Home > #OWS, economics, modeling > Mortgage tax deductions and gentrification

Mortgage tax deductions and gentrification

December 22, 2014

Yesterday we had a tax expert come talk to us at the Alternative Banking group. We mostly focused on the mortgage tax deduction, whereby people don’t have to pay taxes on their mortgage. It’s the single biggest tax deduction in America for individuals.

At first blush, this doesn’t seem all that interesting, even if it’s strange. Whether people are benefitting directly from this, or through their rent being lower because their landlord benefits, it’s a fact of life for Americans. Whoopdedoo.

Generally speaking other countries don’t have a mortgage tax deduction, so we can judge whether it leads to overall more homeownership, which was presumably what it was intended for, and the data seems to suggest the answer there is no.

We can also imagine removing the mortgage tax deduction, and we quickly realize that such a move would seriously impair lots of people’s financial planning, so we’d have to do it very slowly if at all.

But before we imagine removing it, is it even a problem?

Well, yes, actually. Let’s think about it a little bit more, and for the sake of this discussion we will model the tax system very simply as progressive: the more income you collect yearly, the more taxes you pay. Also, there is a $1.1 million (or so) cap on the mortgage tax deduction, so it doesn’t apply to uber wealthy borrowers with huge houses. But for the rest of us it does apply.

OK now let’s think a little harder about what happens in the housing market when the government offers a tax deduction. Namely, the prices go up to compensate. It’s kind of like a rebate: this house is $100K with no deduction, but with a $20K deduction I can charge $120K for it.

But it’s a little more complicated than that, since people’s different income levels correspond to different deductions. So a lower middle class neighborhood’s houses will be inflated by less than an upper middle class neighborhood’s houses.

At first blush, this seems ok too: so richer people’s houses are inflated slightly more. It means it’s slightly harder for them to get in on the home ownership game, but it also means that, come time to sell, their house is worth more. For them, a $400K house is inflated not by 20% but by 35%, or whatever their tax bracket is.

So far so good? Now let’s add one more layer of complexity, namely that, actually, neighborhoods are not statically “upper middle class” or “lower middle class.” As a group neighborhoods, and their associated classes, represent a dynamical system, where certain kinds of neighborhoods expand or contract. Colloquially we refer to this as gentrification or going to hell, depending on which direction it is. Let’s explore the effect of the mortgage tax deduction on how that dynamical system operates.

Imagine a house which is exactly on the border between a middle class neighborhood and an upper-middle class neighborhood. If we imagine that it’s a middle class home, the price of it has only been inflated by a middle-class income tax bracket, so 20% for the sake of argument. But if we instead imagine it is in the upper-middle class neighborhood, it should really be inflated by 35%.

In other words, it’s under-priced from the perspective of the richer neighborhood. They will have an easier time affording it. The overall effect is that it is easier for someone from the richer neighborhood to snatch up that house, thereby extending their neighborhood a bit. Gentrification modeled.

Put it another way, the same house at the same price is more expensive for a poorer person because the mortgage tax deduction doesn’t affect everyone equally.

Another related point: if I’m a home builder, I will want to build homes with a maximal mark-up, a maximal inflation level. That will be for the richest people who haven’t actually exceeded the $1.1 million cap.

Conclusion: the mortgage tax deduction has an overall negative effect, encouraging gentrification, unfair competition, and too many homes for the wealthy. We should phase it out slowly, and also slowly lower the cap. At the very very least we should not let the cap rise, which will mean it effectively goes down over time as inflation does its thing.

If this has been tested or observed with data, please send me references.

Categories: #OWS, economics, modeling
  1. December 22, 2014 at 10:49 am

    Let’s consider the other market dynamic, which you call going to hell.

    Combine the following incentives:

    * You can’t defer capital gains tax on the same unless you’re “moving up” to a more expensive home.
    * You can’t take a capital loss on an owner-occupied home (but can on a rental property).
    * You can’t take depreciation on an owner-occupied home (but can on a rental property, for the building).
    * There are various tax shelters involving “low income housing.”

    So if the value of your property goes down, you can eat the whole loss, or go into the slumlord business.


    • FogOfWar
      December 22, 2014 at 11:09 am

      First point is no longer true–that’s the old regime, replaced by the $250/$500 exclusion twice every five years. Second and third points are very true and can make a huge difference.


  2. FogOfWar
    December 22, 2014 at 11:18 am

    Also, on the last sentence: that’s the law on the mortgage interest deduction currently: it is NOT one of the tax provisions that are indexed to inflation. Some tax numbers are and some aren’t in a good approximation of a random algorithm…

    By request, here are the US federal income tax brackets in 2014: 0% / 10% / 15% / 25% / 28% / 33% / 35% / 39.6%. Where each kicks in and out depends on your filing status. Actually, one could make an equal/similar argument mathematically that the mortgage deduction is a pro-marriage policy because married couples get hit by the marriage penalty and thus get a better value for mortgage interest deduction than similarly-situated unmarried couples. Hmmm…



    • liberal
      December 24, 2014 at 12:47 am

      Actually, for many couples there’s atax _benefit_to being married.


      • FogOfWar
        December 24, 2014 at 3:55 pm

        For those with one spouse having zero or near-zero income yes, but for most two-earner couples it’s a tax penalty. A generation ago with more primary-earner/housewife couples it was more of a marriage tax bonus, now it’s more common to be a marriage penalty.


