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Remodeling Homeowner Incentives: A Plan to Revive the Housing Market by Replacing Mortgage Interest Deductions with Tax Credits

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Almost four years after the 2008 mortgage collapse, whole neighborhoods stand empty, the construction industry is in shambles, and despite very modest improvements countless homeowners remain upside down on their loans and on the verge of default. Meanwhile, the economic recovery continues to lag. The evidence is undeniable: attempts to put an end to the U.S. mortgage crisis have failed.

The Housing and Economic Recovery Act of 2008 and other measures have done little to solve the housing problem, and it's clear that additional steps must be taken. In October, 2011, President Obama announced a new plan to encourage home refinancing inspired by Columbia University economists Chris Mayer and Glenn Hubbard (a former advisor to President George W. Bush). But even Mayer and Hubbard have expressed reservations that the plan won't go far enough.

While encouraging mortgage refinancing is a good start, it is time that we considered deeper, more meaningful reforms that would help existing homeowners, encourage prospective buyers and spur the construction, banking and real estate industries now and in the future. Exchanging the popular home mortgage tax deduction for a cashable tax credit, as Nobel Prize winning economist Joseph Stiglitz has proposed, would help us achieve these objectives. When combined with the President's refinancing plan, it could well end the mortgage crisis once and for all.

According to Stiglitz 1:

[W]e need assistance to average homeowners. We pay through our tax system nearly half of mortgage interest for the rich, but little if anything to find housing for the poor who don't own homes. Converting our mortgage deduction to a cashable tax credit would not only be fairer, it also would help ordinary Americans to stay in their homes.

For many years, economists and other experts with diverse political persuasions have supported similar proposals to substitute a tax credit for mortgage interest deductions. For example, in 1983 Senator Bob Dole introduced a mortgage bill that would substitute tax credits for deductions under certain circumstances.2

Now is the time for Stiglitz and others to present concrete proposals. To start the discussion, the plan outlined below supports vulnerable homeowners with aid that will decrease foreclosures. Substituting a tax credit for all interest deductions may initially be expensive, but the costs would decrease over time as existing mortgage balances are reduced. Because of the continuing weakness in the economy and the support that the mortgage deduction continues to receive, existing mortgages could continue to have their interest deductible. However, all new mortgages would only be eligible for the tax credit described below. (One difficulty will be that for many taxpayers, the deductibility of mortgage interest is what fuels the taxpayer's ability to take many other deductions instead of taking the standard deduction.)

Tax Credit Proposal:

1. A refundable tax credit for 25% of interest paid on first mortgages.

  • 25% is a middle-income rate and so will benefit everyone below that income level. Since the homeowner will not need to itemize to get the refund, it will benefit all homeowners, not just those that itemize deductions. The credit provides relief for all homeowners without further interference in mortgage contracts, but does not inhibit other measures to provide additional aid for at-risk homeowners. The 25% credit is a compromise between those who pay the highest tax rates and those who either pay no taxes at all, or pay taxes at a low rate. Suggestions for credit instead of deductions have been common, but increasing the credit percentage with strict limits may be a better alternative.
2. Maximum annual credit of $5,000.
  • This credit will provide for a subsidy for all homeowners and particularly for those with less than20,000 per year in interest payments. The subsidy could almost equal payments for three months per year. If the interest rate were 5%, the mortgage total could be up to400,000. The5,000 limit reduces tax incentives for the largest homes and promotes more responsible home ownership. Even with a lower maximum credit, such as4,000, homeowners would receive substantial assistance.
3. Homeowners could apply for the credit to be paid directly to the lender, thereby reducing their monthly mortgage payments by almost 25%.
  • If the credit is made available for the 2012 calendar year, a significant percentage of at-risk homeowners could avoid foreclosure because some of the interest for the year has already been paid or accrued. Paying the credit directly to the mortgage holder would assure that the credit is only used for mortgage payments. Arrangements could be made to pay the credit directly to the mortgage holder as it is accrued as long as the remaining balance is being paid by the homeowner.
4. Homeowners with existing mortgages would have the option to either keep their income tax deduction or convert to the tax credit system. Over time, this would reduce the percentage of the tax expenditure that supports the most expensive houses. It also rewards middle and lower income borrowers that presently receive little or no benefit from interest deductions.

5. For those that advocate scrapping the deduction altogether, future inflation will reduce the maximum value of the deduction unless the maximum is indexed for inflation.

This system could assist anyone with mortgage payments, but it would especially help homeowners with recent mortgages in which the monthly payments go mostly to interest and little to principal.

Though not a complete solution, the tax credit would provide benefits to all income groups and maximum benefit to middle- and lower-middle-class homeowners. It targets the benefits towards those who own homes but either do not itemize deductible expenses or are not in a high tax bracket. It is simple to set up and does not require modifying terms of existing mortgages.

Converting the mortgage interest deduction to a tax credit would make sense at any time, but it is particularly urgent in the present economic climate. This program, unlike the current interested deduction, will encourage home ownership for those with middle and lower incomes. No longer will most benefits go to those who need them least.

1 Joseph A. Stiglitz, "A Chance to Improve Bailout," USA Today, September 30, 2008.
2 "Its proponents say that by giving the tax credit directly to the home buyer, the measure could save the Treasury about $600 million. With the mortgage-subsidy bonds, which are tax-exempt and therefore reduce Treasury revenue, much of the tax benefits go to investors in the bonds and financial intermediaries such as banks and lawyers. The Reagan Administration, however, reflecting apparent recognition of the bonds' popularity, has said it would support the Dole proposal, with some changes, if it were the only alternative to repealing their use." NY Times, September 18th, 1983