This article identifies the origin of the tax loopholes used to implement the nation’s housing policy, and proposes a tax benefit which rewards homeownership without first requiring a mortgage debt or resale.

Housing subsidies encourage indebtedness and transience, not homeownership


America is slowly climbing out of the doldrums of an historic financial crisis into economic recovery, and the plight of the California homeowner is glaring. Vacancies, foreclosures and related trappings have invaded the once-booming suburbs. Homeowners saw the prices of their homes skyrocket during the Millennium Boom, only to be traumatized by the loan defaults which followed close behind.

The multiple listing service (MLS) housing market is desperately grasping at willing and able homebuyers and sellers. Homebuilders are anxious and idle while the excess housing produced by the 2000 construction boom sits vacant, awaiting tenants and buyers. Brokers are eager to generate leads (buyers and users) that will turn into fees, and lenders have frantically reined-in their loose lending by only funding government-guaranteed fixed-rate mortgages (FRMs).

Brokers, lenders and builders alike contributed in their own way to the present decline in homeownership (a drop from 60% to 56% over just the past four years in California). Now all three are doing everything they can to encourage an increase by fighting for legislation they believe will support their interests.

The allies they claim are the housing subsidies imbedded in the tax code, known as:

  • the mortgage interest tax deduction; and
  • the principal residence profit exclusion.

Those homebuyers who take on home mortgages up to $1,100,000 can deduct all interest they pay on those mortgages to reduce their taxable income and thus their income taxes. Conversely, homeowners who wish to sell and terminate homeownership can exclude up to $250,000 of profit per owner from being taxed. While these “housing policy subsidies” were not enacted to induce the population to buy or own a home, that hasn’t stopped the real estate industry from using them to its financial advantage. Real estate industry professionals describe them as catalysts of the American dream. They posit these tax policies induce homeownership by making it more financially feasible through a subsidy. [Internal Revenue Code §§121; 163(h)]

The result of these tax loopholes, however, has not been increased homeownership but rather an increase in mortgage indebtedness and home resales. Homebuyers are encouraged to finance their purchase with a mortgage since acquiring a home free and clear of debt and retaining it as the family residence triggers no tax benefits (except deductible property taxes, if they are not subject to the alternative minimum tax).

As a result, homeowners often justify their debt by relying on the mortgage interest tax deduction to help bear the additional costs. Thus, the homeowner is betrayed by the so-called “subsidy” these tax deductions provide since the deductions influence the homebuyer to pay an increased price for his home. Unfailingly,  the subsidy is too small to offset the increased costs and risks of the larger mortgage he needs to finance the purchase of the property.

The interest deduction’s legacy

Interest deductions took root in the late 19th century. The first federal income tax was established in 1894 and all forms of interest were deductible. However, homeownership was not what motivated Congress to enact such a policy. An interest deduction was viewed primarily as a business situation.

Most people at that time in history paid cash for their homes (as is the case today in countries with less sophisticated financial systems), and mortgages were generally only taken out by farmers or investors. Not until the 1950s did the home mortgage gain anything close to its current significance. Since then, the home mortgage has become the going concern of the housing industry, and the tax deductions and exclusions are considered entitlements for those homebuyers who must borrow and for those who sell.

The true tax benefits of interest rate deductions were lost long ago — arbitraged away — by increased pricing and interest rates which pass them on to the seller (increased price) and the lender (increased interest and charges).

The true tax benefits of interest rate deductions were lost long ago.

