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Turning A Sacred Cow Into Hamburger

If your job depends on winning an election, or if you work for someone in that position, there is probably never a good time to dispatch a political sacred cow.

But for the rest of us, there may never be a better time than right now to phase out one of the tax code’s most unfair, unproductive and unjustifiably popular provisions: the itemized deduction for interest on home mortgages.

This longstanding tax break drives up housing costs, distorts household spending patterns, promotes excess consumption of utilities and commodities, and costs the government about $100 billion a year in foregone revenue - with the benefit heavily tilted toward some of the highest-income taxpayers, who have the largest and priciest homes.

With this pedigree, you might think the public would be clamoring to repeal the deduction. But this subsidy for personal debt has been one of the most popular provisions of the tax code for generations. In 1986, when Congress eliminated deductions for most types of personal interest, it left the deduction intact for interest on debt of up to $1 million that is used to buy or improve a principal or secondary residence, and on debt of up to an additional $100,000, regardless of what it’s used for, so long as a primary or secondary home is used as collateral.

The real estate industry is, not surprisingly, one of the biggest backers of this deduction, arguing that it encourages the American dream of home ownership. In reality, it encourages not greater home ownership, but greater home borrowing. I wrote about this back in 2010, just as we were feeling the effects of all that government-induced borrowing. Helped along by the mortgage-interest tax deduction, homebuyers bought more houses and bigger houses than they could afford, using massive mortgages to finance their purchases. Meanwhile, from the early 1980s to 2008, the value of outstanding home equity loans - loans secured by a home but not necessarily used for its purchase - rose from around $1 billion to more than $1 trillion.

While the subsidy provided by the deduction encourages people to take on more debt in order to acquire homes, it does not actually make home ownership more affordable. By absorbing part of the interest cost on home mortgages, the government enables people to buy larger and more expensive homes than they could otherwise afford. Buyers end up spending, after taxes, whatever they would have spent on housing anyway, but the subsidy enables them to spend it on larger homes that carry higher prices due to artificially induced demand.

Even if the deduction actually did make it easier for Americans to buy bigger and better homes, it’s not entirely clear why that’s something the government should pay for. Money devoted to housing cannot be spent on other, unsubsidized goods and services. The mortgage interest deduction promotes the housing sector at the expense of other areas of the economy. Why allow a tax deduction for mortgage interest, for example, but not for school tuition - or the interest on education loans?

Furthermore, the deduction’s benefit is disproportionately aimed at the affluent, who are more likely to buy houses in the first place. The bottom 56 percent of the population, by household income, receive less than 5 percent of the benefit of the deduction. The top 20 percent, meanwhile, get 75 percent of the benefit. While I have written several times about the dangers of shifting too much of the overall tax burden onto a small group of relatively high earners, a tax incentive to encourage well-off people, who would already buy houses, to buy more and bigger houses is not the way to go about balancing the tax load.

Yet despite its flaws, the deduction is widely accepted as the key to individual home ownership and a life of presumed prosperity as a property owner. When asked whether policy advisers ever suggest that members of Congress push to eliminate the deduction, one adviser told NPR, “If you’re relatively green in Washington, I suppose that happens. And I suppose you’re laughed at.” He explained, “The mortgage-interest deduction is a sacred cow.”

Even a sacred cow has to die sometime. This is an excellent time to put this one out to pasture, because the deduction happens to be worth less now than it has been at any point in the recent past.

Mortgage interest rates are at record lows. The average rate for a 30-year fixed-rate mortgage recently hit 3.53 percent, down from 4.52 percent a year ago. That means homebuyers have less interest to deduct. Meanwhile, maximum tax rates are also at lower levels than in the past, despite the current president's eagerness to raise them for higher-income Americans. With lower tax rates, taxpayers save less on every dollar of interest they pay.

The accompanying chart shows how an individual taxpayer’s benefit from the mortgage-interest deduction might be different now compared to 10 years ago. The average fixed-rate mortgage value for 2002 is based on data from Freddie Mac.

YearOutstanding mortgage debtAverage interest rate for a 30-year fixed-rate mortgageMaximum income tax ratePre-tax interest billValue of deductionAfter-tax interest cost

The mortgage-interest deduction, in this case, would be worth less than half as much now as it was in 2002. Even without the deduction for a mortgage at 2012 rates, today’s cost would be less than the after-tax interest cost on the same mortgage a decade ago.

It would not be fair to eliminate the deduction for people who already have taken out mortgages on the assumption that the tax break will be available to them. And it would make no sense to prevent people with older, higher-rate loans from refinancing at today’s better terms by removing the tax benefit they have on their current loans. But we could eliminate the deduction for new mortgages and credit lines, which would gradually phase out the deduction as older loans are repaid. Or we could keep the deduction available for new loans, but limit it to a relatively small amount of principal - maybe $200,000 rather than $1 million, with no deduction for home equity lines. This would steer more of the benefit toward taxpayers with less expensive houses, and would avoid encouraging people to take on equity lines that put their homes at risk in the event of default.

In the short term, these steps would work against the Federal Reserve’s attempt to stimulate the economy, and especially the housing sector, by pushing down mortgage rates. But the brief drag on housing would be worth it to take advantage of the opportunity to eliminate the deduction while its impact is minimal.

Once the presidential election is behind us, we will hear a lot of proposals to overhaul the tax code. Any serious effort would take a hard look at the mortgage interest deduction. But don’t get your hopes up. Not many people, and especially not many in politics, want to tangle with sacred cows.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s most recent book, The High Achiever’s Guide To Wealth. His contributions include Chapter 1, “Anyone Can Achieve Wealth,” and Chapter 19, “Assisting Aging Parents.” Larry was also among the authors of the firm’s previous book, Looking Ahead: Life, Family, Wealth and Business After 55.

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