The McMansion Tax Break

The home mortgage interest deduction allows taxpayers to deduct interest on loans of up to $1 million to buy or build one or two personal residences.

Question 1. Ask the Candidate:

Would you limit the tax break to one basic home? And would you focus the subsidy on qualified households who need the subsidy most?

Contrary to popular perception, the home mortgage interest deduction never has made social or economic sense. It has failed to have any significant impact on home ownership rates; in fact, the vast majority of this subsidy helps higher-income households who could buy a basic home without any help. This subsidy also drives up house prices and probably rental prices as well; and our economy would grow faster if the subsidy were limited and better focused.

The Three Major Tax Subsidies for Home Ownership

We all know how important it is to have a secure and affordable home. There also are advantages to society if neighborhoods are stable and residents take responsibility for their property and community life. Homeownership, so integral to the American dream, serves both goals. Furthermore, owning a home usually has beena good investment, notwithstanding the recent subprime debacle.   

It should not surprise us, therefore, that Congress would adopt policies to help increase the number of homeowners. But the considerable tax breaks for homeownership, while highly popular, cannot be justified either as social or economic policy.

The three largest tax breaks –the deductions for mortgage interest on up to two homes and for property taxes on your principal home and an unlimited number of vacation homes, plus the tax exemption for your gain when you sell your principal home—saved homeowners a staggering $120 billion in 2011 alone, and are estimated to save them over $700 billion from 2011 through 2015.[1] Yet the great bulk of those tax savings are for people whocould 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.

The Home Mortgage Interest Deduction

Helping the Comfortable To Live More Comfortably. Yes, this deduction allows well-off people to deduct the interest on as much as $1 million 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.

"The Higher the Tax Bracket, the Better the View"
—advertisement for luxury Florida property

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 homesthat only people who already live comfortably can afford. A 4% interest payment on a $1 million loan can produce a $40,000 deduction. That’s a nice little sum. And high-income households use the deduction to shelter income that otherwise would be taxed at high rates.

Consider Cathy, an executive who bought a suburban palace just outside Oklahoma City. Last year she deducted $40,000 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 $13,200 (33% x $40,000). Ed saves $1,500 (15% x $10,000). Yes, Cathy pays 4 times more interest, but saves almost 9 times more taxes.

How Much Money is Involved? In 2011, the mortgage interest deduction saved certain homeowners a total of $83 billion in federal income taxes.[2] All of the savings went to homeowners who itemized their deductions. 

You see, only itemizers may claim the deduction (as well as deductions for such things as interest on home equity loans, state and local taxes, and charitable contributions). Typically, only 35% of all taxpayers—mostly those with the top 35% of all income--itemize. The remaining 65% pf taxpayers claim a standard deduction. This is a limited fixed amount Congress specifies each year for singles, married couples, and heads of households, yet it is more than they could deduct if they itemized. 

The standard deduction in 2011 was $5,800 for singles and $11,600 for married couples.

Who Gets the Money? Now, you certainly are wondering, who got that $83 billion—that Big Government intrusion into our housing markets?   Households with the bottom half of all income received only 2%. The top half received the other 98%.[3]

Households % of
Tax Savings
Share of $83
Billion Tax Savings
Bottom 50%
(income less than $44,000)
2% $1.5 billion

Top 50%
(income at least $44,000)

98% $81.5 billion

[all figures have been rounded off] [4]

Moreover, the top 4% of income earners, people with at least $200,000 of income, got $29 billion of that $83 billion. That’s 35% of the total tax savings!

The top 4% is likely to receive about $160 billion of the estimated $464 billion of tax savings from the deduction for the years 2011 – 2015

Imagine that Congress eliminated the deduction but got the same result by having the Department of Housing and Urban Development (HUD) distribute cash grants to homeowners to replace the tax savings they would have received.  Then, the grants would have to be fully transparent. Now imagine that you’re watching the HUD hearing on television, and the chair announces that 2% of the $83 billion would be distributed to the bottom half of all households measured by their income, and 35% to the top 4% of all households. Just imagine the public’s reaction!  

Experts 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 bipartisan Advisory Panel on Federal Tax Reform in 2005 (the “Bush 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.”[5]  Similar conclusions appeared in the Report of President Obama’s bipartisan National Commission on Fiscal Responsibility and Reform, led by former Republican Senator Alan Simpson and former Obama presidential advisor Erskine Bowles (the “Simpson-Bowles Commission”).[6]

The Congressional Budget Office, which provides Congress with nonpartisan analyses needed for economic and budget decisions, has noted 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.”[7]

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.

