and so on. Bourassa and
Grigsby postulate that there would be no effect on home demand or prices, although no modeling
is done to compliment their proposal. It is possible that gradually eliminating the deductions
could simply delay the negative short-term consequences for the economy and housing market.
This could happen if households do not anticipate the full effects of the deductions’ elimination
until closer to the chosen cut-off date.
A net improvement in the long-term performance of the economy relative to today could be
expected from elimination of the mortgage interest and property tax deduction if the deductions
lead to distortions in the economy. A reduction in economic distortions would result in capital and
labor being directed to more productive employment in the non-housing sectors of the economy.
The resulting increase in federal revenue from the elimination of the deductions could also
improve the long-term budgetary situation of the United States as federal tax revenues would
increase, implying less reliance on deficits to finance spending. A ballpark estimate of the
expected increase in federal revenue from eliminating these two deductions is equal to what these
benefits currently cost the government—$121.0 billion annually.
Limit the Deductions
If the policy objective of Congress is to promote homeownership through the tax code, and
Congress believes the mortgage interest and property tax deductions increase homeownership,
then limiting the deductions to more effectively target the benefits is an option. Currently, the
mortgage interest deduction may be claimed on interest paid on up to $1 million of mortgage debt
that finances a primary or secondary residence, interest paid on up to $100,000 of home equity
debt (which may be used to finance spending unrelated to the home), and is available every year
the mortgage is in repayment. State and local property taxes are also fully deductible. It could be
argued that the deductions provide a tax benefit to a large number of taxpayers that would
become homeowners regardless if they existed or not.
The mortgage interest deduction could be limited to interest paid on a mortgage amount that more
closely resembles that of a first-time homebuyer. The Congressional Budget Office (CBO) has
estimated the cost of gradually reducing the maximum mortgage amount on which interest can be
deducted from $1.1 million to $500,000.44 The CBO proposal would not take effect until 2013
and would decrease the maximum mortgage amount by $100,000 annually until it reached
$500,000. The CBO estimates this option would raise a total of $41.4 billion between enactment
(2013) and 2019.45
43 Steven C. Bourassa and William G. Grigsby, “Income Tax Concessions for Owner-Occupied,” Housing Policy
Debate, vol. 11, no. 3 (2000), pp. 521-546.
44 The mortgage interest deduction may be claimed on interest paid on up to $1 million of mortgage debt that finances a
primary or secondary residence and interest paid on up to $100,000 of home equity debt.
45 Congressional Budget Office, Budget Options Volume 2, August 2009, p. 189, http://www.cbo.gov/ftpdocs/102xx/
doc10294/08-06-BudgetOptions.pdf.
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Another option would be to leave the maximum mortgage amount unchanged, but limit the
amount of interest that could be deducted. Thomas Hungerford, specialist in public finance at
CRS, has estimated revenue gain from one such proposal if it took effect in 2012. He estimates
that limiting the amount of interest that could be deducted to 10% of adjusted gross income (AGI)
would raise $30 billion in the year of enactment, whereas limiting the amount of interest that
could be deducted to 30% of AGI would raise $4 billion in the year of enactment. The revenue
gain over time would depend on how the housing market continued to respond to the new policy
and future interest rates.
Similarly, one possible modification to the state and local property tax deduction would be to
limit the amount of taxes a homeowner could deduct to a certain percentage of AGI. The CBO
has estimated the revenue gain from limiting the deduction for all state and local taxes to 2% of
AGI. Their estimates suggest that such a proposal could raise around $625 billion between 2010
and 2019. Since property taxes account for about 30% of all state and local taxes households pay,
the CBO estimates suggest that limiting the property tax deduction could be an effective option
for increasing revenue.46
Other options include limiting the mortgage interest or property tax deduction to interest and
taxes paid on a taxpayer’s first home. This could encourage first-time buyers to remain in their
homes longer as the deductions would no longer be available if they moved. Another option
would be to limit both deductions to a taxpayer’s primary residence. Current law allows for the
deduction of interest on a second residence and home equity loan, as well as the deduction of
property taxes on every home a taxpayer owns. The deductions could also be limited to those
homeowners below a certain income threshold. Currently the deductions are generally available
to homeowners of all income limits, although there are some restrictions based on income as a
result of limitations on the amount of itemized deductions some higher-income taxpayers may
claim.
Replace the Deductions with a Credit
The mortgage interest deduction and property tax deduction could be replaced with a tax credit.
The current deductions tend to provide a proportionally bigger benefit to higher-income
homeowners since they buy more expensive homes and are subject to higher marginal tax rates.
