The MID truth test

This article examines the arguments for protecting the mortgage interest tax deduction (MID), reveals who truly benefits from the subsidy and questions both its viability and actual use as a marketing tool by real estate brokers and agents.

They doth protest too much

One of the most contentious debates in the real estate industry is over the mortgage interest tax deduction (MID). Arguments on this issue quickly turn political, with MID proponents coming from the right’s low-/no-tax camp and those rallying for repeal of the deduction firmly entrenched on the high horse of the left.

Proponents of the MID argue it:

• stimulates homeownership;
• provides tax relief for the middle-class; and
• generally limits the government’s reach into the taxpayer’s pocket.

Advocates for repealing the MID argue it:

• inflates housing prices;
• subsidizes lenders by encouraging greater amounts of mortgage financing,with the most benefit received by the highest bracket taxpayers who purchase high-tier, highly-leveraged properties; and
• ultimately provides little to no tax relief for the middle-class, instead benefiting buyers of high-tier properties with much higher than average incomes.

Related articles:

Subsidizing the American Dream

The home mortgage deduction: inducing debt and stifling mobility

The submerged subsidy

Surprisingly, despite all the heated rhetoric and political hoopla that surrounds the MID, recent studies have shown that many homeowners and real estate professionals do not know how the tax deduction works. Apparently no one advised them (or anyone else) on the tax savings they might receive.

57% of Americans reported they had never participated in a government-run social program, according to a 2008 study by the Cornell Survey Research Institute. The participants in the survey were then asked to review a list of 21 social programs, including the MID, and to revise their responses.

Upon review of the list, 94% of the group was found to have participated in at least one social program. A later study by the same organization revealed that 60% of respondents were unaware that the MID was a social program organized and run by the federal government to encourage homeownership.

Related article:

The Cornell Research Institute: Reconstituting the submerged state: the challenges of social policy reform in the Obama era

This fact largely extends from what Cornell analysts call the submerged state. The concept refers to the subtle operation of many government social programs that are designed to remain unseen, yet act as an avuncular nudge toward action by the government (read: encourage homeownership).

The MID is government assistance

The MID is a signal example of a submerged subsidy — it takes the form of a rebate, but in fact relies on the generation of tax revenue from other sources to cover the amount of tax the mortgaged homeowner avoided.

First, the fundamental character of the MID must be recognized — it is a social program, facilitated by federal and state governments and funded by taxpayers. Yes, it results in “tax savings” for those who qualify, but the revenues elided by the deduction must be replaced by revenues reaped from someone else. Unfortunately, this supplemental tax revenue is largely culled from those who do not qualify for the deduction: renters and cash buyers, since they must pay more in taxes than the mortgaged homeowner.

The political rhetoric has grossly obscured the reality of the MID. Proponents of the deduction lump it in with the ideology of limited government, when in fact it is a government subsidy that redistributes personal wealth via mortgaged homeownership versus all other arrangements for shelter.

The standard deduction is standard

Many homeowners opt for the standard deduction, which is nearly $12,000 for a married couple filing jointly in 2012. Also, 40% of all reporting taxpayers pay no income tax since their earnings are so low.  As homeowners, they receive no MID benefits.

Thus, those who take the itemized deduction are financially savvy taxpayers, with a sizable mortgage, in the early years of their amortization schedule. We are mindful they also have significant expenditures that qualify for the deduction and that they are often affluent members of the upper-middle class or the one percent (see above, charitable contributions!).

Related article:

The Reason Foundation: Unmasking the mortgage interest deduction: who benefits and how much?

So, given the fact that the MID benefits few average homeowners, what is all the hubbub about? Notice that you do not see typical suburban homeowners clamoring in the streets to protect the deduction. Rather, those who squawk the loudest are two groups: builders’ associations and real estate trade union members.  Mortgage lenders and their lobbyists are in the background doing most of the heavy lifting on this front, since they stand to benefit the most from inflated mortgage principals and increased buyer leveraging.

Subsidizing lenders, benefiting builders

The average tax savings for the owner of a low- to mid-tier single family residence (SFR) is around $1,400 a year — and this much savings only applies at the beginning of the amortization schedule. Remember, the less a homeowner pays in interest in a year, the less they “save.”  Cash buyers (and tenants) simply pay more taxes.

