Greg Fielding's  Instablog

As a recommended reduction in the recent deficit commission proposal, the mortgage interest deduction has once-again come under fire. Good.

The mortgage interest deduction is a subsidy that takes money from every single American and gives it to banks, home-builders, and real estate agents. The deduction is both economically and morally flawed and should be eliminated as quickly as possible.

Naturally, industry and lending groups who directly benefit from the subsidy are lobbying hard to maintain the status quo, spinning the facts to suggest that what's best for them is also best for society as a whole. Calls-to-action have begun.

What is the Mortgage Interest Deduction?

The mortgage interest deduction is a federal tax deduction where property owners can deduct mortgage interest paid from their taxable income for both primary residences and second homes.

However to take advantage of the deduction, taxpayers must itemize their deductions, something that generally only wealthier taxpayers do. The rest of us are usually better off claiming the standard deduction, which in 2009 was $11,400 for married couples. The value then of the deduction to most taxpayers is their total itemized deductions, minus $11,400, times their marginal tax rate. Obviously, those with higher incomes, marginal tax rates and more mortgage interest benefit disproportionately.

For example, if a married couple's itemized deductions totaled $17,400, minus the standard $11,400, that's an additional write-off of $6,000. At a 40% marginal tax rate, that's a $2,400 subsidy. By giving generally-wealthy homeowners the mortgage interest deduction, taxpayers are, in effect, subsidizing that portion of the borrower's mortgage.

In the example above, there is $2,400 less tax revenue collected from that homeowner, which is a de facto tax on every other taxpayer to make up that amount. For 2012, the federal government estimates the the deduction will cost taxpayers $131 billion.

Making Homes Less-Affordable

But, the cost of the mortgage interest deduction is far greater than just $131 billion. Ron Phipps, President of the National Association of Realtors® states:

“Recent progress has been made in bringing stability to the housing market and any changes to the MID now or in the future could critically erode home prices and the value of homes by as much as 15 percent, according to our research."

In other words, home prices are as much as 15 percent HIGHER because of the deduction. All of us, homeowners and renters alike, are being forced to OVERPAY for shelter by "as much as 15 percent."

If the goal of the mortgage interest deduction was to make housing more affordable, the result has been the exact opposite.

If Americans were polled and asked if the would prefer itemized mortgage interest deductions as they are, or the standard deduction and be able to buy their home for 15% less, the overwhelming majority would choose to scrap the mortgage interest deduction.

What is the Purpose of the Mortgage Interest Deduction?

Like all subsidies, wealth is transferred from one group to another for a specific purpose. In this case, wealth is transferred from taxpayers to homeowners with big mortgages - or more specifically, to the banks where the larger mortgage payments are then made...but for what purpose?

Agricultural subsidies, for example, transfer wealth from taxpayers to farmers to help ensure that we have a ample food supply regardless of drought, floods, or fluctuating world food prices. Finer points can be debated, the purpose is clear and there is definite societal value in a sufficient national food supply.

So what is the social value in the mortgage interest deduction? What are the benefits that make the $131 billion and 15% higher home prices worth it? In a letter addressed to the deficit commission, National Association of Realtors® President Ron Phipps warns:

Never dismiss or underestimate Americans’ passion for homeownership, notwithstanding the current crisis. Calling homeownership the "American Dream" is not a mere slogan, but rather a bedrock value. Owning a piece of property has been central to American values since Plymouth and Jamestown. Homes are the foundation of our culture, the place where families eat and learn together, the basis for community life. The cottage with a picket fence is an iconic part of our heritage. Do not take that imagery or that passion lightly.

The tax system does not ―cause homeownership. People buy homes to satisfy many social, family and personal goals. The tax system facilitates ownership. The tax system supports homeownership by making it more affordable.

First off, by Phipps' own admission, the mortgage interest deduction makes homes 15% more expensive, not more affordable. Second, despite Phipps' denial, the "American Dream" as homeownership is exactly a marketing slogan, pushed by NAR and other industry groups for the last 30 years.

But, does this tax system actually facilitate homeownership? The vast majority of homeowners would probably still own a home if they used the standard tax deduction instead. Granted, some might buy less-expensive homes, but only a fraction would otherwise be renters.

Is there really much value to society in some people buying marginally more expensive homes? Or in getting a few more people to buy instead of rent? Enough to justify 15% higher home prices?

The History of the Mortgage Interest Deduction

Ron Phipps writes:

"The tax deductibility of interest paid on mortgages is a powerful incentive for home ownership and has been one of the simplest provisions in the federal tax code for more than 80 years.

Though technically, sort-of true, the spirit of the law was never to actually subsidize home-ownership until quite recently.

When the first modern federal income tax was created in 1894, all interest was deductible. This was struck down by the Supreme Court as unconstitutional, but the constitution was amended and all interest was deductible again in 1913.

Homeownership was certainly not on politicians minds because residential mortgages didn't yet exist. Nearly all interest paid in those days was business expenses. The landscape changed in the 1930's and the birth of Fannie Mae. Homeownership rates began to grow with the new availability of financing. By 1960 the homeownership rate reached 62%. It was in the 1970's, when credit cards became popular, that changing the interest deduction was first considered.

Roger Lowenstein writes in The New York Times:

In any case, the growth of credit cards in the 70's began to turn the interest deduction into a serious loophole. People were becoming plastic junkies; if you paid for a washing machine on credit, the I.R.S. would give you a subsidy. By the 1980's, this threatened the entire system of revenue collection. There was some talk that the Treasury was looking at eliminating deductions, including, possibly, the interest deduction. Economists thought it was a good idea. "Tax economists tend to be skeptical about preferences in the tax," says Joseph Thorndike, the director of the Tax History Project at the nonpartisan Tax Analysts. "Are they targeted to the right people? We give tax breaks for college; do we send more kids to college or help middle-class kids who are going to college anyway?" Fine and well, but was an elected official really going to risk fooling with the mortgage deduction?

