Implications of mortgage interest deductibility

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Mark A.R. Kleiman writes:
The egregious tax loophole is the non-taxability of the imputed rental income on owner-occupied housing. A renter has to pay income tax on the money he earns to pay the rent, but a homeowner pays no tax on the money he saves by owning.

If we eliminate the mortgage interest deduction, we make owner-occupied housing more expensive for those who have to borrow to buy it, but not for those who can pay cash or who bought a house on a mortgage and have now paid it off.

There's a case to be made for giving less favorable tax treatment to homeownership, but if we're going to do that we might as well do it right, rather than just making life harder for people with decent incomes but little wealth who live in cities with big real estate prices.

I agree with the sentiment here, but it's worth noting that just because you can pay cash for your house doesn't mean you have to. You can always leave your money in your S&P 500 fund, take out a mortgage, and take the deduction just like people without substantial savings.

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10 Comments

It's not all that clear you save money by owning a house unless you have paid off the mortgage. The balance of all of it is that you have to have a capital gain of 4% per year or more to break even on owning a house. This was pointed out in various articles in the early 90's when there was a downturn in housing prices.

Does that "break even" point take into account the money you would have spent renting? My understanding is that CurrentPrice-OriginalPrice-Taxes-Interest is not always >0, but that value plus equivalent rental fees almost always is. If it's not, please comment, because I'm looking at buying a house later this year, and I need to know if my math is going to be badly off.

Zed: I'm pretty sure that, given enough time, your statement will always turn true at some point in ownership of the home, assuming you keep it long enough. Consider the worst case: the value of your house drops to 0. Your PurchasePrice + Interest is bounded: once your mortgage is completed, you owe no more interest (and, unless you get a variable rate loan [bad, bad idea], you know what both of these costs are ahead of time -- consider them sunk). Ignoring taxes, your expenses are constant and predictable.

I assert that RentalFees will be less than Taxes for substantially all points in time; no one could afford to rent a property for less than they pay for it except as a loss reduction technique for a very short period of time.

So, given enough time, T*(RentalFees - Taxes) will always grow larger than any constant (such as OriginalPrice + Interest). Any residual value of the house can be considered gravy. :)

In practice, I've found that what I pay in principal and interest and taxes is somewhat less than what I'd pay to rent a similar house, so I've been no worse off at any point owning than I would have been renting -- and that's before taking into account factors such as equity and income tax breaks.

Cost of maintainance and insurance factors in, too, but you can lump these in with the taxes for the purpose of this conversation.

[I'm groggy from 16 hours of straight programming; any logic flaws belong to the pixies whispering these words in my ears at the moment]

One could also argue that returns on investments unfairly benefit people who happen to have money now, as opposed to people who might have money in the future.

I made a nice spreadsheet a few months back for the housing market.

You would EXPECT that the tax ajusted interest, property tax, HOA association, & mortgage (the NONRECOVERABLE costs, compensating for tax savings) would generally be slightly less than renting, which still requires significantly more cash-flow than renting.

Right now, its the opposite, the sunk costs in home ownership are MORE than equivelent rent in the bay area, by $300+. Thus if you buy housing and rent it out, you will lose money on the nonrecoverable costs.

I'm beginning to suspect that there is something deeply wrong with the California real estate market. I can't put my finger on it at the moment, but it seems to come down to what superficially appears to be a large number of people consistently making the same kinds of irrational decisions.

It began to dawn on me that things were more than a little bizarre when a friend (in California) and I (in Texas) were comparing office space costs only to discover that his were coming in at around two-thirds the cost of mine. After some clarification and some research, we discovered that California commerical real estate is apparently quoted per month, while real estate in most other parts of the U.S. is quoted per year. Corrected for the regional dialects, his costs were eight times mine.

It's possible that I'm missing something, but owning property for the purposes of renting it out at a loss seems to be a Catastrophically Bad Investment Choice [tm].

Similarly, the prospect of paying eight times what is available elsewhere for office space would seem to increase overhead on businesses nontrivially, and impact the ability to compete with U.S. businesses based elsewhere.

Both of these sets of decisions seem irrational to me as an outsider.

If Nicholas's statement is true, Zed, then my earlier post falls apart. It was predicated on people not voluntarily tying up money in an investement vehicle that they intentionally price so as to lose money. (I'm having a hard time rectifying this with the stories I've heard of housing being so in demand that "asking price" becomes the floor for what gets offered, and parties typically close much higher -- wouldn't this kind of scarcity allow owners to rent property out at ultra-premium rates to desperate people who can't find a house to buy? Or is the Califorinia housing market in the middle of collapsing?)

Adam, I think the word you're looking for is "bubble".

In an investment bubble, the price of a commodity is based not on the return it can generate through use, but rather on the expectation that its price will continue to increase--perhaps indefinitely--allowing the seller to profit (eventually) by selling it to someone else. Real estate in California (and a number of other locales, as well, these days) is likely being priced based on this belief. And, indeed, if the belief were well-founded, then it might well make sense for buyers to pay a considerable short-term premium over rental costs, in return for a huge profit on resale.

Of course, this belief is not well-founded. That's what makes it a bubble.

The mortgage interest tax deduction is certainly a bonus for all real estate investors, but short term analysis across a market doesn't seem like the best way to determine its usefulness (or lack thereof). The goal of the deduction really seems to encourage a specific type of social behavior.

Harvard has a school that issues reports on these issues. Their best advice to real estate *investors* is to look at the lower third of the market on either coast. Historically, these areas have outperformed the upper third over 7 to 25 year time horizons.

As immigration continues to drive an increase in population in the lower tier of our citizens, I would bet the U.S. housing market will continue to rise until about 2012. At that point, I'm concerned about the reductions in buying power caused by a wave of retirements. This situation occurred in the '70s.

The way to get the most bang-for-the-buck from the mortgage interest deduction is to use mortgage equity to invest in emerging market foreign real estate. But then again, the wealthy that can afford that have lots of tax deduction loopholes. :)

Adam, California, or at least the San Francisco area, recently had a dramatic drop in rents due to the downturn, but there hasn't beeen a corresponding drop in prices due to some expectations that rents will go back up again.

The thing really keeping up housing prices in california is how much people can get paid when they live in the major housing centers. The result is that people move out because they can't afford the rent - food, clothing, no problem, those are relatively cheap, but not becoming homeless is a major difficulty.

California, or at least the San Francisco area, recently had a dramatic drop in rents due to the downturn, but there hasn't beeen a corresponding drop in prices due to some expectations that rents will go back up again.

Ah, in that case, it's just the "loss reduction technique for a very short period of time" that I mentioned in my original post. That makes some amount of sense.

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