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New Perspectives on Homeownership Tax Incentives-first time home owner tax credit

SPECIAL REPORT
tax notesTM
New Perspectives on share the common characteristic of subsidizing
Homeownership Tax Incentives homeownership through a channel other than the
deductibility of mortgage interest, which is the
By Benjamin H. Harris, C. Eugene Steuerle, largest tax expenditure for housing. These reforms
and Amanda Eng include a first-time home buyer tax credit, a refund-
able tax credit for property taxes paid, and an
annual flat amount tax credit for homeowners -- all
Benjamin H. Harris is a fellow at the Brookings largely paid for by restricting the home mortgage
Institution. C. Eugene Steuerle is the Richard B. interest deduction to a rate of 15 percent. Although
Fisher chair and Institute Fellow at the Urban far from perfect, these reforms would provide a
Institute. Amanda Eng is a research assistant with better and more efficient allocation of housing sub-
the Urban Institute. The authors thank Len Bur- sidies and ultimately provide a somewhat larger
man, Donald Marron, Eric Toder, and Bob Williams incentive for wealth accumulation than current
for helpful comments. All errors or omissions are policy does. Our simulations show that relative to
the authors' own. The authors also acknowledge existing incentives, each policy would raise home
generous research support from the Ford Founda- prices and make the tax code more progressive.
tion.
In this report, the authors analyze the economic I. Background
effects of various reforms to the tax treatment of Homeownership is frequently cited as a laudable
housing. These reforms differ from both the current
treatment of housing and most proposed reforms policy goal in the United States. While a debate over
(such as Bowles-Simpson); they attempt to reward the social merits of homeownership remains un-
homeownership directly, not the build-up of addi- settled, advocates cite a wide body of research
tional debt. reinforcing the notion that homeownership im-
Table of Contents
proves American communities.1 Support for home-
ownership has developed into one of the most
expensive social programs in the federal budget,
I. Background . . . . . . . . . . . . . . . . . . . . . . 1315
with tax and spending incentives adding up to
II. Rethinking Homeownership Incentives . 1317
hundreds of billions of dollars annually. Govern-
ment subsidies for homeownership generally fall
A. Social Benefits of Homeownership . . . . 1317 into three categories: implicit and explicit mortgage
B. Drawbacks of Homeownership . . . . . . . 1318 guarantees that lower the cost of mortgages for
C. Shortcomings of Current Law . . . . . . . 1318 homeowners, direct subsidies for low-income home
D. Guiding Principles for Reform . . . . . . . 1319 buyers, and tax deductions and exclusions for
III. Proposals for Reform . . . . . . . . . . . . . . . 1319 homeownership. Deductions and exclusions for
A. First-Time Home Buyer Tax Credit . . . . 1320 homeownership are the focus of this report.
B. Property Tax Credit . . . . . . . . . . . . . . . 1321 The major tax preferences for homeownership in
C. Homeowner Tax Credit . . . . . . . . . . . . 1321 the federal income tax are the mortgage interest
IV. Distributional and Revenue Effects . . . . . 1322 deduction on owner-occupied homes, the deduc-
V. Home Price Effects . . . . . . . . . . . . . . . . . 1323 tion for state and local taxes paid on owner-
VI. Conclusion . . . . . . . . . . . . . . . . . . . . . . . 1324 occupied property, and the exclusion of capital
VII. Appendix: Methodology . . . . . . . . . . . . . 1325 gains on the sale of an owner-occupied home.2 The
References . . . . . . . . . . . . . . . . . . . . . . . . . . . 1326
This report presents three tax reforms designed
to promote homeownership that are fundamentally 1See National Association of Realtors (2012) for the housing
different from earlier proposals. Many of those industry's perspective on the social benefits of homeownership.
earlier proposals would convert existing deductions See also Lerman and McKernan (2008) for the benefits of
into credits but would mistakenly, in our view, homeownership.
2Deductions for mortgage interest and property taxes paid
perpetuate flaws in the current system -- namely, are not technically tax subsidies. The real subsidy arises because
the failure to adequately promote the accumulation net imputed rent -- the unmeasured rental income derived from
of home equity. The reforms examined here instead homeownership less expenses (including interest, taxes, and
(Footnote continued on next page.)
