Home mortgage interest deduction may fall off the fiscal cliff

The home mortgage interest deduction serves to inflate house prices in high income areas without significantly promoting home ownership. Further, it costs the federal government $100,000,000,000 a year, which makes it a target of deficit hawks in Congress. The deduction has widespread support among taxpayers despite the fact only a select few gain any benefit from it. This support makes it a sacred cow in Washington, but it’s starting to look increasingly likely that some compromise in the fiscal cliff debate will curb this benefit. If it does, the so-called housing recovery in high income areas like Coastal California will be stopped dead in its tracks.

Long-treasured mortgage interest deduction may face changes

‘Fiscal cliff’ debate has put home mortgage interest deduction on the table. Critics contend it benefits the wealthy much more than the middle class.

By Jim Puzzanghera, Los Angeles Times — December 10, 2012, 5:00 a.m.

… The home mortgage interest deduction is one of the most cherished in the U.S. tax code. It’s also one of the most expensive, estimated to cost the federal government $100 billion this fiscal year.For that reason, the deduction taken on income tax returns is expected to be on the table in Washington’s search for more money to reduce the budget deficit and resolve the fiscal cliff.

$100 billion is a lot of money. That makes curbing this tax break a tempting target. Further, since the high wage earners who benefit from the deduction are overwhelmingly Republican, the Democrats don’t fear the repercussions of going after this group.

But the specter of scaling back the tax break, particularly with the housing market still trying to recover from the collapse of the subprime mortgage bubble, is raising alarms among homeowners, realtors and home builders.

Those special interests that benefit the most are the ones crying the loudest about its potential reduction.

It’s also sparking a debate about the true effect of the deduction, which critics argue benefits the wealthy much more than the middle class. They contend that the break hurts first-time home buyers by driving up house prices and that other countries that have no such deduction still have high homeownership rates.

Every one of those points of criticism is true.

When people itemize to take the home mortgage interest deduction, they give up the standard deduction. For the majority of Americans, this removes any advantage. It does not help first-time homebuyers or families making less than $100,000 per year. Further, many other countries that don’t have this deduction have home ownership rates equal to or exceeding the rate here in America.

“If we really care about homeownership, then the deduction is just the absolute wrong way to go,” said Dennis Ventry, a UC Davis law professor who has studied its effect.

There is agreement that reducing the interest deduction — no one is talking about eliminating it — would cause prices to drop as buyers scale back the amount they could afford to spend.

My monthly reports on the cost of ownership reflect that monthly payment affordability is relatively high as compared to historic norms. Affordability plus a lack of inventory is what’s driving the recent price rally. If the deduction were reduced or eliminated, the cost of ownership would rise, and affordability would crumble. Declining affordability will at first cause transaction volumes to plummet, and prices would soon follow.

The concerns are even greater in Southern California and other high-priced regions where homeowners benefit more from the deduction because their mortgages are larger.

“A lot of people buy rather than rent simply because, after the mortgage deduction, it’s more affordable,” said Syd Leibovitch, president of Rodeo Realty in Beverly Hills. “To limit it or take it away, I think you’re going to be surprised at the shocking effect it has on the real estate market.”

Let’s be realistic. There are two major policy changes being considered that would flatten the California housing market. Curbing the home mortgage interest deduction is one of them. Lowing the conforming limit on FHA and GSE loans is another.

President Obama’s deficit commission proposed lowering the limit on mortgage principal eligible for a deduction to $500,000 from the current $1 million, removing any break for interest on a second home and turning the deduction into a tax credit capped at 12% of interest paid.

The likely change may take that form, or it may be an overall cap on itemized deductions of $25,000. Either one would effectively reduce the value of the home mortgage interest deduction by about 50%.

A tax credit would allow homeowners who don’t itemize deductions to subtract the interest from the taxes they owe. But while more taxpayers could take advantage of the benefit, a cap would mean those with large mortgages on expensive homes couldn’t get a credit for all the interest they pay.

Other proposals have called for similar changes.

Supporters of the tax break worry that proposed changes would not only push down prices but also spook potential buyers.

Yes, it will do both of those things.

…The mortgage interest deduction is one of the most popular tax breaks. In a nationwide poll released this week by Quinnipiac University, two-thirds of respondents said they opposed eliminating it.

I find it shocking that so many people who don’t enjoy the subsidy still support it. Only about a third of taxpayers claim it.

… President Ronald Reagan said he wanted to keep it because it symbolized the American dream.

“For people of my generation, the baby boomers, from the time we were kids we were told by the federal government and its policies to build our nest eggs around housing,” said Gerald M. Howard, chief executive of the National Assn. of Home Builders, one of the strongest supporters of the deduction.

“Now our elected officials are going to tell us in the name of tax simplification they’re going to further reduce the value of our housing by 10% to 15% right as we’re about to retire?” Howard said. “When you make that kind of case to lawmakers, you should see their eyes widen.”

Considering the values of their homes already declined 30% due to the collapse of the massive credit bubble and its associated housing bubble, the fears of a 10% to 15% reduction in value is fear mongering. If the deduction were curbed, it would probably reduce prices back near the recent bottom.

But a lot of that concern is based on the misconception that the deduction is a boon for average Americans, critics said.

This is a sacred cow to the real estate industry, and it’s almost an entitlement to homeowners,” said Anthony Sanders, a real estate finance professor at George Mason University. “They could cut it in half and it would not harm a lot of middle-income households.”

Cutting the value of the mortgage interest deduction in half looks like it may happen.

Part of the reason I think Congress will do this is because the areas which would be most effected are the areas currently enjoying the most robust recoveries. In other words, if Coastal California is hit, it won’t be as damaging to the national housing market as a change in policy that might impact Las Vegas or Phoenix.

An analysis by Congress’ Joint Committee on Taxation found that 78% of the $83 billion in mortgage interest deductions in 2010 went to households with income of more than $100,000. Households with incomes of more than $200,000 got 35% of the benefit.

The upper-middle class is the only segment of the population that benefits from the deduction. The truly rich often own their homes with no debt, so this won’t impact them near as much as it will high wage earners in places like Orange County.

… In addition, people in high-cost areas benefit the most from the deduction. A 2001 study found that three metropolitan areas — Los Angeles, San Francisco and New York — combined to receive more than 75% of the deduction’s benefit.

Clearly any change to the home mortgage interest deduction will have a dramatic and negative effect on the Coastal California housing market. However, is that really a bad thing? Inflated house prices serve no one other than the banks who enjoy larger interest payments due to the subsidy. Reducing the home mortgage interest deduction may temporarily derail the housing recovery here, but it will have little or no impact in the most beaten down markets where very few homeowners take advantage. With the enormous pressures lawmakers are under to increase federal tax revenues, some form of reduced benefit from the home mortgage interest deduction is looking much more likely.