For generations, the tax laws provided an incentive for taxpayers to own their own home by allowing them to deduct the interest expense on their mortgage. As Congress takes action on tax reform, one of the most-discussed issues is the impact on what has historically been one of the most sacred deductions in the Internal Revenue Code.
To deduct home mortgage interest, a taxpayer must itemize his deductions. A taxpayer must have itemized deductions in excess of the otherwise allowable standard deduction. Historically, home mortgage interest deductions have propelled homeowners’ itemized deductions to a level exceeding the standard deduction.
Recent low interest rates have resulted in lower mortgage interest deductions, resulting in minimal tax benefits for many homeowners — particularly first-time buyers in the SCV.
Tax reform passed by the House this week provides a trifecta of changes that will make it even more difficult to obtain a tax benefit from home ownership.
First, the standard deduction will nearly double, meaning that it will take twice as many deductions to get a benefit from claiming itemized deductions.
Second, many other itemized deductions will be repealed, making it more difficult to itemize.
Finally, the deduction itself is getting a substantial haircut under the House version of the Bill. That last point has received considerable attention in the press.
Under current law, a taxpayer is allowed to deduct home mortgage interest on mortgages of up to $1 million, provided that the mortgage was used to acquire or construct a primary residence or second residence and the residence is collateral for the mortgage.
In addition a taxpayer may deduct the interest on a home equity line of up to $100,000 as long as the line is secured by the taxpayer’s residence. Vacation homes, timeshares and motor homes generally qualify as a second residence. Reverse mortgages, taken out by senior citizens and using the home’s equity as collateral, are an increasing segment of the home equity line market.
The House version of the bill passed Thursday would restrict the amount of deductible mortgage interest to interest on loans of up to $500,000 that were used to acquire or construct the taxpayer’s principal residence. Interest on mortgages on second homes and home equity lines would not be deductible.
The new rules would generally apply to mortgages taken out after Nov. 2, 2017. Existing mortgages would generally continue to be subject to the old rules.
According to Zillow.com, the average SCV home price is about $517,000. The average interest rate for a 30-year mortgage from Wells Fargo is about 4 percent. If a buyer of an average SCV home makes a 20 percent down payment and finances the remainder at 4 percent, he or she will pay about $16,000 of interest the first year of home ownership.
To itemize, a couple would need to pay home mortgage interest and charitable contributions exceeding $24,000 before they saw any tax benefit for the home mortgage interest they paid.
Indeed, many future homeowners will not see significant tax benefits associated with home ownership — even though the home mortgage interest deduction is still on the books.
If nobody is able to claim a benefit for the home mortgage interest deduction, the proposed tax law changes represent a de facto repeal of the deduction.
This is a radical shift in tax policy which has historically promoted home ownership.
I was recently in Australia. I recall reading an article about the long-term impact of similar changes to the Australian and New Zealand tax laws.
In the late 1980s both countries repealed the deduction for home mortgage interest expense. At the time of repeal, about 65 percent of residents in those countries owned their own homes. Since the repeal, home ownership has fallen to about 40 percent.
That means that 25 percent of the population did not experience building a financial nest egg through home ownership. Now, a generation later, that 25 percent is finding it hard to retire and there is enormous political pressure in those countries to increase the amount of social security benefits.
It turns out that the cost of providing increased benefits is substantially greater than the cost to the government of sustaining the home mortgage interest deduction.
Currently, about 64 percent of Americans own their homes. The home ownership percentage has not fluctuated much in the past 60 years and is comparable to the percentages in Australia and New Zealand in the late 1980s.
I realize that it difficult to draw comparisons between the U.S. economy and those of Australia and New Zealand, but during the 1980s, levels of home ownership in the three countries were comparable. Once the Aussie and Kiwi tax incentives for owning a home were removed, home ownership dropped by more than a third.
We will probably experience a similar phenomenon, but the extent of reduced ownership is hard to predict. That means future generations will experience greater difficulty accumulating sufficient wealth to retire comfortably.
Jim de Bree is a retired CPA who has spent over 40 years specializing in tax matters and studying tax policy.
