Do homeowner deductions do any good?

The thousands of deductions, exemptions, credits, exclusions and phaseouts in the Internal Revenue Code give it more holes than swiss cheese.  Today I will focus on one the deductions for home mortgage interest and real estate taxes.  


In modern taxspeak, all deductions are "tax expenditures."  The concept is this.  All the money you earn belongs to the government.  Only through their largess do you get to keep or save any of it.  After all, they printed it.  Since Congress has the power to tax 100% of income, their forbearance is an "expenditure."


The deductions for home mortgage interest and real estate taxes are tax expenditures, designed to make home ownership more affordable and increase the number of people who can afford to buy their own home.  Let's look at how much these deductiona "cost," and what the government gets for it.  The cost is the amount deducted times the homeowners' average marginal tax rate.  For 2006, the most recent complete data available, The Joint Committee on Taxation estimates that the value of the mortgage interest deduction to taxpayers was $69.4 billion.  They also estimated that the tax expenditure for the real estate tax deduction that year came to to $19.9 billion. 


Now that we've determined that the government "spends" upwards of $90 Billion per year helping people buy houses, let's look at whether that money is well spent.  If housing prices simply rise to absorb the deduction, the price increase would defeat the purpose for the policy of offering a deduction.  Based upon National Association of Realtors research in defense of the home mortgage deduction, the answer appears to be that the deduction causes "some" increase in house prices, with estimates ranging from 3% to 10%.


The Census Bureau says that about 7.5 million new and existing homes sold for an average price of $224,000 in 2006, or close to $1.7 Trillion dollars in sales.  If we use the 5% as our estimate of the amount by which the home mortgage deduction alone caused prices to rise, the impact comes to $85 Billion.  Could it be true - that of the $90 Billion the government "spends" on these deductions, $85 Billion goes to benefit the sellers (or the brokers), with only $5 billion left to make home purchases more affordable?  That would appear to be the case.  Small wonder, then, that we see lobbying for these tax breaks by the National Associations of Home Builders and Realtors, not by the homeowners themselves.

In the absence of these deductions, how many buyers would have left the market?  Consider that existing homeowners take the bulk of these deductions, and very few of them would sell their homes if Congress repealed the deductions.  If Congress eliminated these expenditures, two things would likely occur.  First, the price of homes on the market would decline by $50 to $170 billion (3% - 10%), making them more affordable.  Secondly, Congress would have $90 billion more cash flow to use as they see fit.  The fact that recent market conditions have  brought down prices considerably serves to confuse the issue, but probably makes it more likely that we will see some reduction of these deductions.  


As a financial planner, I advise people on tax and investment strategies.  Several have a mortgage of exactly $1 million, not because they need the money, but because they don't have to withdraw it from their investment portfolio and home mortgages offer the most tax-favored form of interest deduction.  Its smart tax planning for these individuals, but poor tax policy for a government that's strapped for cash.