In the past couple of days, around 40 million Americans happily claimed an income-tax deduction for home mortgage interest. Homeowners and people connected with the real estate industry are, naturally, the tax break’s biggest fans, but it’s almost as universally beloved as Social Security. It also costs the government upward of $75 billion a year.
Treasury Secretary Steven Mnuchin has said that when the Trump administration eventually tackles tax reform, the mortgage interest deduction (MID) will be one feature of the code to go under the microscope, if not the knife. It’s hard to imagine, given the Trump family business, that the president will eliminate the MID entirely. He might, however, lower the $1 million cap (currently $500,000 for a married taxpayer filing separately) on mortgage debt eligible for interest deductions. He might also raise the standard deduction. If he does, and fewer taxpayers itemize as a result, the MID (which can be claimed only if you itemize) could lose importance—not just as a tax-lowering technique but as a factor in big-picture financial planning.
Would that be a bad thing? Owning a home is widely considered a cornerstone of the American dream. Further, proponents of the MID say that by encouraging homeownership, it stimulates economic growth, helping families build wealth and boosting job creation in housing-related industries. Yet most economists disagree. They point out that homeownership rates in countries that don’t offer the deduction are no lower than in the US. And they add that the MID alone isn’t enough of an incentive to push renters into buying. (Ask any millennial.) But it does push buyers into buying more expensive houses. Jeffrey Dorfman, an economist at the University of Georgia, says the MID even induces people who could afford to pay cash for a house to take on a big mortgage instead. They write off the interest and invest their extra cash flow. For a person in a high tax bracket, those two activities together can add up to a juicy little return.
In other words, what the deduction really encourages is more leveraging, which translates into rising home prices. By seducing people into buying more house than they can afford, the MID is a big reason that residential real estate has been such a lucrative asset class over the long term. No wonder the National Association of Realtors lobbies so loudly to keep it intact.
So what’s wrong with rising home prices? For one thing, as we saw in the most recent financial crisis, they encourage speculation, bubbles, and crashes. In regions where housing is scarce and costly, the economy is disproportionately dependent on real estate values, partly because of the “wealth effect”—people feel rich when their homes are appreciating, so they spend more money. It’s also worth noting that the MID doesn’t benefit all Americans equally. According to the nonpartisan Tax Policy Center, more than 85% of deduction benefits go to homeowners with $100,000 or more in annual income. In large swaths of the US where home values aren’t hyper-inflated, many taxpayers don’t even bother claiming the MID.
Finally, while homeownership may have seemed like a reliable route to financial security for previous generations, Americans who came of age during the Great Recession saw leveraged real estate explode like a ticking time bomb. When millennials get out from under their student loans, it may make more sense for them to start saving for their kids’ college education, or for their own retirement, than for a down payment on a home that will once again saddle them with enormous debt. Some economists even suggest that eliminating the MID’s distortion on the housing market would improve affordability throughout the US.
Another way to say that, of course, is “would cause house prices to fall.” And there’s the rub. If Trump tinkers with the MID, it won’t just hurt the hedge fund managers in Connecticut and tech billionaires in California. It’ll also ding home values in all the states in between. Furthermore, adds Greg Daco, Oxford Economics’ head of US macroeconomics, states that depend heavily on property taxes would suffer a grievous hit to revenues—albeit after a lag—if a change in the MID reduces home values and/or dissuades home buying.
The bottom line: Expect a bitter battle before this deduction gets a makeover.
Joanie Warner is the Thought Leadership team’s Managing Editor for financial services.