As Congress looks for ways to close the growing deficit and curb spending, the mortgage interest deduction could be on the chopping block, and with good reason: it’s one of the largest expenditures in the tax code. But some worry taking it off the table will slow the housing market recovery and have long-term economic consequences.
“We are in the midst of a housing recovery that is still very fragile,” says Nicolas Retsinas, senior lecturer in real estate at the Harvard Business School. “Any withdraw of a subsidy or incentive runs the risk of jeopardizing the recovery, but given the size and impact of the deduction and the focus of it and Washington’s budget reform it’s hard to believe it’s not being looked at. There are too many commas involved for lawmakers not to look at it.”
Earlier this week, the nonpartisan congressional Joint Committee on Taxation released its report of potential tax reform measures and real estate played a central role, making it likely lawmakers will revamp the mortgage interest rate deduction.
House Ways and Means Committee Chairman Dave Camp, (R-Mich,) is spearheading the effort to simplify the tax code, already holding 20 committee hearings with the most recent focusing on the mortgage interest deduction.
Lawmakers are treading lightly with this politically-sensitive issue; after all, it’s been around since 1913 and homeowners have gotten used to the hefty deduction.
The Joint Committee on Taxation estimates that 34 million households claimed the home mortgage deduction in 2012, costing the federal government $68 billion in revenue. However, those taking advantage of the deduction skews heavily toward taxpayers along the East and West coasts, according to a recent report from The Pew Charitable Trusts. Homeowners in Maryland claim the deduction at a rate of 37%, with residents in West Virginia and North Dakota at the other end of the spectrum with just 15% taking it.
Different proposals have been put forth on how to reform the deduction, including lowering the $1 million ceiling on the amount of loan that can be deducted, not making it eligible for second homes and transforming the deduction into a credit.
President Obama has proposed restricting the deduction and other tax breaks to the value they would have in the 28% bracket.
No matter what Congress decides to do with the deduction, experts agree that any change needs to be done slowly.
“There is an expectation that if Congress just does a little bit today with the deduction,” says Jerry Hanweck, professor of finance in George Mason's School of Management. He noted that when Congress got rid of the ability to deduct interest on consumer loans, “they did it a little bit at a time, and people thought, ‘well that’s not going to be the end of it’ and they cut back in spending, because of losing the tax advantage.”
How the deduction is modified will impact the housing market and economy as well as the geographical distribution of the benefit.
Impact on Home Prices
Patrick Newport, director of long term forecasting at IHS Global Insight, says eliminating the deduction would cause home prices to decrease slightly, especially in markets with high home prices. “Cities with higher-income people and home prices, like Boston or San Francisco, would see bigger price decreases than those in say, South Dakota. Prices in cities would drop more than those in rural areas.”
Hanweck adds that buyers are more likely to buy smaller, less expensive homes without the credit. “They are going to want to put more money down because they are going to want smaller mortgage payments.”
Since the deduction is more appealing to wealthier taxpayers, getting rid of it would hurt the higher-end and luxury home market, according to Ted Gayer, senior fellow of Economic Studies at the Brookings Institution.
“The deduction is structured now to overwhelming target the wealthier and people getting big loans. Without it, you would see more support of median and lower-income homeowners and would see more construction of these type homes.”
The composition of the market could also shift to more renters than owners. Not having the deduction to rely on could delay consumers to make the leap to become homebuyers.
“There are many psychological decisions that go into deciding to buy a home,” Retsinas explains. “Our research shows that even people who don’t take the deduction consider it important and consumers will use not having the deduction as part of their reasoning not to buy a home. “
Experts agree that home ownership could tick down without the deduction, but they disagree on how much it would hurt the economy.
Retsinas says home ownership helps create a stable workforce which is vital to a thriving economy and that every country around the world supports some type of home ownership, though not necessarily through a deduction. “Where we went wrong is that we forgot homes are to be lived in, not to buy and sell and use like cash.”
Hanweck worries that without the benefit the nation’s GDP could decrease by one percentage point over the next two to three years since housing activity, which makes up a large portion of economic growth, will likely slow. However, he says eventually construction of new rental units and smaller homes could offset the decline.
Homeowners would have less discretionary spending without the deduction which could also impact economic growth. “People who bought big houses would see a substantial decrease in discretionary funds, and just like when the payroll tax was reinstituted at the start of the year, we will see consumers slowing their spending and saving more.”