Homeownership in the U.S. is good for everyone—correct? And the more people that own homes, the better—correct? Not necessarily so, conclude some individuals. Many would argue that the Federal government’s push to increase homeownership rates from 2004 through 2007 via subprime lending with little or no equity requirements was directly responsible for the housing bubble and the parallel recession. That leads some to believe that any subsidies to homeownership are unwarranted.
As the-powers-that-be cut deals and play economic and political poker in Washington, DC, regarding the massive ongoing deficits, it is the tax payers that will bear the brunt of the politico’s decisions. For decades the U.S. Government has encouraged homeownership, and yes, still subsidizes homeowners. Besides the government guarantees on loans via the two Government Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac (resulting in lower interest rates), along with minimal down payment loans from the FHA, the largest remaining subsidy is the deductibility of mortgage interest payments and local property taxes from taxpayers Federal income taxes.
At risk today are the interest expenses and property tax deductions on primary and a second dwelling for owners. So what will be the ramifications if Washington, DC, cuts these deductions for all or any layer of income producers?
Just because homeowners with mortgage loans pay property taxes and mortgage interest, does not mean that they currently benefit from the mortgage interest deduction (MID) and related property taxes. To benefit, the homeowner would have to itemize deductions and also have total deductions that would exceed the standard rate that all tax payers receive. As of now, a homeowner can deduct the interest payments on their primary and one other dwelling having a combined total loan amount of $1 million. In addition, interest from a home equity loan or line of credit up to $100,000 per year is also deductible.
The USA Today studied tax returns and the related percentage of tax payers opting for itemizing deductions that benefited from the MID. Remember that, just because an individual itemizes deductions, if those total deductions fail to exceed the standard deduction, there is no tax benefit from homeownership for that person or couple. The standard deduction for a couple filing jointly in 2012 is $11,900. Thus, if their total itemized deductions are equal to or less than $11,900, in actuality they receive no Federal income tax benefit from the MID.
USA Today reporters utilized 2010 IRS data and found that the MID currently reduces annual total Federal income tax collections by $108 billion per year. Naturally, more individuals would benefit from itemizing in states with greater home values (and hence larger loans and interest rate payments) and fewer in those states with lower home values and correspondingly smaller interest payments.
The study found that just 26 percent of tax payers benefited from the MID in 2010, ranging from a low of 15 percent in North Dakota to a high of 37 percent in Maryland.
The following table shows the percentage of tax filers in each state that benefited from the MID.
Not all interest deductions result in the same savings even for a constant level of interest paid. It depends on the homeowner’s effective tax rate. Bloomberg BusinessWeek gives an example on how $10,000 of mortgage interest saves $3,500 in taxes for a taxpayer in the 35 percent income tax bracket, while that same $10,000 of mortgage interest payments by a taxpayer in the 15 percent tax bracket saves just $1,500. For this reason alone, some argue that the MID results in greater benefits to the wealthy. I would hypothesize that the $1,500 in utility may be of more value to the 15 percent tax bracket individual than the $3,500 to the 35 percent taxpayer.
The USA Today authors reported that California, Hawaii, Maryland, Nevada, Virginia and Washington (which are states with comparatively high home prices) have average deductions exceeding $12,000 per year. Greater home values are associated with higher incomes. The benefit of the MID to those with higher incomes (and correspondingly larger tax burdens) would logically imply that more high-income individuals gain from the MID than those with less income. USA Today’s analysis found that approximately one-half of the total mortgage interest deducted was claimed by homeowners making more than $100,000 (that same group pays 73 percent of all income taxes). Homeowners making less than $50,000 are responsible for just 8 percent of the total MID deductions.
So what happens to property values if the mortgage interest deduction is negotiated away? Many studies have been completed (from the Brookings Institute to the National Association of Realtors®) finding that deletion of the MID would cause home values to sink from 6.9 to 15 percent. Wharton professor Todd Sinai estimates that a complete elimination of the MID would see an average annual tax bill increase of slightly greater than $1,000. But for individuals earning less than $40,000, eliminating the MID would see a typical average annual tax liability of $110. Those earning from $125,000 to $250,000 would lose a tax savings from the MID of $2,700. And for those making more than $250,000 would end up paying an average $5,400 more in annual income taxes if the MID were eliminated.
How much do I think that home values would decline? Take the $1,000 average annual savings from income taxes by the MID and capitalize it at reasonable cost of capital of 5 percent (equivalent to saying that value = annual income divided by an appropriate discount rate, In this case value loss).
$1,000 / 0.05 = $20,000 estimated loss in value
Now divide the $20,000 by the current median U.S. home price of $178,600 and the implied reduction in value is 11.2 percent. Since, however, a greater amount of the benefit of the MID flows to higher-priced homes, I would expect a greater value decline in the higher priced homes and less in the more moderate home price ranges.
If you want some additional detailed analyses and a review of issues regarding the MID and potential changes – and the strengths and weaknesses of some alternatives and changes to the MID — click here. This 41 page study from the Urban Institute and the Brookings Institution and assumes that the MID is effectively of greater benefit to the higher income segment. I do not agree with this assumption.
Just because a homeowner today does not benefit today from the mortgage interest deduction does not mean that the MID is of no value to them. Given the unprecedented deficits since 2009, we all know that tax increases will be in our future. And when taxes do rise, the MID will buffer that increase. Thus, with even no tax benefit today, future expectations give value to the MID for current and prospective homeowners.
My preference? Keep the MID as it is unless we have wholesale tax reform (either a flat tax or a sales tax). There are some individuals that, without the tax savings of the MID, would not be able to afford their current homes. And for others, just the shock-absorber effect of the MID to future marginal income tax rate increases is still valuable.
In full disclosure, I have paid off my house and have no loan and hence no MID, and yet I am still in favor of keeping the mortgage interest deduction intact.
Tell me what you think.
Ted