Housing Deductions

Housing never came up in any of the presidential debates, even though both candidates discussed the income tax changes they had in mind.  But just so you know, housing-related tax deductions, including home mortgage interest and real estate taxes, account for 49% of total itemized deductions. In fact for middle-income tax itemizers, 56% of deductions are housing-related, which means any discussion of capping itemized deductions would reduce tax benefits for the middle class. Naturally during the campaign anything that affects the middle-class would be taboo, but not so much today.

In listing what he did over the last four years, Obama didn’t mention any housing accomplishments. And, in listing all the problems that Obama failed to fix, Romney didn’t mention housing either. Both candidates carefully avoided discussing the mortgage interest deduction when talking about taxes. Romney suggested capping aggregate deductions at $25,000 without explicitly limiting any particular deduction, and Obama criticized Romney for not specifically calling out which deductions he would limit. Because the election is (thankfully) behind us, we can look back and wonder: now what? What if the administration decides to cut the itemized deductions on housing?

First of all, who actually itemizes their tax deductions?  Remember if you don’t itemize, you can’t take real estate deductions.   The IRS says only one-third of tax-filers itemize, but this ranges hugely by income. Only 15% of filers with less than $50,000 adjusted gross income (AGI) itemize their deductions, compared with 96% with $200,000 or more AGI. Higher-income filers include a much higher average total of itemized deductions, too. A cap of $17,000 – which is what Romney suggested– is roughly equal to the amount that the typical itemizer with less than $50,000 AGI deducts, so many lower-income itemizers wouldn’t be affected at all by that cap. But even a higher cap of $25,000 would hit many people in the $50,000-$200,000 range and probably most in the $200,000-plus range.

Among all filers, 49%  of their itemized deductions is housing-related, which includes home mortgage interest, real estate taxes and a few other small deductions like mortgage points and qualified mortgage insurance premiums. 56% of the middle-income filers deduct housing expenses, more than the share for lower-income or higher-income filers.

Housing-related deductions are a larger share of overall deductions for lower-income and middle-income filers than for higher-income filers. A limit on these deductions would be a regressive tax. Here’s why. Higher-income filers pay a lot more in state and local taxes, and because tax rates often rise with income, these deductions account for a larger share of itemized deductions.

Among itemizers with $200,000 or more AGI, 36% of itemized deductions are state and local taxes, compared with just 18% for the middle-income filers and 8% for the lower-income filers. In fact, higher-income filers deduct more for state and local taxes than for home mortgage interest – in part because the mortgage interest deduction is limited to interest on the first million of mortgage debt, which would affect higher-income filers most.

At the same time, the home mortgage interest is, by far, the largest deduction for middle- and lower-income itemizers. Lower-income people also rely more on itemizing deductions for expenses that higher-income filers are more likely to get covered by insurance or their employer, including medical/dental expenses and unreimbursed business expenses.

Many middle-income folks itemize and deduct more than $25,000, so a cap at that level would snag many in the middle-class. There’s no question, though, that if a cap on deductions is low enough to affect filers with less than $200,000 AGI, the home mortgage interest deduction would be most affected. Together, the mortgage interest deduction, real estate taxes and other small housing-related deductions account for the majority of deductions for filers under $200,000 AGI, even though these housing-related deductions are a smaller share of what higher-income filers itemize.

Removing the mortgage interest deduction might lower home prices, particularly at the high end, which would hurt home sellers. High-cost areas with high homeownership benefit most from the mortgage deduction. Younger, higher-income households in expensive homes benefit greatly from the mortgage interest deduction. Here’s why: being younger and therefore in the earlier years of a mortgage, a larger percentage of their mortgage payments are interest rather than principal and therefore provide a larger deductible.

Also, higher-income households are in higher tax brackets and therefore benefit more from mortgage deductibility, and people in more expensive homes have larger payments to deduct. However, even in the absence of the mortgage interest deduction, homeownership today is still more affordable than renting. It’s 45% cheaper to buy a home than to rent a similar home today, assuming itemized deductions and that the resident is the 25% tax bracket.

But even without any itemizing, it’s still cheaper to buy than to rent in every large metro area.  Thus, even without the tax deduction, low mortgage rates and years of post-bubble price declines have made buying much cheaper than renting.

Dane Hahn is a real estate professional practicing in the Englewood/Sarasota area.  You can reach him at 941-681-0312 or at dane.hahn@gmail.com see him on the web at www.danesellsflorida.com.