Will the mortgage tax break survive?
Just as the U.S. housing boom appears to be slowing, debate is starting among policymakers about reining in one of the most sacred cows of American public policy: the mortgage-interest deduction and other generous tax benefits granted to homeowners.
A presidential commission on tax reform will take up the subject for the first time today. "Everything's on the table," said Charles Rossotti, a panel member who was commissioner of Internal Revenue from 1997 to 2002.
The mortgage-interest deduction will save homeowners $61.5 billion this year. No one expects the commission to recommend its elimination. Instead, the panel is likely to consider scaling back the deduction for mortgage interest on second homes or home equity loans, and changing the deduction for property taxes, among other things.
The stakes in such a discussion are huge.
Changing the tax benefits for homeowners, even if done slowly, could cause short-term convulsions in the market as buyers recalculated what they could afford. The tumult could be most pronounced for homeowners in states with the highest prices. In the long term, however, housing could ultimately become more affordable as some of the stimulus that has sent prices soaring is removed.
Any proposed shift will encounter strong and possibly overwhelming resistance. But with a rising budget deficit, the prospects for change are much greater than they've ever been, according to those involved in the debate.
Homeownership wasn't always a favored child. When the individual tax code was created in 1913, all types of interest were deductible. Most fell away over time, but housing remained and became even more special.
Eight years ago, capital gains taxes were eliminated for sellers who had profits of up to $250,000 (for individuals) or $500,000 (for couples). That's created a vast amount of wealth and helped power a housing boom that has seen prices double or triple in hot markets.
Some policymakers and analysts are beginning to wonder if such breaks are providing the wrong incentives, giving hefty deductions to millionaires buying Beverly Hills estates as well as speculators snapping up Las Vegas ranch houses hoping to turn a quick profit.
A drain on federal coffers
U.S. Comptroller General David Walker said provisions such as the capital-gains exemption are costing the government much more money than anyone forecast when they were first proposed. In a new study, the Government Accountability Office calculated the exemption drained $29.7 billion from federal coffers last year.
"We need to review the reasonableness, appropriateness and effectiveness" of such provisions, Walker said.
Presidents and members of Congress have long heralded the importance of homeownership, saying it gives people roots in a neighborhood and makes them better, more caring citizens. A home, not a college education or a fulfilling job, is the embodiment of the American dream. Politicians are also mindful of the fact that the United States' 74 million homeowners form one of its largest special interest groups.
President Bush set up the President's Advisory Panel on Tax Reform in January to recommend changes in the tax code. The panel, co-chaired by former Sens. Connie Mack and John Breaux, will submit suggestions to Treasury Secretary John W. Snow this fall. Bush will choose among the recommendations to propose to Congress.
Bush specifically charged the panel to take account of "the importance of homeownership and charity in American society."
That led many to conclude that the homeowner deductions were safe. "The mother of all tax subsidies ... shall remain untouched," wrote economist and tax expert Martin A. Sullivan in Tax Notes.
Alternative minimum tax
That was good news for the real estate agents, home builders, contractors, do-it-yourself stores and anyone planning to cash in by selling their house -- among the strongest supporters of the status quo. But unfortunately for them, the mood changed over the summer.
"There has been a growing expectation that the framework for taxing housing could be revised," said National Association of Realtors tax counsel Linda Goold.
One reason for the shift: the expected demise of the alternative minimum tax. Originally designed to make sure those with high incomes didn't deduct their tax liabilities away, the AMT is not indexed for inflation. As a result, the number of people who will have to pay it is expected to increase dramatically over the next decade, eventually incorporating much of the upper middle class.
At a meeting in July, the nine panel members agreed unanimously to recommend eliminating the AMT as an unfair and poorly designed parallel tax system. Because their mandate is to be revenue-neutral, that required them to come up with $1.2 trillion in other receipts over the next decade.
"The money has to be found by either raising rates or changing tax expenditures," said commission member Elizabeth Garrett.
Homeownership benefits
Tax expenditures are the government's term for money it forgoes due to targeted tax relief. According to the Government Accountability Office, the number of tax expenditures has risen since 1974 from 67 to 146. The annual amount of lost revenue has tripled during that time, to $730 billion. That's about twice the size of the current budget deficit.
The biggest tax expenditure, totaling more than $100 billion in its various permutations, is to homeowners. Almost as big are the employers' tax-free contributions to their employees' health benefits and the tax-free status of 401(k) contributions.
"We privilege homeownership as a form of investment by a considerable amount," said Garrett, a professor of law and politics at the University of Southern California. "You always have to ask yourself, is preferential treatment justified?"
She noted that homeowners can deduct interest paid on up to $1 million in mortgage debt on a first or second home, and that the deduction is worth more to families in higher tax brackets.
"If we were going to subsidize homeownership through a spending program," Garrett said, "it's not clear this is how we'd design it."
A gradual phase-in
In February, the Congressional Budget Office said cutting the $1 million mortgage deductibility ceiling in half would affect 700,000 homeowners and raise $2.7 billion.
A sudden drop in the ceiling "would reduce home values, mortgage lending and home building at the top end of the housing market," the study's authors warn. Their solution: phase it in gradually.
A notable feature of the recent housing boom is that it's enriched many owners but hasn't expanded homeownership, which is supposed to be the point of these benefits.
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