The Wall Street Journal
By: S. Mitra Kalita & Nick Timiraos
December 16, 2010
The U.S. government has long subsidized homeownership through tax deductions and loan guarantees. Now, it is re-examining whether it can afford to underwrite the American Dream.
Earlier this month, a presidential deficit commission proposed reducing the mortgage-interest deduction, the largest government subsidy for housing. Next month, the White House will propose an overhaul of mortgage titans Fannie Mae and Freddie Mac amid a broader debate over how widely the U.S. should guarantee mortgages. Today, it backs nearly nine in 10 new loans.
Taken together, the proposals could set in motion the largest shift in government support for housing since World War II. Already, the Obama administration has suggested it wants to turn away from the heavy emphasis in recent years on simply increasing the homeownership rate, which critics say helped inflate the housing bubble.
To be sure, Congress has repeatedly fended off efforts to pare back the mortgage tax break, arguing it makes homeownership more affordable. And any quick moveby Washington to pull back support for housing carries risk.
The real-estate industry is warning that any policy changes could be disastrous for the fragile housing market, dissuading would-be buyers and depressing prices further. Even modest price declines could leave millions more Americans underwater, owning homes worth less than they owe on mortgages. That could undermine the economic recovery by depressing consumer demand and lengthening the construction-industry downturn.
"It would be a huge blow to the real estate industry," said Chris Summers, a realtor in Medfield, Mass. "This has been the cornerstone of making homeownership an attainable American Dream."
But analysts at housing-research firm Zelman & Associates said in a note to clients that real-estate industry groups had "grossly misrepresented" the benefits of the deduction and the impact of any change. "To say it's going to 'kill the industry,' you're saying people aren't going to buy houses if they can't deduct the interest," said Dennis McGill, director of research.
Mr. McGill said that if changes in the deduction were phased in gradually, it wouldn't hurt housing demand and would decrease prices only marginally in certain markets. The market could digest the deficit panel's proposal "fairly reasonably," he said.
Already-jittery buyers are watching closely. "I wouldn't want to be the last one who bought a house before they announced it was all over," said Dick Klem, a 66-year-old federal worker and avid boater looking to buy a waterfront home in the Northern Virginia suburbs. He estimated the mortgage-interest deduction could save him $10,000 annually on a property he looked at about three weeks ago.
While the deduction wasn't created with homeownership in mind--Congress made all interest tax-deductible when it approved a federal income tax in 1913--it helped fuel a postwar home-buying boom during which the government also guaranteed a steady supply of cheap, fixed-rate mortgages. In 1940, about 44% of Americans owned their homes. Last year, about two-thirds did.
Economists say the deduction now mostly encourages wealthier Americans to take on more debt. That's because the deduction applies only to the roughly one-third of taxpayers who itemize their returns, typically those with higher incomes.
They say industrialized nations such as Canada and the U.K. have achieved comparable rates of homeownership without such incentives. The U.K., for example, gradually reduced its mortgage-interest break over 12 years, scrapping it for good in 2000 without hurting homeownership rates. Likewise, credit- card balances saw little effect from the repeal of the deductibility of credit-card interest in 1986.
"This represents a move toward neutrality and getting the government out of the business of allocating investment through the tax system," said Eric Toder, co-director of the Washington-based Urban-Brookings Tax Policy Center. "Economists have for a long time been worried about a system that encourages people to buy bigger homes instead of, say, buy stocks or invest in a business."
While the deduction makes homeownership more attractive in certain markets with abundant housing supply, it only does so for higher-income borrowers, according to a recent study by economics professors Christian Hilber and Tracy Turner at the London School of Economics and Kansas State University, respectively. In denser urban areas with limited housing stock, the deduction actually reduces homeownership, because it inflates home prices, the study found.
Moreover, in the run-up to the housing bubble, "notions of what homeownership meant changed," said Raphael Bostic, a senior official at the Department of Housing and Urban Development. The goal of homeownership increasingly tilted toward owning something that could go up in value, as opposed to having a place to live that "you can manage for the long haul," he said. "Investment overshadowed consumption."
President Obama has proposed small cuts in the mortgage-interest deduction for top earners in the past, but many housing-market observers agree that this time around could be different, because of swollen U.S. budget deficits. Mortgage deductions will reduce tax revenue in 2012 by $131 billion, according to White House estimates.
Currently, the deduction allows taxpayers to deduct interest paid on mortgages up to $1 million for first and second homes, and up to $100,000 in additional home-equity borrowings. The deficit panel seeks to replace that system with a flat 12% tax credit for interest on mortgages up to $500,000 for first homes. Other tax proposals would partly offset the costs of the change for many taxpayers.
Property-tax deductions are also on the chopping block, which could make homeownership more costly. And the panel's proposal has implications for sellers of homes, such as taxing capital gains the same as ordinary income. Currently, the profits that sellers make on houses--up to $500,000 for married taxpayers, $250,000 for single--can be excluded from the capital-gains tax.
The White House said last week it would might incorporate the panel's proposals for a tax overhaul in next year's budget.
In new Wall Street Journal/NBC News poll Wednesday, 60% of Americans found it totally or mostly acceptable to eliminate the mortgage deduction on second homes, home-equity loans and any portion of a mortgage over $500,000.
The government also confronts tough choices over how to unwind its massive support for the mortgage market without destabilizing housing. Federal policy has fueled home buying by backstopping mortgages, particularly the 30-year, fixed-rate mortgage, through the Federal Housing Administration, as well as Fannie and Freddie, which have racked up huge losses for the government in recent years.
Without that support today, rates could be at least two to three percentage points higher, said Michael Farrell, chairman of Annaly Capital Management, a New York-based, mortgage-bond investor. The Obama administration has signaled support for maintaining some type of limited government guarantee to keep mortgage markets operating smoothly. But less government backing of mortgages could mean higher down payments, which are common in other countries, and higher interest rates for borrowers.
"The most likely scenario is that government intervention will make homes slightly harder to sell over the next few years," wrote Lisa Marquis Jackson, vice president at John Burns Real Estate Consulting, in a note to the firm's homebuilder clients last month.
Write to Nick Timiraos at email@example.com