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This article digests the current use of U.S. housing subsidies. This is the first article in a series evaluating domestic and foreign housing subsidies. The second article can be found here.
Housing policies in the world market
Homeownership in the United States (U.S.) is deeply intertwined with the psyche of the population. For many, homeownership is both an economic objective and a moral purpose; the “American Dream” of homeownership is associated with personal independence, community involvement, fiscal responsibility and national pride.
Owning a home, to some, is equivalent to a patriotic duty. Government agencies charged with supporting homeownership, like the Federal Housing Administration (FHA), Fannie MaeA government-sponsored entity operating in the secondary mortgage market. and Freddie Mac, reinforce the association between house and nation (as does the tax code).
In the wake of the recent recession, as many global economies continue to tremble on the verge of collapse, it is now an opportune time to question the history that led to our present model of homeownership. As first tuesday has often discussed, the business of real estate in the U.S. has entered a new paradigm. [For more information about the new real estate paradigm, see the May 2010 first tuesday article: Looking through the window towards recovery: a real estate paradigm shift.]
Brokers, agents, and voters in general are now more willing than ever to discard the ineffective or harmful policies of the past and replace them with simpler, more sensible practices that will reduce debt and the risk of losing a home while predictably increasing the wealth of homeowners. As that paradigm shows its composition, national and state governments will look to the rest of the world for alternative models of housing to discover which systems are effective in promoting deep-rooted, long-lived success, and root out those which lead (as ours has) to disaster.
The first step to improvement is to recognize that the U.S. did not reach its current situation of mortgage loan dependence by accident. Our high-debt, homeownership-driven economy was built over time by government tax incentives, especially incentives intended to support the first time homebuyer with no savings and little or no understanding of economics. Such incentives exert tremendous influence upon taxpayers; doubly so when owners are able to avoid taxation merely by owning rather than renting their residence.
Subsidized housing today in the U.S.
Tax policies commonly thought to favor homebuying and homeownership — through loopholes which permit homeowners to reduce their taxable income — are featured in several U.S. tax codes. These incentives, although not always legislated with the intention of promoting homeownership, have played a crucial role in the formation of the high-debt, rental-averse population which flourished during the Millennium BoomThe years 2000-2007 leading up to the current economic recession, characterized by loose lending practices and unsustainably high property prices and sales volume.The years 2000-2007 leading up to the current economic recession, characterized by loose lending practices and unsustainably high property prices and sales volume.. [For more information about the real beneficiaries of the tax subsidies, see the March 2011 first tuesday article, The home mortgage tax deduction: inducing debt and stifling mobility.]
The mortgage interest tax deduction is only available to homebuyers and second home buyers who take on mortgages, permitting them to deduct all interest they pay on principal balances up to $1,100,000. As a deduction from the indebted homeowner’s adjusted gross incomeNet income and profits from all three income categories (trade or business, passive and portfolio) (AGINet income and profits from all three income categories (trade or business, passive and portfolio)), it reduces the homeowner’s taxable income and thus his income taxes.
This incentive to trade taxes for mortgage debt amounts to a significant subsidy (20%-30% of the monthly loan payment for higher tax bracket earners), received as a reduction in the income taxes a buyer would otherwise pay. However, to qualify for tax relief, the homebuyer must do more than own — he must also finance the purchase of the principal residence or vacation home.
The interest paid on mortgages secured by first or second homes is broken down into two categories for the personal interest deduction:
- interest accrued and paid on the balances of purchase or improvement loans up to a combined principal amount of $1,000,000; and
- interest accrued and paid on all other loan amounts up to an additional $100,000 in principal, called home equity loans.
The amount of the permitted interest deduction is determined in part by the homeowner’s AGINet income and profits from all three income categories (trade or business, passive and portfolio); the greater the AGINet income and profits from all three income categories (trade or business, passive and portfolio), the smaller the total amount of permitted deductions. The amount of tax savings ranges from 10-15% for low-income homeowners to 35% for high-income homeowners on the amount of interest they may deduct. Thus, the wealthier one is (to a point), the greater the subsidy for borrowing to enter into homeownership.
Limitations on wealthier homeowners are imposed by the itemized deductions phase-out and the alternative minimum tax (AMT) restrictions on total deductions [For more on the specific rules of federal tax policy, see first tuesday’s Tax Benefits of Ownership, Third Edition. Not a first tuesday student? Click here and enroll in any course for one year's access to all books and forms published by first tuesday.]
Additionally, the principal residence profit exclusion allows homeowners who sell their property to exclude up to $250,000 of profit per owner from being taxed. This applies to any sellers who have occupied part or all of a residential property as their principal residence for at least two years out of the five years prior to the sale.