Of course, the possibility of saving anything by way of the MID requires the homeowner to itemize their tax deductions. Whether or not the homeowner opts to itemize depends on the amount of their income, the total amount of purchase-assist loan principal and whether they have other expenses that qualify for the deduction, such as:

• charitable contributions;
• medical expenses;
• home property tax; and
• home mortgage interest.

Builders have good reason to advocate for the deduction, for their artificially increased profits depend on it. Residential builders have two building options:

• multifamily units, which are eventually sold to investors and occupied by tenants; or
• SFRs, which may be either detached homes, or attached condo units built for resale to owner-occupants.

Builders turn a much a greater profit on the sale of SFRs thanon multifamily units. SFRs are sold exclusively to working individuals and families, interested in pride of ownership and the hallowed pursuit of the inculcated American dream (their very own piece of paradise). Multifamily units (apartment buildings in particular) are sold exclusively to investors. That is, they are sold to individuals or corporations interested in profit — sophisticated professionals in the real estate industry.

Liberated from the emotionally misleading pride-of-ownership suffered by homebuyers, these investors will not pay a dime over the price they set based on an expected capitalization rate (cap rate), a price ultimately determined by market rents. Homebuilders need the MID to remain firmly in place in order to extract greater profits from the momentum pricing paid by owner-occupants in new SFR sales – it’s the mortgage that tops off the price, not the buyer’s cash on hand.

Savings are offset by prices

Price inflation resulting from the MID is paid upfront in the purchase price, an arbitrage with the cash-for-profits going directly to builders, and subsidizing lender profits by way of larger mortgage amounts.  Any and all “savings” that purportedly go to the buyer are spent up front to pad the profits of builders first by an excessive price, lenders second through more and larger mortgages and real estate brokers/agents third with percentage fees on the excessive price. Everyone, arguably, is benefiting from the overleveraging, except taxpayers without a mortgage.

Then the government essentially reimburses the homeowner over the first ten years of their mortgage by allowing tax deductions for interest, mortgage insurance and property tax and tax-free profit on the later sale. This is all conditioned on the buyer having the financial wherewithal to itemize. For those who do not itemize, well, they have just made a donation to the builders, lenders, brokers and homeowners who do reap the benefit of the deduction.

The undisclosed subsidy

first tuesday has reported extensively on agent and broker culture, including the near absolute reluctance to disclose legal and tax information to their clients for perceived fear of somehow engaging in the unauthorized practice of law or accountancy. As we have made clear on several occasions, the notion that a licensed real estate agent is not authorized to discuss the tax benefits of a transaction is a gross misunderstanding of the agent’s fiduciary duties and legal obligation to share such information, when known and to the extent known, with their client. The duty is to give the client a “heads up” to prevent surprise in the future – why didn’t you tell me? Never have to say you are sorry! 

Nevertheless, the misunderstanding about agent conduct persists today reflected in deception by silence. In light of this fact, it seems like a glaring contradiction to argue that repealing the MID will affect home sales volume when essentially all SFR/MLS agents operate under the misconception that they are disallowed from discussing the tax benefit during marketing and negotiations and thus do not. [Carleton v. Tortosa (1993) 14 CA4th 745; Calif. Civil Code §2079.16]

Related article:

Real estate licensees and the unauthorized practice of law

Marketing the subsidy (or not)

An effective litmus test for whether the MID is used during the marketing and negotiation periods is to look at the marketing materials used in the industry. None of the hundred or so so-called standard forms published by the real estate trade union provide an opportunity for the client or his agent to calculate the expected tax savings of ownership. Rarely, if ever, does one see a FARM letter or listing advertisement touting the tax benefits of purchasing a home.

Real estate professionals, most especially brokers, are educated on the tax benefits of ownership and most keep abreast of current tax law as a matter of continuing education — courses focusing on §1031 reinvestment being all the rage this past decade.  Yet, this information (along with material legal information) is almost invariably cloistered from the client’s view.

Instead of functioning as an indispensable marketing tool for SFR broker and agents, the MID is relied upon as a foggy notion of ownership benefits, disseminated among the public as “common knowledge” and unquestioned as an essential component to realizing the American Dream.

If the tax deduction is so crucial to the continued growth and profitability of the real estate market, why then is it not discussed in detail with homebuyers? Perhaps it is because the truth isn’t quite so seductive.