SAN FRANCISCO — The burgeoning federal debt makes it unlikely that the mortgage interest tax deduction will survive in its present form, but any proposed changes to the tax break for homeowners will likely spark a fierce debate over the fundamentals of the U.S. housing market, the value of homeonwership, and consumer behavior.
That’s according to panelists at a housing forum hosted Friday by real estate search and valuation company Zillow Inc. and the University of Southern California’s Lusk Center for Real Estate.
"I think its entirely likely that something big is going to happen (with the MID) starting next year with either administration," said Jason Gold, director and senior fellow at the Washington, D.C.-based Progressive Policy Institute, an independent think tank.
Some members of Congress have proposed eliminating or changing the mortgage interest deduction as one way to help address the nation’s $15 trillion debt and a $1.1 trillion federal budget deficit.
At the end of this year, a series of tax increases and spending cuts to address that deficit are scheduled to go into effect automatically, unless Congress acts to prevent or alter them. Revamping the mortgage interest deduction is one of the solutions proposed to head off that "fiscal cliff" scenario.
Two years ago, a bipartisan deficit reduction commission recommended scaling back the mortgage interest deduction, which is currently capped at mortgages worth up to $1 million for both principal and second homes and home equity debt up to $100,000. The deduction is available only to taxpayers who itemize.
The commission, often referred to as Simpson-Bowles, proposed turning the deduction into a 12 percent nonrefundable tax credit available to all taxpayers, capping eligibility to mortgages worth up to $500,000, and eliminating the deduction on interest from second homes and home equity debt.
The National Association of Realtors, which has consistently defended the mortgage interest deduction in its current form, was highly critical of the recommendation, claiming any changes to the MID could depreciate home prices by up to 15 percent, and promising to "remain vigilant in opposing any plan that modifies or excludes the deductibility of mortgage interest."
At the end of July, the trade group launched an email campaign designed to educate roughly 82 million consumers about the value of homeownership and the federal housing subsidies, including the MID, in place that support it.
The MID and home prices
The MID is a "tax expenditure," meaning its cost must either be made up through higher taxes elsewhere or by adding to the debt, and it costs the government about $90 billion a year.
Richard Green, the director of the USC Lusk Center for Real Estate, told forum attendees that reforming the MID is necessary for fiscal sustainability.
"We need to get revenue," Green said. "You need to make a judgment about what’s better or worse for the economy. In my opinion, it’s better to do it with tax expenditures, rather than rates, though you may have to do both to get to where we need to be."
Because mortgage interest rates are currently so low, he added, "this may be an opportunity to do less damage by reforming the mortgage interest deduction than at other times."
Christopher Thornberg, founding partner at Beacon Economics, agreed. The current low interest rates mean that changing the MID "will have a more moderate impact on home prices," he said. "With that in mind, it’s exactly the time to get rid of it."
He estimated home prices would drop perhaps 6-7 percent overall if the MID were eliminated.
Green declined to estimate how much prices would decrease.
"I have no idea. We’re in a world in which to try to make predictions is much harder than it would have been 10 or 15 years ago," he said.
Dowell Myers, a professor and director of the Population Dynamics Research Group at the USC Sol Price School of Public Policy, said declining prices are "the last thing we want."
"Lower prices are good as long they rise 2 percent per year. I don’t want them to fall 2 percent per year," Myers said. "We must rebuild slowly."
Thornberg disagreed. "I weigh 190 pounds. I guarantee you that first day on the StairMaster is going to be miserable. But that doesn’t change the fact that I need to lose weight," he said.
Just as food and gas prices should be as low as possible, a household’s biggest expenditure — housing — should be as inexpensive as possible, he said. "Over the past five years, falling home prices were a symptom of the underlying problem. They didn’t cause the recession," he said. "In the long-run basis, cheap housing is good for the economy."
He advocated more homebuilding to drive prices down.
Green noted that in some other countries, such as the United Kingdom, there is no mortgage interest deduction. "They get big mortgages just like us, but they pay them off quicker because there’s no incentive to carry a lot of debt." Over time, we could see the same pattern in the U.S., he said.
Panelists observed that eliminating or limiting the scope of the MID could have unintended consequences. Lower home values could mean fewer property taxes paid. More incentive to pay down a mortgage could mean fewer goods consumed and fewer stocks and bonds invested in in the short run. Each would mean less revenue generated than proponents of cutting the MID anticipate, Green said.
"In the short term, it would have an anti-stimulative impact," Green said.
"In the long run, it means our household balance sheets are better," which means people can retire and have money to spend in the future and also be protected from financial shocks, he added.
A mortgage is "a long-term forced saving that builds a storehouse of wealth," Gold said. "We need to make housing something that people can rely on and not this playpen of speculation."
The panelists noted that most economists are against the MID. "(Economists say) it makes housing more expensive, distorts the market, and the revenue that we could get out of it is more important than what it could do to the market," Gold said.
Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis, has said that the MID acts as an incentive for homebuyers to take on bigger mortgages than they might need, making it harder to safeguard the financial system against systemic risk.
Lowering the fraction of mortgage interest households are allowed to deduct from their taxable income would help protect the financial system in the event of another housing boom and bust, Kocherlakota said last year. To encourage homeownership, policymakers could replace the MID with a tax credit that offsets part of a buyer’s down payment on a home.
A Georgia State University study published in May suggested that lenders capture between 9 and 17 percent of the subsidy created by the MID through higher mortgage interest rates.
Because the MID is capped at a $1 million mortgage, the study looked at more than 900,000 "jumbo loans" loans made in 2004 (those for more than $333,700) and found that rates dropped as loan sizes crossed the $1 million mark, and that the larger the portion of the loan that was above this mark, the lower the rates went, SmartMoney reported.
