Tuesday, March 8, 2011

That Darn Home Interest Deduction

A recent proposal released by the government deficit reduction commission has pinpointed the home interest deduction as one of the ways to increase government tax revenue. The debt reduction commission released two separate scenarios for ways that this proposal could be implemented.

The first proposal, referred to by some as the "Zero Plan" would eliminate most tax deductions to raise an estimated additional $1.1 trillion in taxes, while compressing the tax code down to three rates, the lowest at 8 percent, the middle at 14 percent and the top one at 23 percent.

The second proposal keeps the existing tax system, but eliminates the deduction for mortgage interest on second homes, home equity lines of credit, and home loans above $500,000.

Needless to say, the national association of Realtors and the mortgage bankers association are stridently opposed to either proposal. The reason for this opposition is quite easy to see. When the tax advantage of mortgage interest is reduced or eliminated, it will decrease demand for homes relative to current levels. Under the first proposal, there would most likely be a universal drag on housing prices as incentives would shift firmly toward renting a place to live instead of buying it. In the second proposal, prices for luxury homes, vacation homes, and general housing in high land-value markets like California and New York will be the most adversely effected.

The fundamental problem with either of these scenarios is that our current weak housing market enjoys interest rates that are the lowest on record. If one of these proposals moves through and rates increase, there is a possibility of another housing collapse. This would occur because of a 'double whammy' from reduced tax favorability of home loans and reduced affordability from higher interest rates. Each person that wanted to purchase a house would be able to afford less home per dollar of monthly payment as the cost for insurance and taxes both increase. The prospect of another major value compression is not something that most people are anxious to see, since most are still recovering from the last housing collapse.

However, one of the factors to take into consideration is how we got into the housing crisis in the first place. One of the major factors that influenced many people to purchase a home was the ability to deduct mortgage interest. This resulted in more people buying who would have otherwise stayed as renters. Another key factor in the price escalation is artificially low interest rates that resulted from government agencies purchasing loans that nobody in the private sector wanted to own. By using this mechanism, the government has subsidized low rates and long loan terms for home buyers. This also contributed to an escalation of home prices. This artificial marketplace attracted capital that would have otherwise gone to some other productive use.

This leaves us with the ultimate question of what to do? If the current situation of government subsidized loans and mortgage interest deductions is left in place, it will continue to influence resource away from other productive uses. However, if tax incentives are abruptly changed it could spur another price disruption. Either situation presents characteristics with the former representing a long-term problem and the latter being more of a short-term difficulty. Typically, politicians ignore long-term problems in favor of short-term fixes (especially if they occur around elections). However, this situation is one where the government can capture additional tax revenue by incurring a short-term problem that facilitates a more healthy long-term economic environment.

One of the additional effects that will be created by a reduction or elimination in the mortgage interest deduction is a dramatic increase in the profitability of income properties. The reason for this shift is because decreases in home affordability influence more people to rent instead of buy their house. As more tenants enter the pool, it will strengthen rent income for property owners. In addition to this, the reduction in mortgage interest deductions will suppress price appreciation. This will allow investors to purchase properties at a higher cash flow ratio than otherwise would have been possible.

In the end, it is difficult to say what will happen with the mortgage interest deduction. There are powerful political forces in opposition to removing it, but there are also powerful political forces pushing for action that reduces the budget deficit and helps to solve the US government debt crisis. In any situation, it is most important for individuals to be aware of what is happening and make decisions that are the best for them and their families. Ultimately, the only person whom you can count on to attend to your interests is you.

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