  3. Auros
    December 22, 2014 at 3:02 pm

    It seems totally obvious that the mortgage interest deduction is and always was a terrible idea, creating a bunch of perverse incentives without ever benefitting homeowners much. (Most of the value ends up in the pockets of mortgage issuers, in the form of higher interest payments.) But it’s impossible to imagine it being rolled back. (And if you did roll it back, you’d probably need to do it via some kind of phase out process, so as not to slam people who have bought a house in the last 5-10 years with a suddenly-much-higher cost for their existing housing, nor cause a one-time massive windfall loss on housing capital value. Like, you’d need to have a ten year process during which the amount of mortgage value that can qualify is declining; but once a mortgage is issued for a property, that property qualifies to keep whatever deduction applied to it at the time, for the subsequent 30 years.)


    • December 22, 2014 at 4:29 pm

      If you tie the deduction to the mortgage then if someone changes their mortgage to, for example, take advantage of changing interest rates they would be penalized by the tax policy.


      • Auros
        December 23, 2014 at 12:51 am

        I was suggesting you’d tie it to the property, not the mortgage, specifically thinking of re-fis. Though perhaps it would be better to phase it out by keeping most of the existing rules for calculating the deduction, but over the course of 20 years or so, keep discounting the value of it each year until it goes to zero. So, if currently you could deduct, say, $10k from your taxable income, the first year of the phase-out process that would instead be $9.5k, then $9.0k, etc…

        In any case, it’s pretty much unthinkable that they’ll ever actually get rid of it, so considering exactly how to do it is pretty much academic. :-/


        • December 23, 2014 at 8:04 am

          At one time the personal interest deduction and income averaging were also considered untouchable but they were eliminated in 1986 and 1981 respectively. I think a gradual phase out is more workable than something tied to the property. For one thing, tying it to an existing property would advantage existing houses over new construction.


    • FogOfWar
      December 24, 2014 at 2:05 pm

      Lower interest payments with the tax deduction, not higher, so I’m not sure mortgage issuers benefit, at least from this perspective.

      If you’re going to propose a gradual phase-out I’m not sure 10 years is anywhere near a long enough duration–would still have massive impacts as the market will anticipate the run-down in the tax shield over the medium term.



  4. December 22, 2014 at 4:46 pm

    “so we can judge whether it leads to overall more homeownership, which was presumably what it was intended for”

    Encouraging home ownership is an after the fact justification. (see http://scholarship.law.duke.edu/cgi/viewcontent.cgi?article=1561&context=lcp). No one knows the reason for excluding personal interest payments form income (all interest was deductible 1913-1987) but the difficulty separating business loans from personal loans is one possibility.

    “if I’m a home builder, I will want to build homes with a maximal mark-up, a maximal inflation level. That will be for the richest people who haven’t actually exceeded the $1.1 million cap.”

    That is assuming that there is an unlimited demand for $1.1 million cap houses. Since in fact not all houses built are for that market it would seem that the analysis is wrong somewhere.

    Also, I see you declare gentrification to be bad. It can be. However, it not always is.


  5. December 22, 2014 at 5:38 pm

    “In other words, it’s under-priced from the perspective of the richer neighborhood. They will have an easier time affording it. The overall effect is that it is easier for someone from the richer neighborhood to snatch up that house, thereby extending their neighborhood a bit. Gentrification modeled.”

    Or not. In the last 25 years we have had four major modifications of the income tax system or rate: 1981, 1986, 1993, 2001, 2012. In 1980 the top tax rate was 70% and now it is 35% (http://www.businessinsider.com/history-of-tax-rates?op=1). Has the rate of gentrification dramatically slowed since 1980?


  6. swiffy
    December 23, 2014 at 11:57 am

    I hate going up against your tax expert, but I think this post is wrong at its foundation.

    There is a deduction available for mortgage interest paid if you itemize. There is for sure no deduction for payments of principal, including down payment.

    The deduction is commonly thought of as a “mortgage interest subsidy”. Ie, an itemizing borrower might think of a net interest rate of 3% instead of 4% after accounting for the tax benefit. There is no benefit to cash buyers.

    Policies to lower mortgage interest rates definitely do promote home buying activity (this is a big part of an accommodative rate policy) and probably boost home prices somewhat too. But it’s clearly wrong to attribute a 35% boost or anything remotely close to a subsidy effect.

    Beyond this, the neighborhood argument you make is not strong. Sellers are generally trying to find the buyers who will pay the most. In the competition among potential buyers, the direct benefits of being richer may swamp any benefit from a greater subsidy.


    • FogOfWar
      December 24, 2014 at 2:00 pm

      To clarify the math: the amount by which the home price is expected to increase is the net present value of the combined tax savings on the interest components of the mortgage interest paid. Agree completely that will not be 35% in most cases, and in fact at current low rates it’s a lower number than at higher rates. So, just to take some silly simplifying assumptions, on a $100 “value” house at 4% MGE rate assuming a 15 year balloon mortgage, a 0% discount rate and a 25% tax bracket, the sale price of the house would be expected to be $115.



      • Cmas
        December 25, 2014 at 1:09 am

        “the amount by which the home price is expected to increase is the net present value” — generally wrong, and no argument or model is presented to explain the reasoning.


  7. December 24, 2014 at 10:20 am

    The economic benefits of tax policy depends on what economic cycle the economy is in. If tax policy is out of sync with the inflation cycle or the recession cycle the cycle will be amplified. If the tax code is encouraging people to go into debt during the inflation cycle, the tax code is helping to create higher inflation rates because more money is being created as people monetize the higher prices. As long as the financial sector is willing to create the larger loans and borrowers are willing and able to service the debt prices will continue to rise. If either party decides that the price is to high prices drop. This is what occurred when the primary home bubble burst. We had 20 years of price appreciation in home prices in a 7 year period because of tax policy and bank deregulation. Please let me explain how the tax code could help the Federal Reserve maintain stable prices and full employment. wp.me/p42WQA-1E


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