The deduction is projected to cost taxpayers an estimated $609 billion through 2016, and the study results suggested lenders, not homeowners, will receive $55 billion to $104 billion of that subsidy, the publication said,
A recent survey of economists, real estate experts and investment strategists conducted by research and consulting firm Pulsenomics LLC on behalf of Zillow found 60 percent favored getting rid of the mortgage interest tax deduction, with 10 percent saying it should be eliminated immediately and 50 percent saying it should be phased out gradually.
Thirty percent of respondents said the deduction should remain, but that there should be more restrictions on eligibility. Only 11 percent said the deduction should remain as is.
No ‘shock treatment’
Panelists noted that the mortgage interest deduction is politically polarizing because there is a disconnect between how people use it and how it is perceived.
For example, Green said most people in Texas do not itemize their taxes (indeed, only about a third of all U.S. taxpayers do), and therefore they cannot take advantage of the MID.
But studies show "they love the mortgage interest deduction," he said. "There’s a detachment between how taxes actually affect people and how they feel about it."
Green also pointed out that even if the MID were limited to primary residences with a mortgage of no more than $500,000, the middle class would remain largely unaffected.
"Away from California, $500,000 is not a middle-class (home) — that’s an upper-income house. That’s why disproportionately (the MID in its current form) is more beneficial for California, coastal markets, New York, San Diego."
Thornberg agreed. "Clearly this benefits richer people more than it does the middle class."
According to the Tax Policy Center, those in the middle income quintile received $139 from the deduction in 2011, while those in the top income quintile received an average of $2,344. The average benefit overall was $460.
John Burns, CEO of John Burns Real Estate Consulting LLC, said scaling the MID back to $500,000 "really won’t kill the housing market." He added that, because most taxpayers don’t itemize, making the MID a 12 percent tax credit available to all taxpayers would probably boost the amount of money in people’s pockets. He said, however, that such changes "would hurt the move-up market dramatically."
The panelists seemed to support either a gradual phase-out of the MID or alternatives to the MID.
"I would never prescribe shock treatment, particularly" right now with the current state of the economy, Green said.
Thornberg agreed. "Most policies should be phased in, not done overnight."
Green and Gold said they would support something like a credit to first-time homebuyers as an alternative to the MID, though Gold doubted such an alternative would be politically viable.
Myers suggested a MID targeted only to people under age 35.
"Baby boomers are going to be retiring and selling off their houses. I would worry that if (their children) are spooked away from homeownership because we get rid of the MID, it’s a social signal that homeownership" is not for them, he said.
Green said homeownership is "a good thing" for families with children in particular.
"In the U.S., there are two ways you can live in a house — you can own, or have a one-year lease. If you have kids you care about and want to keep them in the same school district," security of tenure "really leads to good outcomes," Green said.
Housing Secretary Shaun Donovan has said the Obama administration, which has been pushing for changes to the MID that would reduce its value to wealthy families, doesn’t advocate getting rid of it altogether.
"This is not the time to be questioning the fundamental pieces [of U.S. housing policy] … while we’re still very much focused on recovering from the crisis," Donovan said. "Anything that would change the system substantially now [would] have a real risk of stopping the momentum that we have in the housing market."
Last week, David Stevens, president and CEO of the Mortgage Bankers Association, told HousingWire his trade group stands ready to advocate for the survival of the mortgage interest deduction, but that it’s too early to react to political slogans about ending the popular tax deduction.
"We need the housing market to recover — particularly the home purchase market — to recover for the broader U.S. economy to get back on track," Stevens said. "Any uncertainty around the impact of consumers on the most significant tax benefit that the U.S. tax system has for the U.S. consumer could be very disruptive."
Presidential candidate Mitt Romney has not clearly stated his stance on the MID, though has twice has raised the possibility of imposing caps on tax benefits to help lower tax rates, the Wall Street Journal reported.
"Instead of simply cutting the home mortgage interest deduction or the write-off for charitable donations, lawmakers could allow each taxpayer one overall allowance to use as desired. Mr. Romney suggested options ranging from $17,000 to $50,000," the Journal said.
A recent survey conducted by public opinion research firm Belden Russonello Strategists LLC on behalf of The National Low Income Housing Coalition, an affordable housing advocacy group, found that 56 percent of 1,006 respondents favored replacing the MID with a tax credit that would provide the same percentage benefit for all households regardless of income.
Nearly two-thirds, 63 percent, supported a $500,000 cap on the size of mortgage for which one can get a tax break. Support for these changes was bipartisan, with nearly equal numbers of Democrats, Republicans and independents favoring both proposals, the NLIHC said. The group estimated the changes would save $20 billion to $40 billion a year.
When asked how the savings should be used, 71 percent said reducing the federal deficit should be a top or high priority, 63 percent said ending homelessness should be a top or high priority, and 62 percent cutting taxes for middle-income people should be a top or high priority.
The NLIHC recommended directing the savings to the National Housing Trust Fund, which provides communities with funds to build, preserve, rehabilitate and operate rental homes that are affordable for extremely and very low-income households.
"The mortgage interest deduction is very popular, but the American people understand that it can be improved to help more middle- and low-income homeowners. At the same time, the savings from reform can be used to end homelessness and create jobs by building more rental homes that low-income families can afford," said Sheila Crowley, president and CEO of the NLIHC, in a statement.
"The American public is ahead of policymakers on this issue. It is time to enact reforms that will stop the subsidy of million-dollar houses and use the savings to help middle- and low-income families who need it most."