Jun022015

What happens if the home mortgage interest deduction gets eliminated?

The home mortgage interest deduction is an expensive subsidy that doesn’t warrant its cost.

home mortgage interest deductionIf you listen to the people who benefit most from government housing subsidies, there is never a good time to reduce or eliminate a source of government largess. If you’ve been reading this blog for very long, you have a finely tuned bullshit detector. Whenever you read the shrill cries of realtors, homebuilders, and high wage earning loanowners lamenting the dire consequences of reducing or eliminating the home mortgage interest deduction, your bullshit detector should tell you to discount whatever they say as the self-serving nonsense it is.

The fact that the home mortgage interest deduction is in danger is scaring the bullcrap out of the usual suspects. In truth, the HMID is an expensive subsidy that inflates house prices without increasing home ownership rates. It fails to accomplish it’s stated purpose, and it costs the government $100 billion per year. It should be cut back or eliminated. The only thing standing in the way is the scare tactics used in its defense.

If you agree there is a need to reform the home mortgage interest deduction, the question becomes “what is the best way to reform it?” Politicians consider a variety of proposals and wrestle with the special interest groups opposed to any changes.

A senseless subsidy

Most Western economies sweeten the cost of borrowing. That is a bad idea

May 16th 2015conehead

… Despite the fact that the world is mired in debt, governments make borrowing costs tax-deductible, cheapening debt and encouraging borrowers to pile on more.

… Interest payments on mortgages are tax-deductible for personal tax purposes in at least some way in America and over a dozen European countries, including Belgium, Italy, the Netherlands, Spain, Switzerland and most Nordic states. …

Governments worldwide believe in the cult of home ownership. The notable exception is Germany where renting is encouraged, renters have good savings options, and house prices are stable.

The global convention that debt should enjoy tax perks emerged as much by accident as design. … Mortgage-interest deduction was allowed in 1913, at a time when few Americans had mortgages. It was only after the second world war that this perk became associated with the political aim of boosting home-ownership. …

deeply_in_debtWhat most people don’t realize is that the home mortgage interest deduction was preserved in the 1986 tax reform to put homeowners on equal footing with landlords. As an owner of rental property, I get to write off 100% of my interest costs. If I owned my primary residence, I would only be eligible for the same tax break through the HMID. Without the deductibility of home mortgage interest, we would see complex tax structures where people put their homes into entities and rented it back to themselves so they could be landlords for tax purposes. The HMID eliminated the need for such crazy and complicated tax structures.

A third way of showing the size of the tax distortion is to see how it affects the calculations that borrowers make. The annual interest payments on a $1m mortgage can be reduced by over a quarter as a result of interest deductibility. …

This merely causes high wage earners to bid 25% higher than they otherwise would for property. Cities like Irvine would suffer the most from any restrictions on the HMID.Ponzis

In America rich households get much of the benefit of the mortgage-interest relief—and few of those defaulted. …

Yet in the real world, there is a strong bias towards debt. What explains this? The tax break is one factor, but not the only one. The bias also reflects the wiring in humans’ brains. Savers are prone to think that the fixed flow of payments offered by debt is safer than it actually is. When asset prices (in particular property) rise, borrowers are tempted to think that they will rise further and use debt to buy more assets in order to magnify their profit. …

The real danger is falling into Ponzi thinking. During the housing bubble people came to view mortgage debt as a special category of debt that didn’t require repayment, at least not from their wage income. The only connection to their wages was the monthly debt service payments they made to sustain the massive debt.

They never intended to repay the debt, particularly since the amount was so inconceivably large. The plan was always to have the house repay the debt at time of resale. The only question was how large the check would be that they took with them.

This kind of dysfunctional thinking is based on the premise that house prices only go up, so the house will always be capable of repaying the debt; since the house would repay far more than the borrower originally borrowed to buy the property, the borrower felt comfortable with borrowing against the increasing value to support their lifestyle. This is Ponzi thinking.

