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 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.]
You don’t want to abruptly kill it, but yes, please start phasing it out. Most “average Americans” barely even see any benefit. Other countries around the world don’t have it (UK, Australia, France, Canada), and seem to get by just fine.
It just never made sense to me. Sure, let’s give people a tax break for taking on debt…and hey the bigger the debt, the bigger the tax break. What a great idea. Contribute to higher home prices and encourage people to become debt slaves while losing $70 billion in tax revenue annually (the vast majority of it from people who are well off). Yeah, that seems worthwhile.
The irony of making homes affordable to the middle class through subsidies like the mortgage interest deduction, is that we’ve done just the opposite. We’ve created a system of subsidies and extensions of credit to expand the number of borrowers which in turn has just inflated home prices. Our country has shown that it’s great at getting people to sign the dotted line and get them into a mortgage, but we seem to care very little about what happens after that. In the end we haven’t helped these lower to middle income borrowers, we’ve trapped them under a mountain of debt.
I don’t disagree with the homeowners that will be angry to pay more to the government, but I fundamentally disagree with the interest deduction. It incentivizes people to keep debt and not pay off their home. It disproportionately favors homeowners over renters. It’s also another factor pushing up and inflating home prices, while median wages have not increased over the last decade. People paint a scary scenario of house prices falling, but house prices need to fall to more reasonable levels. It’s better for people to pay lower prices for homes, and subsequently pay less interest, than to get a small return from the government on interest. I don’t think the government should use taxes as a means to encourage or discourage certain economic sectors, behaviors, etc, I would replace the interest deduction with an equivalent across the board tax decrease.
It just stuns me that borrowers don’t see the benefit of paying lower overall prices for housing from the elimination of the subsidy, rather than paying more, but getting a small tax return from the government.
Wow, what a proposal, intriguing at best, but very one sided.
That is the stupidest proposal I have heard, well right in there with eliminating Fannie & Freddie. Don’t even think these things in a severe housing recession unless you want a housing and banking depression. And, by the way, take me off your mailing list and forget any future business from me.
I can agree with the doing away with all tax lopeholes if and only if everyone pays a flat rate tax, equal to everyone across the board. lets just say 8% for federal and 2% for states.
I can just hear the complaining now, but the issue is not how much is taken from each american but how much the government is allowed to waste and spend on programs that benefit nobody except to keep a politician in office. Every time you turn around the current administration is trying some other method to dig deeper in to our pocket. The heart of the issue is that we the people are paying for retirement and medical programs for union members that we can not afford and shouldn’t have to pay. Why do they get special benefits as employees of the government and we the people have to pay into our own Social Security and medical programs. Why does a Congressman after only one term get a life long retirement and medical program? Who of the American people voted for them to have all that they take from us? When I earn a dollar it is money that I earned and it does not belong to the Government or anyone else.
The mortgage deduction remains one of the few tax advantages average working people have, and remains a major incentive of homeownership, growth of net worth, and economic stability.
Additionally, the mortgage deduction is needed as long as lenders use standard amortized loans requiring borrowers to pay the majority of interest up front rather than evenly distribute the interest over the term of the loan. Standard amortization schedules do not allow a borrower to acquire principle and net worth earlier in the loan cycle to help avoid a loan default during times of economic stress.
I like the idea of removing the interest deduction except for one minor “tweak”. Those with AGI of $50,000 or less get to deduct twice the amount of paid interest on owner occupied mortgages/homes. The $50,000 figure is arbitrary – I’ll let the “experts” decide if it should be more or less. The result would be to help the lowest level of the economy obtain the American Dream.
Thank you Patrick.
This is such a B.S. article full of opinion and short on facts.
Your article describes another elitist plan that will impose more of the country’s tax burden on the middle and lower income workers while denying them the benefit of home ownership. If the lenders will allow home loans to be assumed, property can still be transferred and if interest rates are lowered, more of the payment wil be used to reduce the principal which will provde less interest deductions. Property owners are also subjected to frequent increases in local taxes for schools and other services so they are paying their share. When renting, the landlord gets the tax deductions while the renter absorbs the cost of property ownership through rent.
Cash home buyers who are in the middle and lower income brackets are the largest group of homebuyers. Without the help with interest deductions to lower actual home payments there will be gigantic loss of ability of those less fortunate (who do not have $200,000 in cash) to purchase a home. Ability to pay is based, in a large part, upon the housing debt to income ratio. Removing the interest deduction from the equation will be the death knell of the lower income groups. And how do you come up with a “loss” of revenue to the government? The government didn’t have it in the first place.
I like you article but you’re completely off base in reality in my opinion. (I build and sell to low and very low income families whose dreams are to own their homes) and “raising” the monthly payment by disallowing the mortgage deductions deprive those families of homeownership, their dream!!
Interesting article. However, The world situatation was different in 2000 so how can we say what happened in the UK then would happen with us now. And,who says the people in the US don’t want to give up entitlements. I think the majority do want cuts in spending and waste. I feel our government is out of control in areas and non existant in others. Why not look at restructing government instead of increasing taxes?
What a goulash of thought. Some of it defying the rules of logic ” It would seem, then, the elimination of the tax loophole actually helped increase the country’s homeownership rate — and broker fees — since prices were driven by more demand.”
Let’s return to yesteryear, when in 1986, Regan gave the dollar sucking Democratic Congress tax reform including the elimination of the capital gains. The great SUCKING sound was money lost to investor’s ( homeowners AND business). Real Estate did not recover until 1998!!! Be very careful about messing with the tax code, you will most likely NOT get the desired effect.
But MOST IMPORTANT – Congress has NOT EARNED the right to CONFISCATE more of our money. The people keep electing sycophantic dollar vampires. And this author wants to offer more of OUR TREASURE to those self-serving scumbags that populate the houses of congress.