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Real Estate News and Advice |
December 3, 2008 |
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 Confusion Over Mortgage Interest Rate Deductions Spurs Debate
by Blanche Evans
Instinctively, the real estate industry flinches whenever talk of removing a homeowner benefit such as the mortgage interest rate deduction comes up, but the President's Advisory Panel on Tax Reform is doing exactly that. Should the real estate industry be panicked? That depends on how individuals feel about a flat tax, or trade-off. At its Oct. 8 meeting, the President's Advisory Panel on Tax Reform discussed the tax benefits associated with changes to housing tax policies, sparking concern from National Association of Realtors' President Al Mansell. The panel's discussion focused on the mortgage interest deduction (MID). While its discussion was not conclusive, panel members reviewed proposals to change the deduction into a 15-20 percent tax credit, says the NAR. Panel members also discussed reducing the current cap of $1.1 million of indebtedness to something between $300,000 and $350,000. But Mansell says it is inappropriate to reduce the $1.1 million cap and suggested that a tax credit could create undue complexity. But others say the mortgage interest rate deduction is prime for elimination. According to a joint study by the Housing and Urban Development and U.S. Census Bureau, nearly 40 percent of all residential properties in the U.S., both owner-occupied and rental units, are owned free and clear with no mortgage. Further, 60 percent of all current mortgages originated four years prior to the survey, Residential Finance Survey: 2001. However, between 1991 and 2001, total mortgage debt outstanding increased by more than 80 percent, and has continued to grow, increasing another 50 percent between 2001 and 2005. For most people, who take the standard deduction, the mortgage interest rate deduction would still be irrelevant. "The mortgage interest deduction will be eliminated, once legislators and taxpayers understand that it is irrelevant for many homeowners," argues California real estate educator Martha R. Williams, J.D. "In the example given, the interest on a $150,000 loan at 6 percent interest is slightly less than $9,000. For a married couple filing jointly for the tax year 2005, the standard deduction will be $10,000. The deduction for property tax will be added to the $9,000 interest deduction, of course, but the standard deduction will also be increased by any dependent deduction(s). For a head of household, the standard deduction for 2005 will be $7,300, but by definition, the head of household will also add dependent deduction(s) to that amount. A single taxpayer, who will have a standard deduction of $5,000 for the 2005 tax year, will be the most likely beneficiary of an interest deduction for 2005 under the facts given, assuming that the single taxpayer's income is high enough to warrant itemizing. Even the single homeowner's advantage is reduced, however, as the proportion of interest to principal paid each year decreases over the life of an amortized loan." She suggests that the "apparent confusion" surrounding the real benefit of the mortgage interest deduction is one more argument in favor of a flat tax. The NAR believes that the mortgage interest deduction (MID) is one of the most effective incentives stimulating home ownership and warns that changes to the MID could seriously erode the value of homes and homeownership. "There has been no assault on the MID since 1996," explains the NAR website. "MID has a checkered history, however. In 1995, and in each Congress since then, House Majority Leader Dick Armey (R-TX) and Senator Richard Shelby (R-AL) introduced legislation to create a "flat tax" system that would significantly broaden the tax base and lower the rates so that there would be a single tax bracket. This legislation would repeal the MID. "Other legislation has been proposed that would limit the MID in various ways. In addition to flat tax bills, many academic and social welfare organizations have advocated a reduction in the MID, with the "savings" to the government being allocated to various housing goals. The most frequently described proposal would reduce the cap on mortgages from $1 million to $300,000 and use the revenues for various federal housing programs. While these proposals may have some appeal with certain constituencies, they would be very controversial. This proposal would be very unfair to high cost areas and could cause significant reductions in the value of more costly housing. This, in turn, would have an adverse impact on the local tax base of many communities. In addition, these proposals do not reflect any recognition of the way that Congress works. While the tax writing committees could change the MID, they have no jurisdiction to establish the trust funds or make other appropriations that social welfare advocates envision. Thus, there is no practical way to raise the tax and appropriate the money. "The latest proposal to change MID comes from various policy analysts who advocate converting the deduction into a credit that could be utilized by non-itemizing homebuyers. Some analysts have even advocated that such a credit-conversion approach could be used to redistribute the MID benefit from upper-income homeowners to lower-income homeowners and homebuyers." Williams suggests that the mortgage interest deduction could be a good "bone" to throw Congress in order to keep other homeowner tax benefits intact. "There is such a great disparity among taxpayers when income levels and home values are compared, it can be hard to generalize," she explains. "Even though the mortgage interest deduction is of no use for many homeowners (including those who own their property free and clear, as well as those with low interest payments and/or taxable income), its loss could be significant (if not traumatic) for homeowners who were unfortunate enough to be buyers at recent market highs. Someone who just paid $600,000 for a starter home in California, and is making a payment of more than $2,500 a month on an interest-only loan, definitely benefits from the mortgage interest deduction. The deduction is