TAX NOTES, December 23, 2013 1315
COMMENTARY / SPECIAL REPORT
mortgage interest deduction allows taxpayers to that individuals have no discretion over whether to
deduct mortgage interest on up to $1 million of debt pay state and local taxes and thus taxpayers with
used to purchase or refinance a primary or second- high subnational tax burdens are less able to pay
ary home. Taxpayers may also deduct interest paid federal taxes.5 Capital gains on the sale of a home
on up to $100,000 in home equity loans or addi- were taxed until 1951, when a new law allowed the
tional mortgage debt. These limits are not indexed deferral of capital gains taxes if the sale proceeds
to inflation and have been constant since 1988. were used to purchase another home of equal or
Taxpayers may also deduct many types of nonbusi- larger value. Between 1964 and 1981, Congress
ness state and local taxes paid, including residential passed a series of laws granting older homeowners
property taxes.3 Unlike the mortgage interest de- a one-time exclusion on capital gains on the sale of
duction, there is no cap on the amount of deductible a principal residence. By 1981, a one-time $125,000
property taxes that taxpayers may claim.4 A third exclusion was available to all homeowners over age
major tax expenditure for housing is the capital 55. In 1997 the rollover provision and one-time
gains exemption on the sale of an owner-occupied exclusion were replaced with a $250,000 per-person
home. For taxpayers who have lived in a primary exclusion on principal residence capital gains. In
residence for at least two of the five years before contrast to the 1981 one-time exclusion, homeown-
sale, the first $500,000 ($250,000 if single) in capital ers could claim this exclusion more than once.6
gains are exempt; these limits are not indexed to
inflation. Combined, these tax preferences usually In recent years, calls for reform of the homeown-
mean that homeowners pay less in taxes if they ership subsidies have intensified. Several proposals
invest in owner-occupied housing than if they in- have sought to limit and equalize the tax benefit for
vest in other taxable assets. homeownership by retaining the subsidy for mort-
Tax expenditures for owner-occupied housing gage interest, but at an equal rate across taxpayers.
are mostly a byproduct of long-standing tax law For example, both President Obama's fiscal com-
and not the outcome of a conscious effort to design mission and the Bipartisan Policy Center's Debt
pro-homeownership policies. Taxpayers have been Reduction Task Force recommended replacing the
allowed to deduct mortgage interest since the in- mortgage interest deduction with a tax credit for
ception of the income tax in 1913, when all con- mortgage interest paid and eliminating the deduct-
sumer interest could be deducted. Other forms of ibility of property taxes (National Commission on
interest deductibility have gradually been disal- Fiscal Responsibility and Reform (2010); Bipartisan
lowed over time, most significantly in 1986 when Policy Center (2010)). Other researchers have also
Congress eliminated the deduction of interest on explored various credit designs, including Carasso,
consumer debt, such as credit cards and auto loans. Steuerle, and Bell (2005a); Gale, Gruber, and
Stephens-Davidowitz (2007); and Viard (2013).7 In
Similarly, property taxes have always been deduct- the spirit of reform, this report also examines ways
ible under the regular income tax (although not the to transform existing housing subsidies, but instead
alternative minimum tax). One justification was offers policies that would subsidize homeowner-
ship without reducing the cost of debt finance to
such an extent that it discourages the build-up of
depreciation) -- is untaxed. Imputed rent is hard to measure, so home equity.
the deductibility of property taxes and mortgage interest are
used as proxies.
3The mortgage interest and property tax deductions are
itemized deductions. Under the individual income tax, taxpay- 5An alternative perspective is that state and local taxes,
ers deduct the larger of the standard deduction, equal to $12,200 especially property taxes, are benefit taxes that are associated
for married filers and $6,100 for single filers in 2013, and the with higher public services in taxing localities and thus are a
sum of their itemized deductions (the largest itemized deduc- form of consumption that should not be deductible.
tions are for state and local taxes paid, mortgage interest, and 6Both the one-time exclusion before 1997 and the $250,000
charitable contributions). Taxpayers whose combined itemized exclusion available after 1997 were subject to residency require-
deductions are less than the standard deduction do not claim ments.
the mortgage interest and property tax deductions and thus do 7Many proposals would also limit the maximum size of the
not directly benefit from those provisions. mortgage eligible for tax preferences (currently $1 million),
4State and local taxes paid, including property taxes, are not eliminate the deductibility of interest on second homes, and
deductible under the alternative minimum tax -- a parallel tax disallow write-offs for home equity loans. For example, the
system with different limits and treatment of deductions than Bowles-Simpson proposal would limit the maximum mortgage
the regular income tax. In 2010, 4.1 million taxpayers were to $500,000, while Viard would cap it at $300,000. A 2005 tax
subject to the AMT, with a disproportionate share coming from reform panel established by President Bush recommended
high-tax states, such as California, New Jersey, and New York converting the deduction to a 15 percent nonrefundable credit
(Tax Policy Center 2013). This disallowance is the largest single and limiting the maximum mortgage eligible for the subsidy to
source of income by which the AMT tax base exceeds taxable 125 percent of the median local home price (President's Advi-
income in the regular income tax. sory Panel (2005)).