President Reagan was not. Addressing the National Association of Realtors in 1984, he said, "I want you to know that we will preserve the part of the American dream which the home-mortgage-interest deduction symbolizes." He didn't mention that it also symbolized the American love affair with debt; after all, it encourages people to pay for their homes with a mortgage instead of with equity. Two years later, in the tax-reform act of 1986, Congress ended the deductibility of interest on credit-card and other consumer loans; it left the mortgage deduction in place.

But Congress did set a cap. Today, a taxpayer can deduct the interest on mortgages worth up to a total of $1 million on his or her first or second homes. Also, you can deduct up to $100,000 on a home-equity loan. (And what prevents you from using a home-equity line to buy a flat-screen TV and then deducting the interest? Absolutely nothing; go for it.)

In reality, it was not until 1986 that the mortgage interest deduction was singled out as a stand-alone subsidy. Is High Homeownership Even Good? Beginning with Reagan, and accelerating through Presidents Clinton and Bush, the federal government has promoted homeownership versus renting. Unquestionably, some of the policies passed through these years contributed to the housing bubble and bust. But, on a society-level, is a high homeownership rate a even a good thing? Certainly, a mobile workforce is more dynamic than a workforce where people can't move as easily. Also it makes little sense economically to have so much wealth tied up in such an illiquid asset as a house. That's money a renter could have used to pay for schooling or start a business. Others would argue that higher homeownership rates help stabilize communities and bring a host of other iconic, intangible goodies to the table. But, common sense suggests that it is commitment to a community, rather than commitment to a mortgage that brings those positive externalities. Felix Salmon writes:

For me, it’s important to distinguish between two things which are separate, if highly correlated: homeownership, on the one hand, and the amount of time that you expect to stay in your home, on the other. A lot of the rhetoric about the upside of homeownership elides these two things; and for a long time doing so made perfect sense. After all, someone with a 30-year mortgage is likely to stay put for much longer than someone with a 1-year lease.

...

So it seems to me that owners, with shortening time horizons, are less likely now to do things like install high-efficiency appliances and invest time and effort into their local schools, while renters, with lengthening time horizons, are more likely to. Probably homeowners still score higher on the positive-externality front than renters do, but the difference is narrowing.

...

My feeling is that a lot of what we’re seeing is related to rental properties generally being designed for and marketed to the childless, while families, who tend to stay put if only to give the kids continuity, are more likely to own and to build up real local communities. Parent-teacher meetings are a great way of getting to know your neighbors. But if and when families start to rent nice places, they’re just as likely to build strong communities as those who own. It’s not homeownership that creates the positive externalities, so much as simply intending to stay where you are for a while.

Has the Mortgage Interest Deduction Resulted in Higher Homeownership Rates?

While homeownership as public policy can be debated at length, the issue here is that the mortgage interest deduction is being sold to us, in part, as a policy that facilitated homeownership. Does it?

Consider this chart, via Carpe Diem. The majority of these countries do not have any form of home mortgage interest deduction. The notable exceptions beyond the United States are The Netherlands, Sweden, Switzerland, and India, which all have some variation of deduction.



The U.S. is on par with England, Canada, and Australia, none of which have a deduction. Clearly the mortgage interest deduction does not foster homeownership. It is Time to End the Mortgage Interest Deduction The mortgage interest deduction:

• fails to make housing more affordable and in fact caused housing to more expensive for everyone
• fails raise homeownership rates
• costs taxpayers over $100 billion per year
• disproportionately benefits the wealthy
• is not an 80-year-old sacrosanct pillar of our economy
• only exists today because of industry lobbying efforts in the 1980's
• primarily benefits real estate agents, mortgage lenders, home-builders and banks as higher home prices and loan amounts create higher commissions

Even the wealthy with large deduction amounts would probably prefer to simply pay less for their homes.

A Practical End

The deficit commission proposal was refreshing because it addressed the mortgage interest deduction, among many other proposals, which most politicians wouldn't touch with a ten-foot pole. Specifically, the panel called for a a cap on deductions for mortgage amounts beyond $500,000 - hardly the end of the world.

Falling home prices aren't the problem, they are the solution. Excessive debt is the real problem. Policies that encourage debt, like the mortgage interest deduction, facilitate the illness, not the cure.

Even the National Association of Realtors® knows that the mortgage interest deduction is a crap policy. Shockingly, the straightest answer came in 2005 from then NAR economist and infamous spinmeister David Lereah. Form the Times article:

If you scratch deeply enough, not even the real-estate lobby thinks that the interest deduction makes much sense economically. It's just a goody that homeowners, not to mention real-estate agents, have grown used to. Lereah, the economist for the National Association of Realtors, said: "If you're rewriting the book of Genesis, I might have a different approach. But if you make changes in the middle of the game, it's going to have a negative impact of the value of property . . .reduce people's retirement nest egg, funds they have available for college. You're going to cause a great dislocation."

As much as it kills me to say it, David Lereah was right (about this and this only) - this would cause a great dislocation.

So where to from here?

The only practical solution is a gradual phase-out. The $500,000 cap is a reasonable place to start. Homeowners with big mortgages won't be happy about this, but that doesn't mean it isn't the right thing to do.

Disclosure: None Mentioned