The McMansion Tax Break
Taxpayers can deduct interest on loans of up to $1 million used to buy one or two personal residences.
Question 1. Ask the Candidate:
Would you limit the tax break for home mortgage interest so that it subsidizes the purchase of one basic home? Would you redirect some of the tax savings to help qualified renters purchase a basic home or to help lower-income homeowners keep the home they have?
About two-thirds of all households are homeowners.
"The Higher the Tax Bracket, the Better the View."
—advertisement for luxury Florida property
"The most fortunate of men,
Be he a king or commoner, is he
Whose welfare is assured in his home."
—Goethe
We all know how important it is to have a secure and affordable home. Congress knows the advantages to society if neighborhoods are stable and if residents take responsibility for their property and community life. Homeownership, so integral to the American dream, serves both goals. Furthermore, owning a home usually is a good investment, notwithstanding the recent subprime debacle.
It should not surprise us, therefore, that Congress would wish to provide tax incentives aimed at increasing the number of homeowners. But the considerable tax breaks for homeownership, while highly popular, make neither social nor economic sense.
The three largest tax breaks--the deductions for mortgage interest on up to two homes, property taxes on any number of homes, plus the tax exemption for the gain you realize when you sell your principal home--saved homeowners a staggering $113 billion in 2006 alone.[1] Yet the great bulk of those tax savings went to people who could easily afford to own a home without federal assistance. Nowhere is this more apparent than with the mortgage interest deduction, by far the largest subsidy, which extends to home mortgages totaling as much as $1 million per taxpayer.
Helping the Comfortable To Live More Comfortably
Yes, this deduction allows well-off people to deduct the interest on one million dollars worth of loans to buy, build, or substantially improve up to two residences they use personally--a principal one and a secondary one. The entire $1 million might be used to buy a co-op on Manhattan's Upper East Side, or an eight-bedroom behemoth on two acres in Milwaukee, or a spacious house in a Charlotte suburb plus a condo at the beach.
A $1 million mortgage means that the price for the home (or homes) is well over $1 million--the sum of the mortgage plus the down payment. These are homes that only people who already live comfortably can afford. Their 7% interest payment on a $1 million loan can produce a $70,000 deduction.[2] That's a nice little sum. And high-income households use the deduction to shelter income that otherwise would be taxed at high rates. For example:
Consider Cathy, an executive who bought a suburban palace just outside Oklahoma City. Last year she deducted $45,000 in mortgage interest against income that would have been taxed at the 33% tax rate. Her office clerk, Ed, with the salary you'd expect and a 15% tax rate, deducted $10,000 of interest on his two-bedroom bungalow.
When tax time comes, Cathy saves $15,000 (33% x $45,000). Ed saves $1,500 (15% x $10,000). Yes, Cathy pays 4.5 times more interest, but saves 10 times more taxes.
Who Gets the Money?
In 2006, the mortgage interest deduction saved homeowners, as a group, a total of $66 billion on their federal income tax returns. All of the savings went to homeowners who itemized their deductions--only itemizers may claim the deduction; and only 35% of all taxpayers itemize. Now, you certainly are wondering, to whom did the government happen to give that $66 billion?[3]
| Taxpayers | % of Tax Savings | Share of $60 Billion Tax Savings |
| Bottom 52% (income less than $40,000) | 2% | $1 billion |
| Top 48% (income at least $40,000) | 98% | $65 billion |
[all figures have been rounded off]
Moreover, the top 3% of income earners, with at least $200,000 of income, got $20 billion of that $66 billion of tax savings, which happens to be 20 times as much as was saved by the bottom 52% of taxpayers.
Economists Don't Think the Deduction Works
You may be surprised to learn that major studies on the economic impact of tax breaks for homeowners conclude that our economy would likely be stronger, not weaker, if we reduced the tax breaks, especially for owning expensive homes. As noted by President Bush's Advisory Panel on Federal Tax Reform in 2005 (the "Advisory Panel"), "The disproportionately favorable treatment" of personal residences under the tax laws "may result in too little business investment, meaning businesses purchase less new equipment and fewer new technologies than they otherwise might. Too little investment means lower worker productivity, and ultimately, lower real wages and living standards."[4] The Congressional Budget Office, which provides Congress with nonpartisan analyses needed for economic and budget decisions, notes that reducing the mortgage interest deduction "should make affected homeowners less willing to invest in homes relative to stock, bonds, savings accounts and their own businesses." These reallocations of investments from expensive homes, CBO argues, "could eventually boost capital in other sectors of the economy and increase total economic output."[5]
Just as important, the tax breaks as written are not an efficient way to promote high rates of home ownership. If Congress wants more people to own homes, there's no point in targeting people who can already afford them--they'd be buying homes anyway. After all, Great Britain, Canada, and Australia don't provide any tax break for home mortgage interest payments, and their homeownership rate is about the same as ours.