Peculiarly, this tax benefit does not encourage homebuying; only those who sell their property and take a profit are able to benefit. Financially, these federal housing polices function as a subsidy to mortgaged homeowners and sellers in the form of savings from reduced taxes. [Internal Revenue Code §§121; 163(h)]
Other tax incentives exist to sweeten the pot for homeowners. These include:
- the homebuyer’s ability to deduct loan origination points and private mortgage insuranceDefault mortgage insurance provided by private insurers for conventional loans with loan-to-value ratios higher than 80%./ mortgage insurance premiumDefault mortgage insurance required and charged by the Federal Housing Administration (FHA) for FHA-insured loans with loan-to-value ratios higher than 80%. (PMIDefault mortgage insurance provided by private insurers for conventional loans with loan-to-value ratios higher than 80%./MIPDefault mortgage insurance required and charged by the Federal Housing Administration (FHA) for FHA-insured loans with loan-to-value ratios higher than 80%.) fees from AGINet income and profits from all three income categories (trade or business, passive and portfolio) in the year of acquisition;
- the ability to defer taxation on the resale of a home originally acquired in a §1031 exchange and converted to the principal residence [For more information on this form of tax exemption, see first tuesday’s The §1031 Reinvestment Plan, Fourth Edition.];
- write-offs for interest on home equity loans on a second home; and
- the ability for owners to transfer a home among family members or even replace their current residence without triggering a property value reassessment.
Benefits taken by a homeowner on the flip or resale of a home thus include the owner’s ability to subtract up to $250,000 per owner ($500,000 for a married couple) as an exclusion from the profits on the resale, if it has been occupied as a principal residence for two of the preceding five years. Even if the full exclusion is not available, a partial exclusion may often be obtained due to a change in health, employment or other unforeseen circumstances. The full $250,000 exclusion can be taken as often as once every two years. [For more on the profit exclusion, see the July 2009 first tuesday article, The principal residence profit exclusion.]
The two-year holding period required to claim this exclusion has nothing to do with Congress’s oft-stated intention of promoting long-term homeownership and stability. Quite the opposite, in fact; the current structure of homeownership subsidies encourages homeowners to treat their property as an investment, living there for a minimum period before moving on. This transient lifestyle is of course expected of many renters, but homeownership is popularly believed to exist for longer terms.
Combined, these “subsidies” either mandate or encourage homeowners to accept significant amounts of debt in order to obtain or improve a home. The risk of homeownership, in turn, is transferred from overextended lenders and builders to homeowners. As the recent recession indicates, excessive risk (in the form of excessive mortgage debt) is beneficial to no one. Indeed, the danger of mortgage debt in California has proven to be entirely unsupportable unless accounted for by government subsidies and bailouts.
The history behind government incentives
The mortgage interest tax deduction is almost universally favored by real estate professionals (brokers, lenders and builders), but its historical ties to homeownership are almost accidental. When the federal income tax was first implemented in 1913, all forms of interest were deductible. While available to all taxpayers, the mortgage interest tax deduction was originally used primarily by businesses and investors, especially farmers — small privately-owned businesses which required large property to be used as a home and a place to produce their product.
The government began to directly meddle in housing with the creation of the FHA in 1934 and, later, the National Mortgage Administration (Fannie MaeA government-sponsored entity operating in the secondary mortgage market.) in 1938. These institutions were implemented in order to restore confidence in banks, and thus increase the availability of mortgage money from private banks during the Great Depression.
After World War II, the availability of easy credit became crucial to stimulate the depressed post-war economy, and led to a jump in the U.S. homeownership rate, from about 45% in the 1950s to 62% in the 1960s, which then stabilized around 64% until the 2000s. At the peak of the housing boom in 2004, the nationwide homeownership rate reached over 69%. Although most of these owners did not buy because of available tax credits, they came to expect tax deductions for homeownership as a homebuyer’s right.
Beginning in the 1980s, the U.S. government became more explicit in its support of policies encouraging homeownership over renting. The mortgage interest tax deduction ceased to be merely one of the loan costs incurred by investors and became the domain of homeowners. Successive administrations aggressively advocated homeownership, and through Internal Revenue Service (IRS) regulations, supported policies intended to achieve “universal homeownership”. Homeownership boomed — but so did the accompanying debt.
Theory and reality
Why the support for homeownership? Homeowners, it is traditionally thought, are more likely to become an established part of the community in which they live. Unlike renters, they have a financial stake in the well being of their local area, making homeownership a sort of analogue for civic virtue. Studies have found that children of homeowners tend to have higher literacy rates, lower high school dropout rates, and lower rates of teenage pregnancy — but that all may be incidental to unrelated factors such as family education and wealth, not homeownership status.
Over time, homeownership came to be seen as the gateway to the middle class and, of course, the epitome of the highly-publicized American Dream.
