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November 3, 2005

Goodbye, My Sweet Deduction

By EDUARDO PORTER and DAVID LEONHARDT

There are no cows more sacred in the tax code than the deductions for mortgage interest and property taxes. Together, they add up to at least a $75 billion annual subsidy for housing and homeowners. President Bush, in establishing his advisory panel on tax reform, specifically asked the group to preserve support for home ownership.

So it was quite a shock that the panel, which released its final report on Tuesday, concluded that it had no choice but to significantly trim the home mortgage deduction and eliminate state and local tax deductions if it wanted to find a way to simplify the income tax.

By combining that move with a variety of other measures, the panel was also able to bury the alternative minimum tax, a complex tax originally intended to prevent the wealthy from escaping taxes that is now starting to hit millions of otherwise ordinary upper-middle-class families who have a typical range of itemized deductions and personal exemptions.

The panel had a powerful rationale behind its proposal: many economists say the real estate subsidy is one of the tax code's most unfair features, overwhelmingly benefiting the affluent and pulling investment from the rest of the economy into the housing sector.

But for millions of homeowners, what no doubt matters most about the plan is how it affects their bottom line. And for many of them, especially those living in houses in expensive markets in California and the Northeast, the answer is clear: If it becomes law, the value of their homes will almost certainly fall.

The pain that would be caused by putting an end to deductions for mortgage interest and property taxes explains a lot of the motivation behind the attacks that greeted the panel's proposals.

"I think the short-run prospects of Congress adopting these are very low," said Joel B. Slemrod, the director of the Office of Tax Policy Research at the University of Michigan. "They take away a lot of the deductions and credits that people have gotten used to, and we know that losers cry louder than winners sing."

The plan by the presidential panel would reduce the mortgage deduction on homes in two ways.

First, it would limit the amount of the mortgage eligible to be deducted, cutting it from the current cap of a little more $1 million to as low as $227,000 in cheaper housing markets like Springfield, Ohio, to as high as $412,000 in places like New York and many of its suburbs.

Second, families would receive a credit equal to 15 percent of the interest paid on a mortgage below the cap, rather than a deduction that can be worth as much as 35 percent for taxpayers at the high end of the income scale.

Just about everybody involved in the housing and real estate market has raised objections to this proposal. In a statement released Monday, the National Association of Realtors estimated that home prices across the nation would fall by 15 percent, with "a devastating effect on the nation's housing economy." The Mortgage Bankers Association called the proposals "a tax increase for a lot of working Americans."

Even supporters of the changes acknowledge that house prices would fall. "Almost any economic analysis will conclude that there will be some downward effect on prices, especially at the top of the market," said James Poterba, an economist at the Massachusetts Institute of Technology who is on the president's panel. "The question is how large it will be."

The elimination of the deduction for state and local taxes, including property taxes, also has the potential to bring down house values, especially in high-tax states like New York, California and New Jersey, where homes are selling at record-high prices.

One way to estimate the total impact is to calculate how the change would affect a household's monthly housing payments. If home buyers try to keep their monthly house payment steady, an analysis by Dean Baker, co-director of the Center for Economic Policy Research in Washington, suggests, prices could fall by more than 20 percent in higher-priced markets like New York City. Even in cheaper markets, homes that are priced above the average could take a substantial hit.

A family living in Lansing, Mich., for example, with $90,000 in taxable income, would have a marginal income tax rate of 25 percent. In Lansing, the average home price is around $250,000.

If that family were to buy a $500,000 home today with 20 percent down and a 6 percent fixed-rate mortgage - a fairly typical arrangement - the I.R.S. would effectively refund about $7,125 in the first year, according to Mr. Baker's analysis. Adding a 0.9 percent property tax, the total monthly payment, net of federal taxes, would be about $2,160.

Under the new system, however, the family would receive a return of $2,250 from the I.R.S. - 15 percent of the interest at the mortgage limit of $250,000 - effectively pushing their net payment up by $400 each month. If the maximum monthly cost they could afford was $2,160, they would have to settle for a house worth about $70,000 less.

The more expensive the home, the larger the effect. According to a similar analysis by Mr. Baker, a family in the top tax bracket who today could afford a $1 million home in Manhattan would have to trim their budget by more than $200,000 to keep monthly payments the same.

To soften the blow, the panel proposed to phase the change in over five years. But as home buyers across the country were forced to cut back on the value of homes they could afford to buy, they would inevitably drag home prices down.

"If you look at it that way, you have to be prepared for prices to plunge," said Mr. Baker, who has long been expecting housing prices to drop for other reasons.

Mr. Poterba argues that it is unlikely home prices would fall as much as others fear. For one, the changes would also slow investment in housing, reducing the supply of homes along with the demand. Methods of financing homes would also change in response to the tax laws.

Notwithstanding homeowners' pain, reducing the tax code's subsidy to housing is a sound idea, many economists say. "It's an appropriate change to the tax code," said Mark Zandi, chief economist at Economy.com, a research firm. "While it may have made sense a quarter of a century ago, now I don't see a compelling advantage to providing these tax advantages to housing."

To begin with, the mortgage deduction diverts capital from other industries by subsidizing investment in housing relative to other economic activities. Moreover, while the tax deductions were conceived to help people who otherwise could not afford to buy a home, the principal effect today is to encourage upper-income taxpayers to buy ever bigger and more expensive houses.

For all the talk of bolstering home ownership, said Edward L. Glaeser, an economics professor at Harvard, the mortgage tax deduction has done very little to help people into homes. He said the subsidy to taxpayers implicit in the deduction had varied widely over the last 40 years, going up and down with the fluctuation of inflation and interest rates. Yet home ownership over the period has drifted in a band of 63 to 69 percent. And home ownership levels in other affluent countries without such subsidies are generally no lower than in the United States.

Instead, what the subsidy has done is encourage people to build and buy bigger and more expensive houses. "The deduction increases the amount spent on housing," Mr. Glaeser said, "but it has almost no effect on the home ownership rate."

Today, most of the mortgage tax advantages accrue to the rich rather than struggling first-time homeowners. More than 55 percent of the mortgage tax subsidy last year, according to the Congressional Joint Committee on Taxation, accrued to just 12 percent of taxpayers with incomes above $100,000.

Low-income homeowners often do not claim the deduction, opting instead to take the $10,000 standard deduction available to families. Turning the deduction into a tax credit would equalize its value and make it available to more people on the lower end of the market.

"At the high end it reduces demand and will probably push prices down," Mr. Slemrod said. "For low-end housing, it could go the other way around."