The interest deduction loophole costs the Department of Treasury over $70 billion in lost tax revenue annually, but the majority of debt-encumbered homeowners don’t see much for it. Of the tax filers who are homeowners, only half are able to claim the deduction and usually receive less than $2,000 in reduced tax liability (the rest have no mortgages and thus no risk of loss). More than 50% of the benefit is taken by those with incomes exceeding $100,000, and it is fair to say those homeowners have the least need for a subsidy. [For more information about the mortgage interest tax deduction, see the New York Times article, Who needs the mortgage-interest deduction? ]

Ironically, real estate agents and brokers have long avoided giving tax advice about the benefits of owning a home. Legally, a buyer’s broker has no affirmative duty to disclose or discuss the tax aspects of the purchase of one-to-four unit residential property even if the broker knows the tax rules and their impact on the homebuyer. This being so, most agents are instructed by their brokers to refrain from explaining the tax aspects of a transaction as part of the dumb agent rules. Most homebuyers are thus given no expectation by their agent about the benefit a mortgage interest tax deduction or principal residence resale profit exclusion provides. [Carleton v. Tortosa (1993) 14 CA4th 745; Calif. Civil Code §2079.16]

Why is the real estate industry fighting so hard to protect the mortgage interest tax deduction? The answer is simple: fear of change resulting from their lack of information. Brokers and agents have always had the housing subsidies as a fall-back incentive for homeownership. What will happen to sales volume if we eliminate it is fairly predictable, but the gatekeepers of real estate are not willing to take the risk.

Initially, sales volume and prices (along with mortgage fees) will drop slightly — the elimination of the arbitrage — as the tax benefit will no longer be received by the buyer to pass on to sellers and lenders. However, sales volume and prices will only slip for so long, if at all. It usually takes around 12months for sellers to “un-stick” their prices and adjust them to reality in any recession. [For more information about the sticky price phenomenon, see the December 2009 first tuesday article, The flat-line recovery: a side-effect of sticky housing prices.]

Change will benefit the homeowner

As the post-recession plateau recovery continues, the national economy tiptoes on the brink of unprecedented personal and governmental debt levels. Accordingly, economists are frantically trying to deleverage and restructure the U.S. debt in a way voters can stomach.

The consuming and job-holding population is also shedding debt. Strategic defaults by negative equity homeowners are part of the deleveraging process.

Historically, countries in a similar predicament have chosen to either default (Russia, Argentina and Mexico) or inflate their way out through collaboration with their central bankers (Venezuela and Argentina). The United States cannot engage in either of these approaches primarily because we are a wealthy country and the national debt is mostly short-term in nature. Thus, the government is left with two options: cut spending or raise taxes. [For more information about how the Federal Reserve (Fed) views the current economic conditions, see the St. Louis Fed’s article, Fiscal policy and expected inflation.]

Governments need money to operate and provide the services everyone demands of their local representatives. Citizens are refusing to allow spending cuts or the restructuring of the massive entitlement programs which the government has contracted to provide for them: defense and security, health, education and general welfare.

Worse, since 1980 we have abandoned the “pay as you go” approach to government spending which only encourages citizens and politicians to spend. Instead, we now borrow money from Wall Street bankers and bond holders to fuel programs we demand of our government but do not see fit to fund by taxation — at least until now. The U.S. government owes $2 trillion to Japan and China alone! This has led directly, with the help of divisive mortgage lending, to the worst financial crisis and recession since the Great Depression.

As we recede from the housing crisis, policy changes are inevitable. In these moments, the government has an opportunity to correct past mistakes and move forward with a stronger, wiser plan. Those who prepare and embrace these changes will see their businesses flourish.

Our only option to meet this end is to raise taxes — the topic of a candid conversation nobody is having. If Congress insists on a tax-funded housing policy, we at first tuesday propose:

  • an elimination of the tax loopholes presently available to homeowners; and
  • the replacement of these loopholes with a flat-rate annual deduction based solely on owning the home occupied by the taxpayer.

That will change the collective attitude about mortgage debt, while keeping brokers and builders happy. Lenders, however, will not take kindly to the results.[For more information regarding the mortgage interest tax deduction, see the March 2010 first tuesday article, Getting rid of housing subsidies: the mortgage interest deduction and the December 2010 first tuesday article, The mortgage interest tax deduction imbroglio — the squabble continues.]