What Congress Should Do
Overview. The goal of any tax relief for homeownership should be to help people to become and remain owners of a basic home. Renters, who have on average less than half the income of homeowners, receive no federal income tax relief for the rent they pay. Yet over 30% of American households rent, often at back-breaking prices.
Sometimes people rent because they expect to reside only temporarily in an area, or they want to live, for social and cultural reasons, in a place beyond their means (say, Manhattan). Far more often, renters long to own their own home.
From a public policy standpoint, maximizing the number of qualified owners of starter homes is likely to produce healthier families, healthier communities, and a more buoyant economy than is produced by subsidizing extra bathrooms and entertainment centers in expensive homes.[6]
Limiting Size of the Mortgage Subsidy. To eliminate excessive tax breaks for homeownership, President Bush's Advisory Panel proposed that Congress limit relief to a basic mortgage, which it defined as 125% of the median price of houses by county. The precise mortgage limit, and whether it should vary by county, or possibly by region, is beyond the scope of this chapter. The guiding principle, however, is clear: Relief ought to be focused on helping people who need help to buy and keep a basic home.
The Panel also wisely proposed to limit relief to a principal home. No more tax breaks for mortgages on that beach condo in Boca Raton or ski condo in Park City.
Switching to Refundable Tax Credit. If Congress is going to give some form of tax relief for homeownership, what should it be? If Congress's goal, as it should be, is to promote ownership of a basic home, then a tax credit becomes the obvious choice.
We know that every $1 of deductions saves the most taxes for people who otherwise would be taxed at the highest tax rate and saves the least taxes for people who otherwise would be taxed at the lowest tax rate or not at all. Simply put, each $1 of deductions saves 35 cents for people who reach the top 35% rate, and saves only 10 cents for people who reach only the 10% rate.
On the other hand, every $1 of tax credits reduces your tax by $1, regardless of your tax bracket. If you owe $100,000 in taxes, a $1 tax credit means that you would owe $99,999. If you owe $10, a $1 tax credit means that you would owe $9. Tax credits, therefore, are a much more effective way than are deductions to focus tax relief on ordinary households.
For this reason, President Bush's Advisory Panel recommended that the mortgage interest deduction be replaced "with a Home Credit for all taxpayers equal to 15 percent of interest paid on a principal residence."[7] The panel probably chose the 15% rate because it would correspond to the value of an interest deduction of 15%: If you paid $10,000 of interest, a deduction at the 15% rate would save you $1,500 (15% x $10,000), as would a 15% credit on $10,000 of interest. And the panel knew that about 75% of all taxpayers pay a top rate of 15% or less.
A tax credit for mortgage interest payments, however, would have no value for the 30% of all tax returns that do not owe taxes. There is a mechanism in the tax laws for helping these people, and it is called a refundable credit.
We've been familiar with refundable tax credits for 34 years. Since 1974, the earned income tax credit (EIC), a refundable credit, has supplemented the wages primarily of low- and moderate-income working parents who have one or more dependent children yet have trouble making ends meet. The EIC was Ronald Reagan's favorite welfare program because it encourages parents to work. Never, however, has the credit been designed to cover mortgage interest costs.
If Congress created a refundable credit for mortgage interest payments, it would work like this: The IRS would treat homeowners as if they had paid taxes in advance equal to the amount of the credit. To the extent the credit exceeds any income tax they owe, the IRS would send them a refund check up to the maximum credit.
Determining the Size of the Credit. It is not my purpose here to peg the exact size of the credit Congress should adopt. Let us assume for the moment, however, that interest on mortgages up to $400,000 would be eligible for the 15% credit, that the interest rate is 7%, and that the interest payment for the first year would be $28,000. A 15% credit on $28,000 of interest payments would save you $4,200. If your mortgage were $200,000, you would save $2,100.
