Only high wage earners save on taxes due to the home mortgage interest deduction, and the benefit is lost due to higher house prices paid be everyone utilizing this tax subsidy.

Does the home mortgage interest deduction serve any useful purpose? Usually, when the government subsidizes something, it ostensibly serves a greater public good, but if there was ever a greater good served by the home mortgage interest deduction (a debatable claim), this benefit has long since vanished.

As it stands today, the deduction rewards a small segment of high wage earners (see article below). Further, those who gain from the deduction spend this savings on higher mortgage payments to pay for houses made more expensive by others utilizing this savings. In the end, bankers benefit from this subsidy because lenders underwrite larger loans to high wage earners deducting the interest expense on their personal income taxes.

Do we really want to enrich bankers this way? As a taxpayer, do you feel good about that?

The people who benefit from government subsidies never see a good time to reduce or eliminate them. But what would happen if Congress eliminated the home mortgage interest deduction?

Would we build fewer homes? No, but we might build fewer McMansions.

Would low wage earners avoid buying a home? No, because they don’t take advantage of this subsidy now, so it won’t impact them or the markets for lower-priced homes at all.

Realistically, the only thing that would happen if this deduction were removed is that house prices would fall in neighborhoods dominated by high wage earners. Either that, new buyers would endure a higher cost of ownership to sustain prices paid by those who took advantage of the subsidy. In either case, the disruption to the market would be isolated to only those neighborhoods, and arguably, those impacted have the ability to afford the change.

Since an outright appeal of the home mortgage interest deduction would make homes cost a more for high wage earners, any change in the HMID would likely be “grandfathered” so that those who bought in anticipation of the deduction don’t endure a payment shock that forces them to sell.

Of course, even those grandfathered in will have to sell at some point, and their take-out buyer won’t be as leveraged because they won’t have a subsidy to take the sting out of the payment. Housing 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.

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

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

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

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 USDA Home Loans and 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. Such 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.

Another 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. In my opinion, this is the best way to subsidize housing if housing is to be subsidized at all because the benefit accrues to those who most need it, and it would encourage builders to provide more modest workforce housing rather than gaudy McMansions for the well-heeled.

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 advantage of raising the standard deduction is that Congress can slowly erode support for this subsidy as fewer and fewer people qualify to use it. Once it becomes widely known that only those who don’t need it end up using it, the broad appeal will wane, and opponents will gain an upper hand. As today’s featured article demonstrates, this is already happening.

Diana Olick, Friday, 15 Apr 2016

It may be yet another reason why younger Americans are choosing to rent: Buying a home is unlikely to offer them any tax break. That is thanks to near-record low mortgage rates and an increase in the standard deduction. Add them up, and the math doesn’t compute for savings. “It has removed one of the main reasons people had urgency to buy,” noted John Burns of California-based John Burns Real Estate Consulting. “High rent should be a kick in the pants, lowest interest rates should be a kick in the pants, but I think if you were getting a tax break too, I’m sure we’d see more entry-level buyers.“

I’m not so sure about that. His statement implies that more subsidies are the answer, and they never are. The market might get some short-term boost, but it would quickly reestablish an equilibrium price, and we would be right back were we are today.

The standard marital deduction has risen from $1,300 in 1972 to $12,600 today, meaning that the first $12,600 of itemized deductions has no benefit to consumers. According to Burns’ analysis, a typical first-time homebuyer, financing 95 percent or less of a median-priced U.S. home (around $200,000) pays less than $12,000 in mortgage interest and property taxes annually. That is not enough to hit the itemization level. Even with other deductions that bring the taxpayer over the $12,600 limit, the tax savings are minimal.

This is exactly what I describe above. It’s a stealth way to eliminate the deduction by making it less useful. Since I believe all subsidies are unnecessary distortions to the market, I think elimination of this costly subsidy is a good thing.

“It’s interesting, nobody is mentioning tax savings as a reason to buy anymore in focus groups,” added Burns.

This is a clear sign that support for this subsidy is eroding.

The mortgage interest deduction is one of the largest federal expenditures at about $70 billion a year, but it does very little to boost homeownership because it favors wealthier buyers, purchasing more expensive homes.

And since it is so costly and provides so little benefit—a benefit mostly to bankers—as the standard deduction goes up, support for this subsidy will continue to flag.

Mortgage-interest deduction was allowed in 1913 and 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.

In 2012, 77 percent of the benefits went to homeowners with incomes above $100,000, while close to half of homeowners with mortgages, most of them middle- and lower-income families, receive no benefit from the deduction, according to the Center on Budget and Policy Priorities. In a 2013 paper, the CBPP advocated eliminating the mortgage interest deduction and replacing it with a mortgage interest credit: A mortgage interest credit would provide more help than today’s deduction to most middle- and lower-income homeowners with mortgages, while trimming subsidies for upper-income owners. As a result, it would likely do more than the existing deduction to help families that would otherwise struggle to afford the costs of homeownership.

This is option #2 I described above. This would have a greater impact on home construction than the current subsidy because it would make more low-end project feasible. The McMansions will be built either way (although they might be less opulent without the subsidy), but with a tax credit benefiting low-income families the most, they will be able to bid more and raise sales prices on low-end homes, lifting prices above construction costs in many areas.

Members of Congress are often hesitant to touch the issue of the mortgage interest deduction because it is so popular with higher-income homeowners. Housing affordability for young Americans, however, continues to deteriorate, as rents rise and the supply of starter homes falls.

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.

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.

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