This is the second entry in my series on the Mortgage Interest Deduction (MID). The focus of this post is the history of the MID and why we keep it around.
Most of us can close our eyes and picture Dorothy clicking the heels of those Ruby Red Slippers, saying over and over those now famous words, “There’s No Place Like Home. There’s No Place Like Home.”
Filmed in 1939, the storyline began in Kansas. The Kansas of that day was one of dust storms and foreclosed farms. The Great Depression was still in full swing.
For those of you imagining a simpler time, there was nothing simple for many Americans of that era, except perhaps filing their federal income taxes.
In 1939, Form 1040 was a one page document, albeit with three pages of schedules. This compares rather favorably with Form 1040 used today, a two page document with more than ten different versions. To add insult to injury, over a dozen schedules and a dozen separate forms may be required to be completed and filed with the final return. But I digress.
What about the Home Mortgage Interest Deduction? For those dust-bowl Kansans, all personal interest was deductible from income, whether for a mortgage or for a loan to buy that 1938 Buick, described as, “It's a big honey for a little money.” Total interest was detailed on Schedule H and claimed on Line 14 of the 1939 Form 1040.
Although personal interest could be deducted from income prior to 1939 and for many years since, Congress eliminated the deduction for personal interest in the Tax Reform Act of 1986. A majority of those elected to Congress believed that a universal interest deduction created two problems.
First, the personal interest deduction was seen as an encouragement to spend rather than save. Second, it reduced tax revenues. If people put money into savings accounts, it earned interest which was taxable income. But if they ran up debt, they could deduct the interest from their income, which lowered their tax liability.
Although the deduction for most types of personal interest was eliminated, the favorable treatment for MID survived. Contrary to popular belief, MID did not begin as a federal effort to encourage home ownership. When Congress passed the first income tax law in 1913, all interest payments were deductible. Interest was considered a “business" expenses. Mortgage interest wasn't even specifically mentioned
The truth is, in those early years it would not have much mattered as most Americans saved the money necessary to buy a home and did not carry a mortgage. That was less true for those depression era Kansan farmers, many of whom leased their land or borrowed in order to buy it.
But the boom following World War II changed the American landscape as more Americans began buying homes and taking out a mortgage to do so. Movies like Mr. Blandings Builds His Dream Home romanticized home ownership via a home mortgage.
However, deductibility of interest has been a common flash point during debate on tax reform. For the reasons cited above, many have been opposed to any deduction of interest. But despite the almost universal condemnation of mainstream economists, the MID has survived every round of tax reform in the last half century. The reasons for this are two-fold.
First, the MID has some very potent advocates, most notably the National Association of Realtors (NAR), among the most powerful lobbying groups on capitol hill. During the reform discussions held during the Reagan administration, the NAR took out television and radio ads drumming up support to keep the MID. The ads warned that politicians were about to dash hopes of home ownership. The radio spots told listeners,
“Don’t let Congress eliminate your mortgage interest deduction. Keep the American Dream alive.”
A somber voice encouraged listeners to contact their congressman and tell them that their family’s economic well-being depended on the MID.
Second, the continued existence of the MID is dependent, in large measure, on an illusion. In the movie War Games, a brilliant professor attempts to stop a nuclear missile launch based on a mistaken perception. He warns the General preparing to initiate a global nuclear attack.
“What you see … is a fantasy; a computer enhanced hallucination!”
With respect to the presumed absolute necessity of the MID, I paraphrase the professor’s comments and assert, “What you have heard about the MID is a fantasy; a politically motivated, special interest enhanced illusion!” In the words of Judge Judy, "Don't pee on my leg and tell me its raining."
Let’s look at the most typical arguments in support of the MID. I remind readers that the tax code allows interest on mortgages with a value of up to $1 million and home equity loans up to $100,000 to be deducted. I must also point out that the deduction is taken as an itemized deduction on Schedule A, subject to various limits.
First, despite a commonly held conviction, the MID was never created to promote home ownership. The truth is that is exists as much by accident as by design. Deduction of mortgage interest has always existed and has survived as described earlier. Even if increased home ownership was the intent, its success is questionable. A number of studies have proven inconclusive comparing the percentage of home ownership in the United States to other developed countries that do not have preferential tax treatment of mortgage interest.
Second, contrary to the argument that the deduction decreases the cost of ownership, this benefit is spotty at best and is skewed to those with higher incomes. Said a different way, some taxpayers subsidize the cost of ownership for other taxpayers. Even if agreement exists that we should all help others buy a home, the notion of “reducing cost" is also questionable.
It is almost impossible to put forth numbers that cannot be argued – due to variances from state to state, region to region and existing home price versus new home price – so let’s just pick a number. Say median home prices approximate $200,000. For the sake of this example, assume a family bought a house at that price and paid 20% in cash and took a 30 year mortgage at four percent for the balance. Further, although this comment will generate disagreement, assume a family of four spends up to 30% of their gross income for mortgage (including property taxes).
Using the above numbers, together with a property tax rate equal to one percent of the home value, this family will incur a monthly mortgage payment approximating $925. Assume both spouses work and report total income of $45,000. For 2013, the interest paid on the mortgage totaled $6,000. Property taxes were assessed at $2,000.
What was their tax benefit? I would guess that their real estate agent suggested that they might “save” money by buying, perhaps as much as $1,200 (interest and property taxes deductible at a 15% marginal rate). The real tax benefit. Zero. Nada. Zip. Zilch. Butkus. The standard deduction for a couple filing jointly was $12,200 for 2103. Unless they lived in a state that had an income tax, they would have had to pay just over $11,000 (less any charitable contributions or other deductible expenses) in interest and property taxes to get dollar one in benefit.
For this couple, any expected ‘savings’ is just an illusion. A figment of imagination created by the real estate and mortgage industries and perpetuated by our elected leaders.
Let’s use the same conditions as above except the couple earns $90,000 and buys a house for $350,000. What say you now about the benefit? All else being equal, it comes to a staggering $562 for the year. Does anyone really think this amount convinced this couple to buy or not to buy. Really?
How about a taxpayer much higher up on the income ladder. To borrow an example from the Center on Budget and Policy Priorities, a taxpayer with a $1 million mortgage who pays interest totaling $40,000 gets a government tax subsidy of about $14,000. Bottom line, taxpayers underwrite 35 cents of every dollar of his mortgage interest.
In an era of ARP (not to be confused with AARP) with federal programs like TARP (Troubled Asset Relief Program) and more notably HARP (Home Affordable Refinance Program) there is one other aspect of MID that seems particularly troublesome. The tax code allows interest on a home equity loan to be deducted, regardless of the use of loan proceeds.
If you own your home and have sufficient equity to borrow against, you may be able to trade your non-deductible credit card interest for home equity interest, which is not only tax-deductible but will likely have a significantly lower interest rate. The Internal Revenue Code allows homeowners to deduct interest on home-equity loans up to $100,000, no matter how the proceeds are used. A taxpayer can take out a home equity loan, use the money to pay off credit cards and then deduct the interest paid on the home equity loan. That same home owner can then run up credit card debt a second time.
This debt burden can increase risk of losing the home. But, I guess one unintended benefit (or maybe intended) is to increase the need for HARP! Our tax code seems to be working at cross purposes, but more on that issue next time.
The bottom line of this is that many would have you believe that "No Place Like Home" would be a faint memory absent the MID. Don't you believe that!
Later. Y’all come back now, ya hear!