lost above the million-dollar loan threshold, but the homebuyers who benefit from the deduction can be expected to make a bit of noise if Congress attempts to eliminate it. On the other hand, since the deductibility of mortgage interest has already been capped (despite the efforts of homeowners and NAR), that's probably a strong indication that its days are numbered. "If the mortgage interest deduction is phased out completely, the loss of the deduction is likely to impact home affordability in the states with the highest rates of price inflation -- the very places where the deduction is most useful. There is so much pent-up demand in those areas, however, I doubt prices will dip significantly as a result. "Congress has been generous to homeowners in the past, particularly with the increase in the amount of profit on the sale of a home that is tax-free to home sellers who qualify -- up to $500,000 for a married couple -- and that benefit can be realized more than once. That tax break may be even more valuable than the mortgage interest deduction. There is also the step-up in basis that benefits the heirs of an owner of any kind of real estate. Let's hope Congress doesn't have that one in its crosshairs," Williams concludes. The continuing controversy has caused NAR president Al Mansell to write the Federal Taxation Committee. Following is the text of his letter to the committee: Primary Realtor® Committee: Federal Taxation Committee October 14, 2005
Dear Senators: Earlier this year the National Association of Realtors submitted comments to the Panel expressing our views on important tax provisions related to housing and commercial real estate, including the mortgage interest deduction and other housing-related provisions, depreciation of investment and commercial real estate and the special considerations that apply to self-employed persons. Following your October 11 public meeting, we wish to supplement those comments with observations about several points covered in your discussion of the mortgage interest deduction and other tax benefits associated with owner-occupied housing. This letter is intended to make you aware of concerns you may wish to take into account as you prepare your final recommendations. Housing and American Culture Never dismiss or underestimate Americans' passion for homeownership. Calling homeownership the "American Dream" is not a mere slogan, but rather a bedrock value. Owning a piece of property has been central to American values since Plymouth and Jamestown. Homes are the foundation of our culture, the place where families eat and learn together, the basis for community life. The imagery of Tom Sawyer, the great American icon, painting a picket fence and engaging his pals to get the work done is a statement about the central notion of having a place to call one's own and of keeping it up to preserve a family's standing in the community. Do not take such imagery or passion lightly. The tax system does not "cause" homeownership. The tax system facilitates ownership. The result has been that our nation has achieved remarkably high rates of homeownership. The tax system supports homeownership by making it more affordable. While it is true that only about one-third of taxpayers itemize deductions, it is also true that, over time, more than one third of taxpayers receive the benefit. Over time, mortgages get paid off, other new homeowners enter the market and family tax circumstances change. Arguably, the standard deduction gives non-itemizing taxpayers a "better" answer than utilizing the mortgage interest deduction, so it is not clear that non-itemizers have been put at a disadvantage. The federal policy choice to support homeownership has been in the Internal Revenue Code since its inception. We see no valid reason to undermine that basic decision. The Panel's Proposals As President of the National Assocation of Realtors I have already received reports from our members describing consumer uncertainty about the Panel's recommendations. The news reports have created a perception that mortgage interest benefits may be eliminated. The public may be misconstruing the news reports, but the fact remains that the news reports and public perception are already chilling some parts of the marketplace, particularly in high cost areas. The Panelists must understand that limiting or eliminating tax benefits will have an adverse impact on housing markets and the value of housing. The housing market, while large, is a fragile, delicate instrument. For more than five years, housing has been the most lively and vibrant sector in the economy and fueled much of the 2001 – 2002 economic recovery. Some panelists expressed concern about real estate speculation and about the size of houses. We believe that penalizing current homeowners by reconfiguring the mortgage interest rules is a completely inappropriate mechanism for curtailing abusive lending practices or defeating local land use decisions. In addition to the chilling effect news reports have created, we note as well the lack of clarity about the specifics of your proposal. Our own counsel, who attended the October 11 meeting, could discern no clear articulation of either the amount by which the current law $1.1 million cap would be reduced or what the effective tax rate for mortgage deductions would be under a tax credit type of proposal. The limitation amounts have been reported in the media as ranging from $300,000 to $350,000. The lack of specificity is confusing to us, to our members and, most of all, to consumers. It is unwise to create uncertainty of that magnitude in any marketplace, much less in a high-priced, active but delicate housing market. The following are our comments on the various concepts put forth at the October 11 meeting. Converting the Mortgage Interest Deduction to a Credit We believe that any change of this type will create winners and losers. For a benchmark, we have undertaken research projects assessing the impact of a tax credit measured against the current deduction rules. Our emerging conclusion is that, over time, there would be more losers than winners unless the credit rate is comparable to the higher brackets of the tax system. In all events, we believe that the value of the