Tax Reform Proposals - II

In my previous post, I mentioned the President's tax reform commission's idea of putting a cap on the amount of the exclusion for employer-provided healthcare benefits. Their other proposal also involved a cap - this time on the deductability of mortgage interest.

Homeowners in the United States get some hefty tax benefits, and mortgage interest is just one of those benefits. Since the Tax Reform Act of 1986, the deductability of interest expenditures has been severely constrained. The interest on your car loan or your credit card is paid with after-tax dollars. However, if you purchase a home with borrowed money (or if you have a home equity loan, subject to a few more limitations) you can deduct the interest on that debt, effectively allowing you to pay it with pretax dollars. This effectively gives the homeowner a lower cost of capital. Alternatively, it may effectively raise the price that a homeowner is willing to pay, based on that monthly cost baked into his/her/their mortgage payments.

Even though the taxpayer/debtor is the nominal beneficiary of the mortgage interest deduction each year, it is likely that the real beneficiary in economic terms was the seller of the home. The seller was probably able to realize a higher value associated with the lower after-tax cost of home ownership. (My former colleague Kyle Logue wrote a terrific article on this issue regarding transition rules in taxation.)

Current law allows deductions for acquisition indebtedness capped at $1 million, and for home equity indebtedness capped at $100,000. Assuming a 6% mortgage, that translates to a $60,000 tax deduction for a $1 million home debt. Using round figures of say 25 percent as a marginal tax rate, that translates to a $15,000 tax savings. Who incurs a $1 million mortage? Not many folks in my part of the country, but lots of them on the coasts. (Some of them are living in little more than cardboard boxes for their $1 million, but if that's where they want to live, more power to them.)

Cutting this down can raise revenue, and it will tend to raise it from the upper income levels of the middle class, who are most likely to be affected by the cap. Younger families that have not yet earned the income to pay off their mortgages will also be affected, leaving the older folks tax free. And people in areas with higher real estate values (and thus higher purchase prices) will also be affected. Thus, there are some political hot potatoes to pass around here on this one. Moreover, you can bet that the real estate lobby will be putting pressure on this change, especially given the potential to depress values if the cost of capital to aquire a more expensive property increases.

Keep in mind that this is not the only benefit you get from home ownership. Another one that I think deserves reconsideration is the section 121 exclusion of up to $500,000 for a married couple on gains for the sale of a principal residence. That is a big exclusion from the tax base, which I suspect benefits people on the coasts more than in the Midwest. It also adds to the subsidy list for the person owning a home. Home ownership is a good, but it is not the only good to be considered in making tax policy.

EAM