The Inequitable Home Equity Break

Congress gives homeowners who itemize their deductions, and no one else, a deduction for interest on up to $100,000 of home equity loans that they may spend to buy anything they want.

Question 2. Ask the Candidate:

Would you eliminate the preferential tax break for interest on home equity loans that arbitrarily encourages spending over saving and primarily benefits middle- and upper-income homeowners?

The 1986 Tax Reform Act singled out homeowners as the only class of taxpayers entitled to deduct the interest on up to $100,000 of home equity loans used to satisfy their spending desires. This tax break for homeowners was intended to be a transitional provision to help those who owed millions of dollars of mortgages adjust to the more restrictive home mortgage interest rules under the 1986 Act. Singly out homeowners for this special relief didn’t make sense at the time. It definitely doesn’t make sense 26 years later.

A Bit of History

Imagine it is 1986. Democrats and Republicans are engaged in a rare collaboration to rewrite the income tax laws. Their avowed intent is to eliminate unfair and economically unsound tax breaks, lower tax rates, and encourage Americans to save more and spend less. At the time, there is a tax deduction for consumer interest--that is, interest on any loan or credit card debt you incurred for your personal expenses. 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 can spend or save. The remaining 65% of taxpayers claim a standard deduction. So low-and moderate-income households rarely deduct their consumer interest because they rarely itemize; yet when they borrow, as they often must to cover basic expenses, they often pay high interest rates.

By contrast, most households that itemize can pay for their personal spending 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 people whose spending should be subsidized by Congress.

The Home Equity Interest Deduction

Obvious to you and me, maybe, but not to Congress. To advance the cause of tax simplification and to discourage personal consumption, in 1986 Congress eliminated the consumer interest deduction for all itemizers except one group: homeowners.[1] They were allowed to deduct, as they still may do today, the interest on up to $100,000 of loans, if secured by a principal or second home; and the money loaned  may be used for any purpose, such as to buy a car or a yacht, 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 expect, 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,” reported the U.S. Federal Reserve.[2]

So why them? Apparently, this 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 a deduction on only $1 million worth of mortgages under the 1986 reforms.[3]

“Basic tax, as everyone knows, is the only genuinely funny subject in law school.” —Martin Ginsburg, professor, Georgetown Law Center

Yes, it really happened. And this highly preferential tax break still exists, 26 years later. It’s also costly. While there are no published statistics, we can safely estimate that it saves itemizers at least several billion dollars a year.[4]

This deduction also is not an innocent bystander in the recent housing crisis.  A few years back, when house prices were skyrocketing and confidence was high that prices would continue to rise, many homeowners borrowed much of the equity in their homes with an adjustable rate mortgage. They spent the money or leveraged the purchase of another house. When house prices subsequently plummeted and interest rates on their home equity loan rose, many borrowers found they had put themselves in jeopardy of losing their most valuable investment—their home--altogether.

What Congress Should Do

Congress justifiably could postpone this decision until the economy is somewhat strengthened.

Surely this tax break ought to be one of the easiest to eliminate if Congress ever becomes serious about making our tax laws, simpler, fairer, and more economically sensible. The deduction for interest on home equity loans complicates our tax laws, is unfair by favoring higher-income households over all other households, and distorts homeowners’ economic decisions by encouraging them to engage in myriad forms of spending that serve no clear public interest. If our tax laws subsidize any forms of spending, it should be for narrow categories such as health care and education; and in these cases the subsidy should help most those who most need help.

 What the fate of this deduction should be is a particularly good question for incumbents—especially those who have been in Congress for at least 26 years.

[1] To be deductible, the loans must be secured by a mortgage on a principal home or second home.

[2] Canner, Glenn B., 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, were developed in 1986 but were refined by legislation in 1987.

[4] The cost of the home equity loan interest deduction is included in the annual cost of home mortgage interest in the figures provided by the Joint Committee on Taxation. That cost is about $83 billion for 2012 (see Question 1), and we can reasonably assume that at least several billion of that figure is attributable to the home equity interest deduction.

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