The following is an abridged editorial version of the original article. For the full article, please click here.

Should we get rid of the mortgage interest tax deduction on personal residences?

The deduction, which allows homeowners to write off interest on mortgages of up to $1.1 million, causes homebuyers to stretch their incomes and borrow to the max to purchase property. Despite its attractiveness to populist politicians pandering to constituents by pushing homeownership and the fabled “American Dream,” the tax itself actually favors individuals with higher incomes in higher tax brackets who take out bigger loans, rather than individuals with lower incomes in lower tax brackets — the very targets of the public policy push towards getting tenants into homeownership. 

Those presently in favor of the tax deduction point out that making housing less financially attractive is a dangerous idea with the housing market still looking for its crutches.  Without the itemized tax deduction, they argue, the purchasing power of potential homebuyers drops, and at a time when the market desperately needs highly-motivated buyers.

However, evidence from other developed countries suggests that eliminating tax subsidies for personal housing can be done. Britain successfully phased out its mortgage interest tax deduction over a 12-year period.  This did not cause Britain’s housing market to deteriorate (indeed, Britain was subject — as were many other advanced industrial nations — to the same overheated housing conditions as America during the Millennium Boom).

Despite the initial public outcry — primarily by the wealthy — phasing out the mortgage interest tax deduction would be entirely feasible and practical in the United States.

In the 2000s, government policy deliberately began to force-feed homeownership to tenants in an effort to kick the homeownership rate up to 70% throughout the country. Part of that dangling carrot was the marketing of the tax deduction. The collective push eventually inflated the homeownership rate to over 69%.

Prior to the homeownership push, the rate was doing fine at a steady 64% homeownership experienced nationally throughout the 1980s and 1990s —  a natural equilibrium between those Americans deciding to become homeowners or remain long-life tenants. This homeownership equilibrium would not be disturbed by a return to homeownership without an interest tax deduction.

This premature homeownership push and the ensuing easy-credit policies did more harm than good. The first-time home-buying population (those aged 25-34 and single parents) were prematurely placed into homes with promises of property, security and riches. Not only are those homeowners now unable to hold on to their homes, they will not likely be back in the future to drive housing as they ought to have, if they’d been left alone to do so. [For more information on the population of the homebuyers, see the February 2010 Market Chart, First-time homebuyers and new housing.]

Getting rid of the mortgage interest tax deduction will certainly adjust the purchasing power of those looking to get into the housing market, but it will also adjust the prices sellers may ask for their property (after the initial stickiness has worn off).  Removing the mortgage interest deduction would eventually induce a return to real estate market fundamentals. [For more information about the sticky price phenomenon, see the December 2009 first tuesday article, The flat line recovery:  a side-effect of sticky housing prices.]

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Tagged as: real estate fundamentals, sticky pricing