A Taxing Situation for Homeowners

 | Apr 05, 2012 | 10:30 AM EDT
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Last week, the House of Representatives defeated the Simpson-Bowles plan for balancing the federal budget. In a presidential election year, that is not surprising. As I discussed last week, at the rate deficits are growing, the U.S. will be on a terminal insolvency trajectory within as little as three years. This is a crisis, and addressing it must be a federal priority once the election is over.

One of the most contentious issues in Simpson-Bowles is the elimination of the mortgage interest deduction (MID) for primary residences. Investors need to understand this issue because elimination of the tax deduction appears to be inevitable. Contrary to popular belief, however, it would be good for the economy and the financial markets.

As the prospects for real reform get closer, the interests competing for turf not impacted by the necessary changes will result in zealous ideological and political rhetoric in the media, making it difficult to make sense of what is being considered. And MID, because it resonates with the public, will be a subject that receives a lot of media attention.

The deductibility of interest on personal loans in the U.S. goes back to the creation of income taxes, and the creation of the Internal Revenue Service almost 100 years ago. Many of these deductions were removed by Congress in the 1986 tax reform act, but the MID stayed. The rationale for not including the MID in the 1986 tax reform was that it promoted home ownership and that was good for the economy.

Unfortunately, even though this belief is widespread and has been the rationale behind much of the government's legislative efforts concerning housing, it is wrong.  A tax deduction for interest paid on a mortgage is a common ploy by developing countries designed to stimulate economic activity and home ownership. Once an economy is moving beyond the developing stage and home ownership levels rise, most countries do away with the deduction.

Currently in the U.S. the deduction results in lost revenue to the U.S. government that would otherwise be there, about $130 billion annually, which is about 10% of the current federal budget deficit of approximately 1.3 trillion. The reason for arguing against removing the deduction now is that it will hurt home sales. The logic sounds reasonable, but in reality it is not.

For example, Canada has no deduction for mortgage interest; however, the home ownership rate there is about the same as the U.S. Also, home prices throughout Canada today are well above the global peak of 2007, having rebounded very quickly. In Switzerland, there is a mortgage interest deduction available for homeowners, but the rate of home ownership is only about 25% versus about 64% in the U.S.

The point is that rates of home ownership, appreciation, and per capita pricing reflect many other social value issues, not whether or not there is a deduction for mortgage interest.

In the U.S., the deduction is concentrated on a small group of people -- about 20% of mortgagors use the deduction, which requires itemizing. That group is concentrated in the next 9% of asset owners in the U.S., below the top 1%. The very wealthy, the top 1%, and the middle to poor, the bottom 90% of asset owners, don't use the deduction. As a result, simply from a political standpoint, it will be difficult to stop the elimination of the deduction.

More important, the MID actually harms the economy by promoting an inefficient allocation of financial capital into low multiplier consumption. In other words, it rewards people for allocating their income into debt service and consumption and away from saving and investing. (I discussed this last year in the column "Why Housing Will Become Less Important.")

The bottom line for investors is that doing away with the deduction increases capital available for other purposes, which can be positive for the economy. The concern that removing the MID will hurt home values and home ownership rates is not based in facts. But  because of prevailing beliefs, any company involved in the real estate business will almost certainly get punted by speculators, and perhaps investors, as concern that the MID will be eliminated begins to be acknowledged.

That presents some good buying points. Those most affected will be the builders of the largest homes and the money centers with the greatest concentration of their business in the residential mortgage space. Stocks to follow are Toll Brothers (TOL), Wells Fargo (WFC) and Bank of America (BAC).

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