How will the reduced mortgage interest deduction impact California’s housing market?

  • There will be no impact. (44%, 88 Votes)
  • Home sales volume and prices will fall. (31%, 61 Votes)
  • Home sales volume will fall. (15%, 29 Votes)
  • Home prices will fall. (11%, 22 Votes)

Total Voters: 200

The mortgage interest deduction (MID), long the politician’s poster child for homeownership, has taken some hits in recent months.

The MID has been under fire by Democrats for years for disproportionately benefiting wealthy homeowners. But no one really thought it would actually go away or be reduced — after all, homeownership is the foundation of the American Dream, and lobbying by the National Association of Realtors (NAR) has ensured the MID is tied inextricably with that dream.

But then the unthinkable took place and the MID was reduced — and not by Democrats, but Republicans. How did that happen?

2018 Republican tax changes introduced a number of tax cuts that will reduce federal tax revenue significantly in the coming years. For example, the threshold before estate tax is taxed is double under the 2018 plan, and wealthy individuals will need to inherit more than $11.2 million (or $22.4 million for joint filers) before their estate is taxed. Another tax cut is the lower tax rates in 2018 (though these will pay for themselves in future years once inflation adjustments kick in).

In order to pay for these cuts and others, legislators needed to find money elsewhere. One way was to limit state and local income tax (SALT) deductibility to $10,000. Another way was reducing the ceiling of the MID so that less interest will be deductible.

Remind me — what’s the MID?

The MID allows homeowners with a mortgage to deduct the interest paid on their mortgage in a given year. This means a person with an annual income of $100,000 who paid $10,000 in mortgage interest in 2018 will be able to deduct the interest paid from their income to be taxed at their new income level of $90,000.

That’s the simple version. In practice, there are limitations on how much and the type of mortgage interest that may be deducted. There are also other considerations to keep in mind, like whether the mortgage interest paid plus other deductions exceeds the standard deduction taxpayers are entitled to.

The MID is an itemized deduction, meaning the homeowner needs to choose between taking the standard deduction and claiming individual deductions — itemizing. In addition to the MID, other itemized deductions include:

  • medical expenses;
  • charitable contributions;
  • qualified student loan interest;
  • mortgages points purchased at the time of origination; and
  • SALT taxes.

How to qualify for the MID in 2018

Mortgage interest is deductible from income as an itemized expense when the mortgage:

  • funded the purchase price or paid for the cost of improvements to the owner’s principal residence or second home; and
  • is secured by either the owner’s principal residence or second home. [Internal Revenue Code §163(h)]

For mortgages originated after December 14, 2017, only interest on the first $750,000 of mortgage qualifies for the MID. Mortgages originated prior to this point were allowed to take the MID on interest from mortgages up to $1 million, plus an additional $100,000 in home equity lines of credit (HELOCs), regardless of how the home equity funds are used. [IRC §163(h)(3)(f)]

Now, homeowners who wish to take the MID on the interest paid for HELOCs are severely limited. This includes homeowners who took out a HELOC in 2018 and even in previous years. Unlike for mortgages used to purchase a primary or secondary residence, old HELOCs are not grandfathered in for the MID in 2018.

In order to qualify to take the MID in 2018, the home equity mortgage needs to be used to substantially improve the residence securing the HELOC. When the HELOC is used for other purposes (e.g. to pay college tuition, go on vacation or buy a jet ski), the interest is no longer deductible.

Further, interest deductions on home mortgages are only allowed for interest which has accrued and been paid, called qualified interest. [IRC §163(h)(3)(A)]

The new rules sunset after 2025. Beginning in 2026 — and absent any further changes —the old rules which allowed mortgage interest to be deducted on mortgages up to $1 million and HELOCs up to $100,000, regardless of their use, will apply. [IRC §163(h)(3)(f)(ii)]

How the change will impact Californians

In California, roughly one-third of taxpayers have claimed the MID each year, or a little more than half of the state’s homeowners (which is around 2/3rds of homeowners with a mortgage, according to Pew Charitable Trusts.

However, under the 2018 tax plan, the share of Californians taking the MID and the benefits from doing so will drop significantly. This isn’t just due to the lowered ceiling on the MID, either.

In order to take the MID, it needs to make sense for the homeowner to itemize their taxes. But beginning in tax year 2018, the standard deduction will now be about twice as high as earlier years. For a couple filing jointly, the new standard deduction is $24,000, up from $13,000.

Further, it’s going to be more difficult to exceed that standard deduction because SALT taxes are now limited to just $10,000 per tax return. This is the same ceiling for individuals or those filing jointly. Other deductions you may have itemized in previous years are also now limited or eliminated, including moving expenses for all those except for military members.

Related article:

2018 changes to tax deductions

Now, if you were living in a state where the standard of living and thus incomes were lower — perhaps a southern or midwestern state that regularly votes Republican — you might not be too concerned. After all, individuals in these states rarely see their SALT bills higher than $10,000 or their mortgages higher than $750,000. But in California, it’s a very different story.

In fact, California’s high home values and high SALT bills make it the state most negatively affected by the tax changes. For example, the average SALT bill in California is about $18,400. Now that the ceiling is $10,000, that’s an additional $8,400 in taxable income the average Californian will now pay compared to previous years.

The result of less reliance on the MID

The reduced value of the MID will be mostly absorbed as a loss for the seller. Since less mortgage interest is deductible, savvy homebuyers will invest in down payments that make up a higher portion of their purchase amount in order to keep their mortgages below the $750,000 threshold.

Homes for sale in the high tier will feel the greatest pull back on home prices, as large mortgages are no longer beneficial from a tax perspective.

For example, consider a home listed for sale for $1 million. An interested homebuyer has 20% or $200,000 available for a down payment. If they offer the full asking price, they will be able to put 20% down and avoid the extra expense of mortgage insurance, but their mortgage principal will be $800,000 — $50,000 above the MID ceiling. Their interest won’t be deductible on the additional $50,000 over the ceiling amount. Thus, unless they can increase their down payment to $250,000, it’s in their best long-term interest to ask the seller to reduce their price to $950,000.

Other than these less common cases, the impact on the housing market will be slight. Homebuyers and sellers operating in the low- and mid-tier price range will not be affected by the MID change in the slightest. Further, the desire for homeownership will propel those in the high tier to continue to buy homes, regardless of the tax consequences.

Agents and brokers — what do you think the impact of the MID change will be? Answer the poll above and share your thoughts in the comments.

Related article:

Income bracket changes under 2018 tax plan