Ponzi thinking is very seductive. Once a borrower losses the connection between borrowing and repayment out of wage income, debt ceases to be a liability. not_thievesDebt actually becomes an asset because through servicing debt, one can obtain cash to spend. Most fail to recognize the folly, and many were made painfully aware of it when house prices crashed.

So what would happen if these subsidies were removed? It would be a revolutionary step because the breaks are embedded in the way firms and homebuyers behave.

So far as withdrawing mortgage relief goes, the historical examples are muddy. Britain’s mortgage-related tax perks contributed to a house-price boom in the 1980s but their abolition in 2000 did not stop another bubble from inflating. The sheer complexity of today’s financial industry adds to the murkiness. But it seems likely that there would be an initial jolt to house prices if the subsidy were withdrawn. The Netherlands saw a price drop of about a tenth when it cut mortgage subsidies in 2012. An equivalent drop is likely in America given the value of the subsidies relative to the housing stock.

affordability_ceilingHousing subsidies inflate house prices by raising the height to which borrowers can push prices up. When house prices are inflated to the maximum extent possible — which is most of the time — any reduction in housing subsidies has a negative impact on house prices by reducing borrowers ability or willingness to boost prices. This is why the Netherlands experienced a 10% price drop after subsidies were removed. The likely also experienced a commensurate decline in sales volumes.

Back in 2012 we had an opportunity to reform the home mortgage interest deduction without disrupting home sales or house prices. In 2012, the housing market was rebounding strongly in response to restricted inventory due to lender can-kicking of bad loans. Nearly every local market was undervalued at the time, so eliminating subsidies would not have impacted current pricing. Since prices weren’t inflated to the ceiling of affordability, lowering the ceiling would not have lowered prices.

The direct pain would be felt by the well-off—almost 90% of the value of the mortgage-interest tax break goes to households making over $75,000 a year. But lower house prices would be uncomfortable given that 17% of households have negative equity. The same is true in the euro zone, which is battling deflation.

And it’s the well-off who will feel the most pain as house prices fall to the new cost-of-ownership equilibrium price.housing_consumer

Reforming the HMID

Proposals to reform, reduce or eliminate the home mortgage interest deduction come in 3 varieties:

1. Reduce the loan size limit, generally with a phase in or grandfather clause.

2. Raise the standard deduction to reduce the positive impact.

3. Shift the benefit from a deduction to a credit to help low-income borrowers instead of high-income borrowers.

It is very unlikely the home mortgage interest deduction would be suddenly eliminated. The potential for disruptions to the housing market are too great, and the lobbyists would spend millions “educating” lawmakers on the perils of a sudden change. What is far more likely is that any change would be phased in and subject to “grandfather” clauses allowing people with existing mortgages to keep some or all of their existing benefits.

The most likely change is to simply reduce the limits on loans amounts eligible for the HMID. The current caps are $1,000,000 for a primary mortgage and $100,000 for a HELOC. If this number is lowered to $500,000, it would only effect high wage earners, a small but powerful voting block. American_ExcessSuch a change is tantamount to a tax targeted at high wage earners, and it would be highly unpopular with a voter group that donates heavily to both political parties. Realistically, the only way this happens is if the change is part of a broader reform measure, but even then, the prospects aren’t good.

The stealth method of reforming the HMID is to raise the standard deduction. This works by reducing the positive impact of all itemized deductions and avoids much of the messy political battles required to go after specific subsidies. Similar to this proposal is a cap on total deductions or changes to the alternative minimum tax that currently catches those who have large itemized deductions.

The final proposal is to change the HMID from a deduction to a credit. This would be a boon to low wage earners who don’t itemize and who don’t benefit from the deduction. It would be a disaster for high wage earners who would see a huge deduction replaced with a paltry credit.

Talk of reforming the HMID springs up periodically, but so far I haven’t seen any real progress or serious political discussion of reforming this subsidy — which is too bad because it clearly doesn’t accomplish much for its high cost unless you consider inflated house prices in Irvine a big bonus, which some do.

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