Unfortunately, neither the mortgage interest tax deduction nor the principal residence profit exclusion has any strong effect upon the level of homeownership nationwide — the national rise in homeownership is attributable almost exclusively to the ready availability of adjustable rate mortgageA variable interest rate note based on a particular index, often starting out with an introductory "teaser" rate, only to reset at a much higher rate in a few months or years. (ARM) mortgage funds, which are issued by lenders at loan-to-value ratios (LTVs) of up to 100%. Although the mortgage interest tax deduction was expected to cost the federal government over $75 billion in 2006 (according to the New York Times), there is widespread agreement among many (though not all) economists that the deduction does nothing to increase the level of homeownership. [For more information about what the use of ARMs says about the health of the real estate market, see the May 2011 first tuesday article, The iron grip of ARMs on California real estate.]
After all, other countries which have eliminated their mortgage interest tax deductions —such as Canada, England, and Australia — have homeownership rates approximately equal to the U.S. In 2005, the Advisory Panel on Federal Tax Reform determined no link existed between the mortgage interest tax deduction and the national level of homeownership.
The panel advised the elimination of the mortgage interest tax deduction as it currently exists, to be replaced by a smaller credit available only to homebuyers who purchased principal residences priced at or below the average regional housing price (within the range of $227,000 and $412,000; million dollar vacation homes would no longer be included). [For more information on the Advisory Panel’s recommendations, see the Panel’s November 2005 Full Report.]
Rather than promoting homeownership, the subsidy encourages homebuyers to maximize their home purchase by fully leveragingThe concept that a lien decreases the owner's solvency and either increases the risk they will lose the property (and their investment) to foreclosure or increases the return on investment. the price with mortgage financing. The increased use of debt to fund purchases in turn drives up housing prices in a positive feedback loop which makes further debt necessary. Homeowners are encouraged to make maximum use of both savings and debt to achieve the highest possible tier of homeownership. [For more information about the link between personal savings rate and homeownership, see the June 2011 first tuesday article, The 20% solution: personal savings rates and homeownership.]
The wealthy, who are already able to afford a home without subsidies, are by far the biggest beneficiaries. In fact, more than half the benefit of the mortgage interest tax deduction is taken by homebuyers earning $100,000 or more annually, since lower income earners generally do not itemize their deductions and thus do not claim the deduction. Wealthy homebuyers and lenders, not aspiring low-tier homeowners, are the winners.
Closing the tax loopholes to correct the balance
Elimination of these tax loopholes would, effectively, work as a progressive tax, causing wealthier owners to pay more for their homes without much change to the payments of those in lower tax brackets (who already pay few taxes, and thus have less to gain from tax deductions).
If the elimination in regressive deductions were accompanied by the creation of a flat-rate annual deduction based solely on owning the home occupied by the taxpayer, with or without debt, lower-income homeowners would actually be more able to purchase a home.
Elimination of the homebuyer’s ability to exclude mortgage debt from taxation would also disincentivize the homeowner’s decision to retain and extend debt on his home. In the absence of government incentives to the contrary (as we currently have), the decision to reduce mortgage debt will always improve the homeowner’s financial situation more effectively than storing that money in savings accounts where it will earn but a small fraction of the rate of interest charged on the mortgage. At present, this decision to reduce or eliminate debt is distorted by the tax implications of the mortgage deduction, which allows owners to reap greater financial benefits (via the tax subsidy) by holding higher amounts of debt.
The choice of whether to place money in an interest-bearing account or to use it to pay down the interest on mortgage debt should not be a difficult one, but it has been made difficult artificially. Repeal of unhelpful tax loopholes would address this imbalance.
While there is some support for the repeal of this misguided and outdated personal interest tax deduction, it remains a politically untouchable subject due to the support of a misinformed population, which largely believes the deduction beneficial to homeownership. The loudest voices disseminating this misinformation consistently come from the real estate industry itself, which fully understands that an initial drop – a “shock” – in home sales volume will occur if tax incentives are no longer available. The National Association of Realtors (NAR) and the National Association of Home Builders (NAHB) have both vocally opposed any change in the home mortgage tax deduction.
At the moment, thanks to the constant threat of a double-dipA second decrease following closely after an initial decrease and a short recovery; indicative of market weakness. Usually refers to recessions. recession, issues of financial crisisAn economic downturn resulting from the failure of banking and government agencies to regulate and adjust to developing market conditions., the re-regulation of mortgage lending and the institution of appropriate consumer protection laws and down payment requirements are all more likely to have a greater immediate impact than a change in taxes, and should thus be granted legislative priority. In fact, under current economic conditions, even a harmful change in taxes might well have no further impact on real estate sales volume and pricing, as California appears to be at or very near the bottom level historically attainable in the market. [For more information about the proposed changes to down payment requirements, see the May 2011 first tuesday article, How much medicine can the sick housing market stomach?]
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