existing stock, particularly in high cost areas, would be diminished. The Tax Reform Act of 1986 provided ample evidence that when the tax benefits associated with real estate ownership are curtailed, the value of real estate declines. A substantial decline in residential values would likely occur with a conversion to a credit that reduced the economic benefit of tax deductions. The 1986 Act provided 5-year transition relief for owners of investment real estate, but even with the benefit of transition rules, the loss of value in the commercial real estate sector was 30 percent. Observers would likely find it ironic that, in today's era of low savings, a change to the tax laws could sharply erode the equity savings of homeowners. We can identify no justification for diminishing the savings families have in their homes. Reducing the $1 Million Cap on Indebtedness The $1 million cap on mortgage indebtedness ($1.1 million when home equity debt is included) as a measure of allowable mortgage interest deductions was adopted in 1987. NAR supported that change from prior law, as it was a substantial simplification over the mortgage interest limitations that had been included in the 1986 Tax Reform Act. The $1.1 million cap has not been modified or indexed for inflation since 1987. Given inflation, the overall real growth in the economy, the substantial increase in the cost of housing and growth in the homeownership rate since 1987, we were startled that the Panel would even consider reducing that cap. Moreover, we believe that it is facile to say that the cap should be reduced to the FHA loan limit amount. We would ask, "Which FHA loan limit?" Those loan limits range today from $172,632 to $312,895, depending on geographic location. (Note these limits can go as high as about $469,344 in Alaska and Hawaii, but not in any other high cost state.) Worse yet, FHA limits vary within a state. In California alone, more than a dozen FHA limits are in effect in various parts of the state. We share Senator Breaux's expressed concerns about the very uneven regional and community application of any proposal that would reduce the current law $1 million cap, particularly to levels as low and as complex as the FHA loan limits. It is unclear how using the FHA community-based mechanism, measured based on Metropolitan Statistical Areas, could be transposed fairly into the federal income tax system. We believe that grafting the FHA system into the tax system would result in extraordinary complexity. Moreover, we note that a $350,000 home in Indiana would be significantly different in size and possibly in quality from a $350,000 home in high cost areas such as Miami and New York and even in a smaller community such as Charlottesville, Virginia. Note, as well, that bipartisan legislation is pending in the House that would raise the Fannie Mae and Freddie Mac loan limits to mitigate financing challenges in high cost states. The FHA limits are generally less than the Fannie Mae and Freddie Mac conforming limits, but the formula for computing the FHA limits takes the Fannie and Freddie limits into consideration. Thus, the clear trend of the financial market policy makers is to make more capital available to lenders. Any proposal that undermines the tax treatment of that capital flies in the face of that intent and seems to send contradictory signals to housing markets. Reducing the Cap and Converting to a Credit The Panel's discussion was unclear about the relationship, if any, between reducing the $1 million cap and converting a deduction into a tax credit. If the Panel were to propose that Congress make both of these changes, the likely adverse impact on housing, and the attendant erosion of family savings, would be staggering. We are compiling for your staff a list of the states and Metropolitan Statistical Areas (MSAs) that have median prices above $300,000 to illustrate just how very far reaching this type of proposal would be. Other Housing-related Issues The Panel did not discuss the impact of this proposal on the second home market. We bring to your attention that this is one of the more vibrant sectors of the housing market. Historically, it has been the general pattern that at least one Congressional district in every state (except Connecticut, where second homes are not concentrated in any particular district), has a lively REALTOR second home/vacation property market. The Panel's discussion concerning the $250,000/$500,000 exclusion on the sale of a principal residence was inconclusive. This provision, enacted in 1997, is among the simplest, most taxpayer-friendly provisions in the Code. We urge you to retain that provision. In addition, that provision was not indexed for inflation, so any reduction of the caps would be particularly troubling. In his presentation, Professor Poterba stated that if less money were invested in owner-occupied housing, more money would be invested in "more productive" assets such as stocks and equipment. We note that stock or equipment ownership does not provide the foundation for community life, does not provide an impetus to encourage good schools, does not foster lower crime rates and does not contribute to the tax base of local governments. Housing does those things. Moreover, it is not a foregone conclusion that individuals who purchase residences for their families would necessarily have the requisite skills to choose and purchase stocks or other securities. Similarly, no family is likely to acquire manufacturing equipment to improve their community or schools. Professor Poterba stated that if families bought smaller houses they might buy more stock. We do not believe it is the function of the tax system to determine the size of a house for any family or its method of saving. We look forward to receiving your report and to continuing this dialogue. Sincerely, Al Mansell, President
Published: October 19, 2005 Use of this article without permission is a violation of federal copyright laws. 
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Blanche Evans is the award-winning senior editor of Realty Times, the Internet's leading independent real estate news service. She is featured daily on the Realty Times Video Network in the "Realty Viewpoint" segment.
