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Econometric Advisors' blog

The Tax Reform Act: Mortgage interest and housing capital gains

Jan 26, 2018, 12:56 PM by Bill Wheaton

Extending the capital gains holding period is probably good, but reducing the cap on the mortgage interest deduction does little for homeownership, as it mainly diminishes a long-standing entitlement for upper-middle-income households to own larger homes.

Changes in the mortgage interest deduction

In assessing this feature of the new Tax Act, it's important to keep current policy in mind. At present, individuals are allowed to deduct the interest on mortgage debt that does not exceed $1 million. That can be any combination of mortgage debt (of any kind) on one’s primary home, as well as on a second home. Given current average leverage ratios, this means homes worth more than about $1.5 million are already under a cap; buy a home more valuable than that and the interest deduction will not increase. Hence, the cost of buying a larger home currently increases noticeably at around this value.

At the other extreme, as many as half of new home-buyers decide not to itemize their deductions and take advantage of mortgage interest deductibility. In many parts of the country, a “starter” home with an 80% loan-to-value ratio will involve a mortgage of only $200,000. At today’s rates, the annual interest on such a loan is around $6,000. Without significant other deductions, itemization may simply not be worth it. Still not convinced? Several recent studies have shown econometrically that states whose income taxes mimic the Federal tax with an extra combined-interest deduction do not have more first-time buyers than those states without the extra deduction. This has cast much doubt on claims that the interest deduction helps to promote homeownership. And why do we extend the deduction to second homes? How does that help homeownership?

More and more economists now realize that the current policy mainly assists upper-middle-income households in buying larger and better homes—up to the $1.5 million range.

The proposed new cap on mortgage interest deduction

The Tax Reform Act’s changes to deductibility should have quite a modest impact on the U.S. housing market. It will become somewhat more expensive to buy houses bigger and better than those in the range of $1 million to $1.5 million, but above that, a cap already exists, and below it, there will be no change.

The extended holding period for the capital gains exclusion

Currently, the tax code’s treatment of housing capital gains is extremely generous. A family (couple) can exclude up to $500,000 in capital gains when they sell their home. More importantly, they can take this exclusion every two years. With proper planning, then, long-term home appreciation totally escapes capital gains taxation. Live in a home until it appreciates to the $500,000 cap, then sell and move to a similar home down the street… and repeat. A nice incentive to move a little more often! The Tax Reform Act lengthens the exclusion period to five years, lowering the incentive to move to avoid taxes—perhaps a good thing. Once again, this an advantage only for households buying and selling expensive housing.

 

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