The average person knows little about the facts of homeownership. President Bush, via a bipartisan Tax Reform Panel, recently had the “audacity” to suggest some changes to the mortgage interest tax deduction.
1) lowering the ceiling on the total amount of mortgage deductibility from $1 million to around $350,000,
2) capping the marginal tax rate of said deductions at 25%.
The anti-Bush crowd yelped in unison upon this announcement. “Now Bush is going to eliminate the mortgage deduction……”, “Bush is going to lower your houses value…”, and Becky Quick this morning on CNBC, “Many people bought their homes expecting this deduction…”
First of all, this is a direct assault on the rich. Anyone who thinks otherwise suffers from bottomless ignorance. It follows that anyone who criticizes these modifications cannot claim to be on the side of the "little guy" in the class warfare of “rich versus poor”.
If you have a 350k mortgage, I am sorry, but you are not middle class. You may be overleveraged but that is a topic for another blog. Before you Manhattanites go apoplectic, screaming about how a 500k mortgage is a small one in your neighborhood, let me correct you. If you live in an 800k two bedroom apartment, you are not middle class….you are poor for New York City. If limiting the interest deduction costs you a couple of hundred dollars per month and you can't afford it, then maybe you should cut back on your $12 martinis and $5 Starbucks lattes. Move to Staten Island perhaps.
Of course, that is one of the central questions a rational person would research before hyperventilating. Who would be affected by these changes and exactly by how much?
In a previous blog, Real Estate Hot Potato…Buy versus Rent & Invest, I have already done most of the math on “how much?”.
Specifically, I studied the costs of home ownership for a 500k mortgage on a 600k home.
We hypothetically borrowed 500k on a 5.75% fixed rate, 30 year mortgage. Below is the calculated monthly mortgage deduction for all thirty 30 years. As I showed in this prior exercise, the mortgage interest tax benefit is, among other things, a function of the borrower’s tax bracket. As I have previously stated:
It is actually one of the few tax laws that favor high income earners.
Total Interest Paid and Monthly Tax Benefits at varying marginal tax rates.
--------------------------------------25%-----------30%-------------35%
Year 1........$28,582.24........$595.46.....$714.56........$833.65
Year 2........$28,202.49........$587.55.....$705.06........$822.57
Year 3........$27,800.32........$579.17.....$695.01........$810.84
Year 4........$27,374.40........$570.30.....$684.36........$798.42
Year 5........$26,923.34........$560.90.....$673.08........$785.26
Year 6........$26,445.65........$550.95.....$661.14........$771.33
Year 7........$25,939.75........$540.41.....$648.49........$756.58
Year 8........$25,403.99........$529.25.....$635.10........$740.95
Year 9........$24,836.59........$517.23.....$620.91........$724.40
Year 10.......$24,235.70........$504.91.....$605.89........$706.87
Year 11.......$23,599.32........$491.65.....$589.98........$688.31
Year 12.......$22,925.38........$477.61.....$573.13........$668.66
Year 13.......$22,211.65........$462.74.....$555.29........$647.84
Year 14.......$21,455.78........$447.00.....$536.39........$625.79
Year 15.......$20,655.28........$430.32.....$516.38........$602.45
Year 16.......$19,807.52........$412.66.....$495.19........$577.72
Year 17.......$18,909.71........$393.95.....$472.74........$551.53
Year 18.......$17,958.90........$374.14.....$448.97........$523.80
Year 19.......$16,951.95........$353.17.....$423.80........$494.43
Year 20.......$15,885.54........$330.95.....$397.14........$463.33
Year 21.......$14,756.18........$307.42.....$368.90........$430.39
Year 22.......$13,560.14........$282.50.....$339.00........$395.50
Year 23.......$12,293.49........$256.11.....$307.34........$358.56
Year 24.......$10,952.05........$228.17.....$273.80........$319.43
Year 25.......$9,531.41.........$198.57.....$238.29........$278.00
Year 26.......$8,026.90.........$167.23.....$200.67........$234.12
Year 27.......$6,433.57.........$134.03.....$160.84........$187.65
Year 28.......$4,746.16.........$98.88......$118.65........$138.43
Year 29.......$2,959.13.........$61.65......$73.98.........$86.31
Year 30.......$1,066.60.........$22.22......$26.67.........$31.11
If section 2) of Bush’s Tax reform were passed, it would immediately cost this buyer, if they were in the top tax bracket, about $238 a month. (from the difference in the 35% column and the 25% column in Year 1).
A short glance reveals that the difference decreases over time, as would be expected since the loan decreases as well. In Year 10 the added cost to a top bracket earner would be $202 and by Year 20 it would be down to $123.
But this only shows the effects of half of the proposed changes i.e. capping the marginal tax reduction at 25%. Now to see the effects of limiting taxable interest deductions on a maximum of $350,000 borrowed, I simply multiply the chart above by 0.70 (because 350k is 70% of 500k).