1316 TAX NOTES, December 23, 2013
COMMENTARY / SPECIAL REPORT
II. Rethinking Homeownership Incentives als borrow against existing equity and use the
Economists often note that returns from all in- proceeds to finance direct consumption.9
Tax expenditures for homeownership are expen-
vestments should be accorded the same tax treat- sive in terms of lost revenue. The Joint Committee
ment. If this were the case, the tax on owner- on Taxation estimates the aggregate cost of the three
occupied housing would ideally apply to income provisions at $121.3 billion in 2013.10 The mortgage
less expenses. In the context of owner-occupied interest deduction was estimated to cost $69.7 bil-
housing investment, however, the income, or im- lion this year, followed by the property tax deduc-
puted rent, is not measured directly. Theoretically, it tion at $27.8 billion and the capital gains exclusion
equals the market rental value of the home. Ex- at $23.8 billion. Eight other tax expenditures for
penses include mortgage interest, property taxes, housing in the JCT's list cost an additional $7.8
and depreciation. In practice, the tax code treats billion in 2013 (JCT (2013)).11
housing differently from other investments. Mainly
because imputed rent is difficult to measure, it is A. Social Benefits of Homeownership
excluded from tax, yet select expenses -- mortgage Defenders of the tax expenditures for homeown-
interest and property taxes -- may still be deducted ership often argue that homeownership provides
from income. Thus, economists often cite the more positive social benefits -- what economists call
measurable mortgage interest and property tax ``positive externalities.'' These benefits typically fall
deductions as tax preferences for homeownership.8 into two categories: spillover effects and wealth
Exclusion of capital gains on the sale of owner- accumulation.
occupied homes is often counted as a third major Spillover effects refers to benefits related to
tax expenditure. homeownership beyond the direct benefit the indi-
vidual homeowner receives, such as the improved
To clarify this distinction, compare a taxpayer social environment associated with more engaged
who invests $100,000 in the purchase of a home civic participation and reduced crime. Residents
with no mortgage with one who deposits $100,000 who own their homes instead of renting gain a
into a bank account and rents an identical home. financial interest in the welfare of their communi-
The former does not pay tax on the return from the ties, which gives them an incentive to help improve
investment while the latter does. For the home- the quality of life in their neighborhood.
owner, there is no measured income on the asset Homeownership is also justified as a vehicle for
from which to deduct mortgage interest or property wealth accumulation. If financial short-sightedness,
taxes paid. Although the two assets in this example the safety net of government programs, or other
have equal value, the homeowner pays less tax. factors lead households to save too little, homeown-
The exclusion of imputed rent from investment ership might offer a means of inducing greater
in owner-occupied housing makes ideal income wealth accumulation. Paying off a mortgage and
taxation of housing investment impossible. Given
this exclusion, the deduction for mortgage interest
corrects for one distortion while magnifying an- 9Consumer interest is generally nondeductible, but home
other. On one hand, the presence of the mortgage equity is a backdoor way to finance consumption with deduct-
interest deduction creates neutrality between equity ible debt. There are limits on use of debt for non-housing
owners and borrowers because it allows borrowers purposes in the AMT, but they are difficult for the IRS to
to deduct one of the costs of ownership. One of the enforce.
10Because of interaction effects, the combined result of re-
benefits of the mortgage interest deduction is that it pealing multiple expenditures may not equal the sum of repeal-
partially equalizes the treatment of new borrowers ing them separately. For example, eliminating the mortgage
(often younger, with less wealth) with equity own- interest reduction reduces the value of the property tax deduc-
ers (often older, with higher wealth). Conversely, tion, and vice versa. Burman, Geissler, and Toder (2008) showed
the mortgage interest deduction magnifies distor- that the error from adding tax expenditures was relatively
tions because it adds to the subsidy for owner-
modest overall. A more serious challenge is that tax expendi-
tures may differ substantially from revenue estimates.
occupied housing. It also further promotes 11The smaller housing tax expenditures include the exclusion
consumption outside the home, as when individu- of interest on state and local government qualified private
activity bonds for owner-occupied housing, the deduction for
premiums for qualified mortgage insurance, the exclusion of
income attributable to the discharge of principal residence
acquisition indebtedness, the credit for low-income housing, the
8The mortgage interest deduction has been justified on the credit for rehabilitation of historic structures, the credit for
grounds that it extends the benefits from the exclusion of rehabilitation of structures other than historic structures, the
imputed rent to home buyers who must use debt financing to exclusion of interest on state and local government qualified
purchase a home. See Toder (2013) for a precise example and private activity bonds for rental housing, and the depreciation
further discussion. of rental housing exceeding the alternative depreciation system.
TAX NOTES, December 23, 2013 1317

Can you still get a first time home buyer tax credit?Reps. Earl Blumenauer and Jimmy Panetta introduced the First-Time Homebuyer Act in the House in late April. The bill, which closely resembles what Biden proposed during his campaign, would create a refundable tax credit worth up to 10 percent of the purchase price, or $15,000, for the purchase of a home.

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Title: New Perspectives on Homeownership Tax Incentives
Subject: This report presents three tax reforms designed to promote homeownership through a channel other than the deductibility of mortgage interest. These reforms include a first-time homebuyer tax credit, a refundable tax credit for property taxes paid, and an annual flat amount tax credit for homeownersall paid for by limiting current tax expenditures for housing. Although far from perfect, these reforms would provide a more efficient and equitable allocation of housing subsidies. Our simulations show that relative to existing incentives, each policy would raise home prices and make the tax code more progressive.
Keywords: Taxes and Budget ;Economic Growth and Productivity;Housing and Housing Finance
Author: Amanda Eng, Benjamin H. Harris, C. Eugene Steuerle
Creator: XyEnterprise XPP 8.4C.1 SP #1
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