The Inequitable Home Equity Break
Congress gives certain homeowners, and no one else, a preferential deduction for consumer loans.
Question 2. Ask the Candidate:
Would you eliminate the deduction for interest on up to $100,000 of consumer loans (called "home equity loans") that benefits only homeowners who itemize?
"Basic tax, as everyone knows, is the only genuinely funny subject in law school."
—Martin Ginsburg, professor, Georgetown Law Center
Imagine it is 1986. Democrats and Republicans are engaged in a rare collaboration to rewrite the income tax laws. Their avowed intention is to eliminate unfair and economically unsound tax breaks, lower tax rates, and encourage Americans to save more and spend less. At the time, a deduction exists for consumer interest--that is, interest on any loan or credit card debt you incur for personal consumption expenses, such as for food and clothes. The deduction encourages spending. It is limited, however, to people who itemize, and only about 35% of all taxpayers itemize.
Congress knows that itemizers, for the most part, are at the top of the income scale and have discretionary income they might spend or save. The remaining 65% of taxpayers take a standard deduction because, even though modest, it happens to be more money than they could deduct if they itemized. It follows that low-and moderate-income households rarely deduct their consumer interest because they rarely itemize; yet when they borrow, as they often must in order to cover basic expenses, they often pay high interest rates.
By contrast, most itemizers can pay for their personal consumption without borrowing. When they do borrow, their strong credit ratings entitle them to low interest rates. It seems pretty obvious that they should be the last group whose consumption should be subsidized through the tax laws.
Obvious to you and me, maybe, but not to Congress. Purportedly to advance the cause of tax simplification and to discourage personal consumption, Congress eliminated the consumer interest deduction for all itemizers except one group: homeowners.[1] They may deduct the interest on up to $100,000 of loans, if secured by a principal or second home; and the proceeds may be used for any purpose, such as to buy a car, pay for their children's summer camp, or travel to Europe. This deduction is in addition to the interest deduction on up to $1 million of mortgages to buy or build a home, as discussed in Question 1.
As you would have expected, homeowners who take out home equity loans "typically own relatively expensive homes, have higher incomes, and have substantially more equity in their homes than most other homeowners," in the words of a Federal Reserve report.[2]
So why them? This apparently was a consolation prize, an attempt to mollify homeowners who held multi-million dollar mortgages on their personal palaces and were about to be "limited" to an interest deduction on only $1 million worth of mortgages under the 1986 reforms.[3]
Yes, it really happened. And this highly preferential tax break still exists, which makes the mollification period over 21 years old. It's also costly. The home equity interest deduction is expected to save certain itemizers income taxes in the neighborhood of $13 billion over the next five years.[4]
The deduction also is not an innocent bystander in the recent housing crisis. A few years back, many homeowners, their appetite for consumption whetted by the home equity deduction as house prices appreciated, borrowed a good portion of the equity in their homes with an adjustable rate mortgage. They then spent the money as they wished. When the price of their home fell, and the interest rate on their loan rose, less affluent homeowners who had engaged in this behavior discovered that they had put themselves in jeopardy of losing their home.
What Congress Should Do
Res ipsa loquitur means "the thing speaks for itself." It's a legal expression for occasions when, once the facts are clear, the legal conclusion is inevitable.
And so it is here. In the matter of the preferential home equity interest deduction, res ipsa loquitur. Let's repeal it.
What the fate of this deduction should be is a particularly good question for incumbents--especially if they've been in Congress for at least 21 years.
[1] To be deductible, the loans must be secured by a mortgage on a principal home or second home.
[2] Glenn B. Canner, Thomas A. Durkin, and Charles A Luckett, "Recent Developments in Home Equity Lending," Federal Reserve Bulletin (April 1998): 244.
[3] The limit on the mortgage interest deduction, and the rules for consumer interest, developed in legislation in 1986 but were refined by legislation in 1987.
[4] Estimate of staff member of Joint Committee on Taxation, a nonpartisan House-Senate committee of the U.S. Congress.