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Mortgage Schmortgage

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Election season is here, and one of the things we always hear about during these campaigns is tax reform. Candidates say they want to simplify the code, make it more fair, etc. Now we’ve talked about the deficit and financial problems before on the podcast in a macro sense, but for this pillar, I wanted to take a deep dive into one tax phenomenon in particular; the mortgage interest tax deduction. I got interested in it after hearing a couple other podcasts like planet money talk about it, and following the history of why it exists in the first place and where it is now was pretty eye opening.

Quick income tax history lesson:

In February 1913, the 16th amendment was ratified and put into law, allowing congress to enact a federal income tax for the first time. Inflation adjusted, this fell disproportionally on the rich, where individuals with incomes over $65K had to pay 1%. Then if you made over a half million, a few more tiers kicked in, with the highest tax bracket at 7% for those making $11M. This meant 98% of Americans paid no federal income tax at all. Yeah occupy wall street!

So most tax historians best guess as to why the personal interest deduction exists, is that it was simply too cumbersome and difficult to keep track of what was exactly a business (taxable income generating) expense, and a personal one. Especially when there were way more family farmers etc. Plus, since only 2% of Americans were paying income tax at all, it didn’t seem like a huge deal to allow for this deduction, as those high income entities were more likely to purchase things with credit for taxable income generation.

Fast forward to the early 1980s. Over the years the tax base had broadened considerably so a lot more people were paying personal income tax. Also, a lot more people owned their own homes, and the vast majority now financed those purchases with a mortgage. There was a big financial crisis in the early 80s much like there is now, and there was a big push to reform the tax code to get things back in line. Sound familiar? The CBO came up with a list of a bunch of things they could do to the tax code to balance the budget, and one of them was to limit the deduction for the personal interest expense.

Finally in 1986 there was a pretty big overhaul that did indeed limit the MID a bit. It no longer was able to be used on unlimited residences, could only be on your primary home mortgage, and it also made sure that you couldn’t deduct credit card interest either, as credit cards were becoming more prevalent. But in general, it still remained, and has basically stayed that way since.

So enough of the history, let’s look at where we are with the MID today. Still, the main purported goal is to encourage home ownership. So let’s think about what exactly that means and how we could measure it. In order for something to increase ownership, it has to take its effect at the margin. The ultra-rich are always going to buy homes, and the ultra-poor are always going to rent. So at the margin, we need to look at the hypothetical person/family that is deciding whether to rent or own. If, at that margin, the MID doesn’t encourage ownership, then we shouldn’t even have it. And this is the person that we are purportedly trying to help right? And the person that is going to have a horrible time if we get rid of the MID?

So today, who is taking the MID? Since 1991, only between 21 and 26% of taxpayers claimed the MID. Most of these taxpayers were in the top brackets. One of the main reasons people don’t claim it, even if they do have a mortgage, is that the standard deduction turns out to be more than the mortgage interest deduction would be.

Currently, the standard deduction for a married couple is $11,900. So anyone who is married and filing jointly gets to deduct that amount from their tax bill automatically. So in order to make it worth it for a couple to itemize and claim the MID, they would have to pay very close to that amount in mortgage interest. So I dug a step further to see if I could find what the average mortgage payment was and how much of that was interest. The most recent data I found said that the median home price in 2010 was about 220K. So let’s just assume the person put 10% down and is carrying a 200K mortgage. Chose 6% as my rate and saw that the first year of payments, $11933.29 was the interest portion.

So to sum up;

  • The MID started out as kind of a quirk in the tax code, probably there just for simplicity when we started the federal income tax in 1913. Never was there a mention of using it to encourage home ownership
  • Because of the standard deduction, people at the margin (the people that it’s supposed to encourage) aren’t taking advantage of it, and probably wouldn’t benefit from it. Only 1 in 4 Americans even claim it, and most are richer.
  • Liberal and conservative economists tend to agree that it doesn’t make sense to have this deduction anymore, but to suggest getting rid of it is a political hot potato, because of decades of rhetoric about how it symbolizes the American dream, and heavy pressure from the housing lobbies.

 

So that’s just one odd piece of the tax code that you can think about the next time people talk about simplifying the code. It seems pretty benign at first, but when you dig into it, it becomes hard to justify the 130B loss in revenue that the government loses by having this in place. I kind of wonder if there are other parts of the tax code that follow this same trend…

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