The additional revenue for the government from limiting the tax savings to 15% of eligible interest could be enormous. For example, the Congressional Budget Office has estimated that replacing the current mortgage interest deduction with a 15% tax credit on up to $400,000 of home mortgages would save about $22 billion in 2008 and about $418 billion over 10 years.[8]
Introducing a Progressive Tax Credit. You might be thinking: Why not create a larger credit for lower-income households for whom a 15% credit falls short of what they need to become and remain homeowners? For example, the credit might begin at 30% of eligible interest for lower-income households and decline gradually to 15% as income rises. In that way, the credit for each $1 of eligible mortgage interest would be largest for people who need help the most, just the reverse of the current situation where the value in tax savings of each $1 of interest deduction rises as one's income rises.
Making the credit progressive advances worthy social and economic goals, but it also makes the law more complicated. For a subject as important as housing policy, I suggest that a degree of complexity in calculating a household's tax savings should be acceptable. A progressive tax credit also would mirror what likely would occur if, one day, Congress replaced the tax relief for mortgage interest payments with direct subsidies to help households buy and retain a basic home.
Making Reforms Prospective. Congress should make the new rules prospective and should lower the $1 million mortgage cap gradually for new home buyers. This way, Congress would not impose unexpected rules on existing homeowners, who could continue to claim mortgage interest deductions on preexisting mortgages. Congress also would temper any decline in the values of expensive homes and would minimize disruptions in real estate markets generally.
Special Grant. The principal obstacle to becoming a homeowner for millions of working households is putting together the down payment. Congress at last recognized this in the American Dream Downpayment Act of 2003, which authorized $200 million per year to provide low-income households with grants toward their down payment. At the expected average of $5,000 per grant, that would help about 40,000 families a year become homeowners.
A terrific start! But, it's far short of enough--only 800 households a state, on average. (And, at this writing, it is unclear whether the Act will be renewed for 2008.) If Congress were to allocate 10 times as much--$2 billion annually--for this purpose, 400,000 working households trapped in rental arrangements but capable of satisfying conventional mortgage financing guidelines could become homeowners every year. And the program could be funded with only a fraction of the additional tax revenue that could be expected from limiting the tax breaks for mortgage interest payments. Furthermore, the program's stimulus to home construction would help offset a drop in construction that would occur if the new tax limitations resulted, as would be likely, in the building of fewer expensive homes and secondary homes.
There you have it. Let's refocus an idea that Americans like--a tax break that helps people become and remain homeowners--so that it maximizes the number of homeowners and no longer wastes taxpayers' money on subsidies for expensive homes.
If that makes sense to you, ask the candidates whether, and how, they would vote to fix this misguided system. You can expect them to worry about alienating some of their biggest supporters. Their answers will reveal something about their values--not to mention their integrity.
[1] Joint Committee on Taxation. Estimates of Federal Tax Expenditures for Fiscal Years 2006-2010, JCS-2-06, Washington, D.C.: GPO, 2006, 33.
[2] If your income exceeds a certain threshold ($159,950 in 2008), the deduction, along with certain other itemized deductions, will be reduced by 3% of the excess over that threshold; in no event, however, can the deduction be reduced by more than 80%. Don't get too worried about this. A married couple with a hefty income of $600,000 and interest payments of $70,000 still could deduct $57,000 in 2008.
[3] The calculations were performed by the Joint Committee on Taxation, see endnote #1, 43.
[4] Simple, Fair & Pro-Growth: Proposals to Fix America's Tax System, Report of the President's Advisory Panel on Federal Tax Reform, November 2005, 71. See also Jonathan Skinner, "The Dynamic Efficiency Cost of Not Taxing Housing," Journal of Public Economics 59 (1996), who posited that the welfare cost of preferential tax treatment for owner-occupied housing could amount to 2.2% of the gross domestic product (GDP), which would amount to well over $200 billion today; William G. Gale, "Fixing the Tax System," The Brookings Institution, February 28, 2007; Dale W. Jorgenson, "Reconstructing the Agenda for U.S. Tax Reform," paper presented to the House Republican Conference, Washington, D.C., August 11, 1993.
[5] Congressional Budget Office. Budget Options. Washington, D.C.: GPO, February 2007, 267.
[6] As we know from recent history, Congress must be careful not to encourage homeownership for households not yet prepared for the costs, including unexpected costs. Many homeowners end up losing their homes because they have not anticipated much higher interest rates from adjustable rate loans, or because they lose their jobs or suffer some other financial setback.
[7] Simple, Fair & Pro-Growth: Proposals to Fix America's Tax System, Report of the President's Advisory Panel on Federal Tax Reform, November 2005, 73.
[8] See endnote #5, 267.