Total Interest Paid.........Monthly Tax Benefit
Year 1........$28,582.24........$416.82
Year 2........$28,202.49........$411.29
Year 3........$27,800.32........$405.42
Year 4........$27,374.40........$399.21
Year 5........$26,923.34........$392.63
Year 6........$26,445.65........$385.67
Year 7........$25,939.75........$378.29
Year 8........$25,403.99........$370.47
Year 9........$24,836.59........$362.20
Year 10........$24,235.70........$353.44
Year 11........$23,599.32........$344.16
Year 12........$22,925.38........$334.33
Year 13........$22,211.65........$323.92
Year 14........$21,455.78........$312.90
Year 15........$20,655.28........$301.22
Year 16........$19,807.52........$288.86
Year 17........$18,909.71........$275.77
Year 18........$17,958.90........$261.90
Year 19........$16,951.95........$247.22
Year 20........$15,885.54........$231.66
Year 21........$14,756.18........$215.19
Year 22........$13,560.14........$197.75
Year 23........$12,293.49........$179.28
Year 24........$10,952.05........$159.72
Year 25........$9,531.41.........$139.00
Year 26........$8,026.90.........$117.06
Year 27........$6,433.57.........$93.86
Year 28........$4,746.16.........$69.21
Year 29........$2,959.13.........$43.15
Year 30........$1,066.60.........$15.55
Now remember, that Year 1 number $416.82 represents the value of the first year’s monthly tax benefit. In other words, under this scenario, renting a $3,000 per month apartment would be roughly equivalent to a mortgage payment of $3,416 per month because of the tax deductible mortgage interest. (of course, it doesn’t take into consideration the other costs of home ownership that I discussed in the previous blog).
In effect, this last table would be THE MAXIMUM DEDUCTION table if both reforms were adopted.
As it stands now, a top income bracket earner with a $1,000,000 mortgage today would start out with around a $1,600 per month tax benefit. (Just double the far right column of the first table.) Under the proposed changes they would see it slashed by about $1,200 to that $416.82 amount.
Today the cost of real estate is roughly $600 per month for each $100,000 worth of home. So if say all 1.1 million dollar homes were owned and bought by top income bracket earners……then Bush’s proposal would theoretically lower these home values by 200k (as imputed from the loss of $1,200 per month in tax deductions).
Likewise, if both tax code modifications were made, the 600k house that I live in would theoretically drop by around $67,000 (as imputed by the loss of about $400 per month in tax benefits and assuming only top income bracket earners lived in this house). But if only the marginal tax rate benefit were capped at 25%, the loss would be closer to $30,000.
In all fairness, those numbers are too high. Not everyone in the market for 600k homes is a top bracket earner so the losses in property value would be somewhat less than my projections. Instead say we have losses of $60,000 and $25,000.
Now these are only rough estimates since that is all that is possible with such multivariate scenarios. Nonetheless, I will conclude with:
If deductible mortgage interest is limited to the first $350,000 borrowed and the marginal tax benefit rate is cut to 25%.....
….then a $1 million dollar home will instantly lose 15-20% of its value and a $600,000 home will lose around 10% of its value.
Obviously, the mortgage tax benefits and projected losses of benefits fade over time and I am basing my new property values from the Year 1 tax consequences. Also these numbers are subject to change if interest rates move. As I type this, the 30 year fixed rate is at 6.00%.
So Becky Quick thinks that they shouldn’t roll back mortgage interest benefits because “people” have bought expecting to get them. By her convoluted logic, government couldn’t reform anything because “people” might not have expected it.
She is dead wrong. Government should strive for logical and fair tax policies. It should do what is right, without regard for anything else. This of course begs the forgotten question of why should mortgage interest be deductible in the first place?
The theory was that when people owned their homes, they took better care of the neighborhood, were encouraged to save, etc. and that this was optimal for society. Hence the government pushed tax benefits to spur homeownership - which hit a record high of 69% in 2004.
But like all subsidies, this one was eventually priced into the market and it now borders on eroding its own original objective of helping make homes affordable. Prices are so high, albeit not just from deductible mortgage interest, that low end home buyers are overleveraging themselves with adjustable and interest-only mortgages. At this point, the mortgage interest deduction is not encouraging home ownership, but rather home-indebtedness.
So the Tax Reform Panel proposed changes to reestablish the original goals of the mortgage interest deduction, by targeting the incentives on the lower end of the housing market.
The only way pundits and Bush-haters in the media can bash these reforms, and still claim to be defenders of the “poor”, is by mischaracterizing the reform proposals.
Of course, mischaracterization and obfuscation are the modi operandi of Big Media. They succeeded in thwarting Social Security reform by this tactic and I would quite frankly be surprised if these proposed tax reforms were passed.
But say these reforms were passed and all million dollar homes were suddenly worth 850k. None of these homeowners will have “lost money” because the reforms will have affected all such homes evenly. It kills me when people buy a house for 400k and it appreciates to 600k and they think that they have made $200,000. It is not like they can sell their house, buy a similar 400k one and pocket the money. In most cases this is not possible because all similar homes will be trading for 600k. An across the board price change like these reforms would cause, will not cost homeowners any "profit". They will still be insulated from the nominal price level of the market. They will always be either selling “high” and buying “high” or selling “low” and buying “low”.
Million dollar homes dropping to 850k would only be an issue for someone planning on selling their home and then roaming the streets. Everyone else would parlay that equity into a similarly discounted home. So it is all a wash.
But the reality is, that most people don't understand anything about the value of their house. They paid X for it, and now it is "worth" 3 times X, ergo they are savvy investors no matter how many boats have risen with the current tide. Don't even think of telling them otherwise.
Bush has gotten little credit for a strong housing market, but that doesn't mean he won't bear a heap of blame for its decline - and that will happen whether these tax reforms are passed or not.
There is a lot more in the Tax Reform Panel's proposal, including many offsets to this "attack on the rich" such as the elimination of the Alternative Minimum Tax, a reduction in the tax on long term capital gains (from 15% to about half that), and a slight lowering of all marginal tax brackets.
Such a capital gains reduction would be very bullish for the economy, but it would not be as bullish as a drastic reduction in the top tax brackets.
Although the Tax Reform Panel is bipartisan, President Bush will bear the brunt of the criticism. But anyone with a clue has to conclude that these reform proposals are spot on the money and will spur more real economic growth instead of just housing inflation for higher end homes.
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