About two-thirds of all households are homeowners in all four countries.

Finally, by attracting so much capital into home ownership, the home mortgage interest deduction (plus the other tax relief for home ownership) probably limits the supply of rental units and increases rental prices, including rentals for low-and moderate-income households.

What Congress Should Do

Overview.The goal of any tax relief for homeownership should be focused on “qualified households” who need some help to become and remain owners of a basic home. These are households that currently rent but have steady incomes and credit reports otherwise sufficient to manage the financial obligations of homeownership. Incidentally, over 30% of American households rent, often at back-breaking prices. Yet renters on average have less than half the income of homeowners without receiving any federal income tax relief for the rent they pay.[8]

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.[9]

Limiting and Refocusing the Tax Relief. To eliminate excessive tax breaks for homeownership, both the Bush Advisory Panel and the Simpson Bowles Commission wisely proposed that Congress limit relief to interest paid for a single residence. You want that beach condo in Boca Raton or ski condo in Park City? You pay for it with your own money. Moreover, the mortgage could be no more than $500,000 (Simpson-Bowles) or 125% of the median price of houses by county (the Bush Advisory Panel). Both commissions recommended that any relief be available to all taxpayers, not just to itemizers. And both recommended that the deduction be converted to a tax credit, which would be far more helpful for the typical household, as discussed below.

The guiding principle: Relief should be focused on people who need help to buy and keep a basic home.  

Switching to a Tax Credit.  If Congress is going to give some form of tax relief to promote basic home ownership, 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 on that $1, 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 deducted saves 35 cents for people who otherwise would pay the top 35% tax rate on that $1, 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 deductions to focus tax relief on ordinary households.

 The Bush Advisory Panel recommended that the credit equal 15 percent of interest paid on the mortgage.”[10] Simpson-Bowles proposed a 12% credit.[11] For example, on $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. Both commissions’ proposals probably reflect the fact that about 75% of all taxpayers each year do not pay more than a 15% rate.

Either proposal could yield significantly more tax revenue for the government compared to current law. Consider, for example, replacing the current mortgage interest deduction with a 15% tax credit, with the maximum mortgage gradually declining from $1 million to $500,000 by 2018. These reforms alone could raise an additional $388 billion from 2013 to 2019, according to the Congressional Budget Office.[12]

Introducing a Progressive Tax Credit. You might think: Why not create a larger credit for lower-income households if 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 income rises.

Making the tax credit progressive would advance worthy social and economic goals but also makes the law more complicated. For a subject as important as housing policy, I suggest that some degree of complexity in calculating a household’s tax savings should be acceptable. A progressive tax credit also would reflect what might 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. This way, Congress would not impose unexpected rules on an existing homeowner, who could continue to claim mortgage interest deductions on the balance of his loan at the time of the new legislation. A sensible transition also would temper any decline in the values of expensive homes and minimize disruptions in real estate markets, which is particularly important at this troubling time for home owners.  

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 offending some of their biggest supporters.  Their answers will reveal something about their values--and their integrity.

[1] Joint Committee on Taxation, Estimates of  Federal Tax Expenditures for Fiscal Years 2011 – 2015, JCS-1-12, Washington, D.C.: GPO, 2012, 36.

[2] Ibid @ 36.

[3] Ibid @ 53. The JCS calculates “income” broadly for placing taxpayers in income classes. It begins with adjusted gross income reported on one’s tax return, plus (a) tax-exempt interest, (b) employer contributions for health and life insurance, (c) employer share of FICA tax, (d) workers’ compensation, (e) nontaxable Social Security benefits, (f) insurance value of Medicare benefits, (g) alternative minimum tax preference items, and (h) excluded income of U.S. citizens living abroad.

[4] The calculations were performed by the Joint Committee on Taxation, see endnote #1, 53. The percentages for 2011 are based on those for 2010; there’s been little change in the distribution over recent years. 

[5] 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.

[6] “The Moment of Truth: Report of the National Commission on Fiscal Responsibility and Reform,” December 2010.

[7] Congressional Budget Office. Budget Options. Washington, D.C.: GPO, February 2007, 267.

[8] Landlords may deduct the costs of the buildings they rent, including for mortgage interest; but it is unclear how much of that tax savings is passed on to tenants.

[9] 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.

[10] See endnote 4 at 73.

[11] See endnote 5 at 31.

[12] Congressional Budget Office. Budget Options, Volume 2, Washington, D.C.: GPO, August 2009, 187.

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