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How the mortgage interest deduction hurts our cities

The tax policy encourages urban sprawl and gives breaks to those who need them least.

The mortgage interest deduction, according to a 2010 analysis by the Tax Policy Institute, disproportionately benefits the top fifth of earners.
MinnPost photo by Corey Anderson

Homeowners these days remind me of the 600 members of the Light Brigade — you know, those “half-a-league-half-a-league-onward” guys. But instead of having cannon to the right of them and cannon to the left, they are beset on all sides by policy wonks who would like to eliminate or scale back the home mortgage interest deduction or MID.

Just to remind you, or in case you are somewhat tax-challenged, people who own their homes are allowed to deduct from their income all interest paid on any mortgage up to $1 million. So, if your interest comes to $10,000 a year and you’re in the 28 percent tax bracket, you save $2,800 on your taxes.

Even though they hinted, Mitt Romney, Paul Ryan and President Obama didn’t have the cojones during the campaign to say that this deduction, which has been one of the pillars on which American homeowners based their investment in a dwelling that was a huge multiple of their earnings, might disappear. But analysts at the Cato Institute and the American Enterprise Institute (on the right), the Brookings Institution and the Center for American Progress (on the left) and the Simpson-Bowles Commission (bipartisan) have all said that maybe we can’t afford it any longer.

Now comes criticism of the MID from another quarter: Smart Growth America, a nonprofit whose aim is to fight urban sprawl and “make it more affordable to live near work and the grocery store.” A report out this week called “Federal Involvement in Real Estate”  takes a holistic look at the government’s $450 billion annual spending on grants, loans, loan guarantees and tax breaks for housing and commercial property. The report’s contention: “U.S. taxpayers are failing to get the most out of all these large federal investments.”

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So what else is new?

The largest share of the federal government’s involvement in real estate comes from FHA loans and loan guarantees, about $1.23 trillion from 2007 through 2011, according to Smart Growth America. It’s not all money out the door. Only if homeowners fail to repay does the government lose money. Of course, bad loans have currently put the agency in the red by about $34 billion.

After that, the government’s biggest commitment to real estate is the home MID, which accounted for $400 billion in tax expenditures over the same five-year period, says Ilana Preuss, Smart Growth America’s vice president. Tax expenditures, in case you’re wondering, are revenues the government gives up by allowing credits, deductions, exemptions and other goodies.

Broad political spectrum

It’s hard to believe that so many analysts from such a broad political spectrum are coming out against a tax break that has been termed “the other third rail of American politics,” the first third rail being Social Security. Supposedly, any politician who recommends its disappearance or phase-out would incur such wrath from the 65.5 percent of households who own homes that he or she would immediately frizzle like bacon on an overheated griddle.

But when there’s a $1.1 trillion budget deficit lying out there, any government giveaway deserves some scrutiny. And, much to my surprise, a December poll conducted by Princeton Survey Research Associates found that 41 percent of the public favored reducing the mortgage interest deduction for all taxpayers. (Twenty-one percent wanted it pared for those earning over $250,000, and 31 percent opposed any change.)   

So what is the rap on the mortgage interest deduction?

Well, according to Preuss, it is no longer doing the job it was designed to do, namely encourage homeownership, which, to the American way of thinking, is an absolute good (a belief that may be debatable). For evidence, she relies on another study — by the Reason Foundation, a libertarian think tank. It points out that while the total amount devoted to the mortgage deduction has fluctuated since 1994, homeownership has remained fairly constant, at about 65 percent. (It climbed to nearly 70 percent during the housing bubble, but then collapsed when it burst.)

The deduction doesn’t induce lower-income people to buy homes. If they can’t itemize — because the standard deduction is larger than their write-offs — they can’t claim it. Instead, the MID encourages those who are well off to spend more on a house they would have bought anyway — or to take out a bigger mortgage and go more deeply into debt.

The deduction, according to a 2010 analysis by the Tax Policy Institute, disproportionately benefits the top fifth of earners — because the bigger the mortgage and the higher your tax bracket, the more you save. In 2010, for example, households with incomes over $200,000 received a $6,253 write-off, those earning $75,000 to $100,000 got a $1,046 deduction and people with incomes of $20,000 to $30,000 saw a tax benefit of only $340. About 40 percent of the $72 billion in revenue forgone by the government went to families with incomes over $200,000. Another 35 percent went to households whose annual incomes were between $100,000 and $200,000.

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Second homes

Preuss of Smart Growth America points out another inequity. “The mortgage interest deduction can be claimed on second homes as well,” she says. Some 30 percent of those who take the deduction on their principal residence take one on a second, too. In the meantime, those who rent apartments receive no write-offs at all.

Giving such a hefty tax advantage to homeowners over renters encourages the construction of single-family homes rather than apartments. And this is continuing at a time, says Preuss, when families increasingly want apartments. If financial incentives were neutral, cities would probably have more people living in more efficient patterns (in smaller homes or multi-family buildings) closer to their jobs.

What if the deduction were withdrawn? Would the housing market collapse?

To hear the National Association of Realtors tell it, the result would be disastrous — a drop in housing values of about 17 percent. But that’s a matter for debate. Jeremy Horpedahl, an assistant professor of economics at Buena Vista University in Storm Lake, Iowa, calculates that housing sales might drop by 0.4 percent; home prices by 3 to 6 percent. Of course, seeing any retreat in the housing market now that it’s making a comeback would not be a terrific development, to say the least.

Smart Growth America is still formulating its recommendations on the MID, FHA and everything else. But others have already determined that the MID must go. Both Simpson-Bowles and the Center for American Progress advocate dumping it and phasing in an 18 percent housing tax credit. (A credit is deducted dollar-for-dollar from your tax bill.) So if a family pays, say, $8,000 in mortgage interest each year, it would get a credit of $1,440, no matter their tax bracket. And they would not have to itemize to receive it.

That fix would still not rectify the imbalance between renting and owning. But it might go a long way toward correcting our tax code’s tendency to give breaks to those who need them least.