The requirement that homeowners itemize their tax returns also limits the number of owners who
receive the tax benefit. A tax credit for mortgage interest or property taxes could provide a benefit
to more homeowners since itemization would no longer be required. Without the need to itemize,
the burden of tax preparation on homeowners would be lessened. Depending on the design of the
credit, it could create a more consistent rate of subsidization across homeowners. Making the tax
credit refundable would serve to make it better targeted to lower-income homeowners.
Over the years, there have been several proposals to replace the mortgage interest deduction with
a credit. A number of the more prominent ones are listed below. All the proposals are slight
variations of one another—typically varying on the amount of the credit and the size of the
mortgage for which an interest credit could be claimed. The major difference is with respect to
whether the proposals suggest a refundable or non-refundable tax credit. There do not appear to
be, however, any proposals for converting the property tax deduction into a credit. The property
46 For breakdown of total state and local tax revenue by source see Table 4 in CRS Report RL32781, Federal
Deductibility of State and Local Taxes, by Steven Maguire.
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The Mortgage Interest and Property Tax Deductions: Analysis and Options
tax deduction could be converted into a credit in a manner similar to the suggestions for the
mortgage interest deduction.
• President Obama’s National Commission on Fiscal Responsibility and Reform
(Fiscal Commission) has recently recommended replacing the mortgage interest
deduction with a non-refundable credit equal to 12% of the interest paid on
mortgages of $500,000 or less.47 The credit would be restricted to a taxpayer’s
primary residence. No credit would be allowed for interest associated with home
equity loans.
• The Bipartisan Policy Center’s Debt Reduction Taskforce, co-chaired by former
Senator Pete Domenici and Alice Rivlin, proposes a 15% credit for up to $25,000
of interest paid on a mortgage associated with a principal residence—interest
paid on home equity loans and second homes would be ineligible.48 The tax
credit would be refundable, which would ensure lower-income homeowners
would be allowed to take advantage of the credit. The proposed credit would be
administered via mortgage lenders who would apply for the credit and transfer it
to homeowners by lowering their interest payments in an amount equal to the
credit.
• In 2005, President George W. Bush’s Advisory Panel on Federal Tax Reform
(Tax Reform Panel) also proposed replacing the mortgage interest deduction with
a credit. Specifically, the Tax Reform Panel proposed a tax credit equal to 15% of
mortgage interest paid. Under the proposal, the credit would be restricted to a
taxpayer’s primary residence. The size of the mortgage for which claiming the
interest credit would be limited to the average home price in the taxpayer’s
region. A similar option was presented by the Congressional Budget Office
(CBO) in 2009. CBO’s proposal called for a 15% credit for interest on mortgages
of less than $500,000.49
• In 1981, CBO outlined a number of options for reforming the tax treatment of
housing, including converting the mortgage interest deduction into a credit. At
that time, CBO determined that moving to a 25% non-refundable tax credit
would increase revenues and that only a small group of wealthy taxpayers would
be worse off. A non-refundable credit of 30% or more would have decreased
revenues. CBO also found that a 25% non-refundable tax credit would raise
house prices for less expensive homes and lower them for higher-priced units.
This effect could lead to some upper-income homeowners experiencing a
decrease in the value of their homes as well as an increase in their tax payments.
Allowing current owners the choice of a deduction or credit could have limited
47 The National Commission on Fiscal Responsibility and Reform , The Moment of Truth , Washington, DC, December
2010, p. 31, http://www.fiscalcommission.gov/sites/fiscalcommission.gov/files/documents/
TheMomentofTruth12_1_2010.pdf.
48 The Debt Reduction Task Force, Restoring America’s Future: Reviving the Economy, Cutting Spending and Debt,
and Creating a Simple, Pro-Growth Tax System, Bipartisian Policy Center, Washington, DC, November 2010, pp. 35-
36, http://www.bipartisanpolicy.org/sites/default/files/FINAL%20DRTF%20REPORT%2011.16.10.pdf.
49 U.S. Congress, Congressional Budget Office, Budget Options Volume 2, August 2009, p. 186, http://www.cbo.gov/
ftpdocs/102xx/doc10294/08-06-BudgetOptions.pdf.
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those capital losses, but the tax revenue losses from doing so would have been
substantial.50
Author Contact Information
Mark P. Keightley
Analyst in Public Finance
mkeightley@crs.loc.gov, 7-1049
Acknowledgments
Michael V. Waterman assisted with the writing of this report.
50 U.S. Congress, Congressional Budget Office, Tax Treatment of Homeownership: Issues and Options, September
1981, p. 55, http://www.cbo.gov/ftpdocs/52xx/doc5207/doc28-Entire.pdf.
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