By: John J. Alexander
As our representatives in Washington, D.C. and St. Paul, Minn., seek ways to address the imbalance between spending and tax revenues, the topic of eliminating the individual mortgage interest tax deduction has come up as a source for new tax dollars. But eliminating the mortgage interest tax deduction is not only counter to the American Dream but is inherently unfair and imbalances the playing field in favor of those who rent.
In their enthusiasm to find new sources of tax dollars, our representatives have forgotten why we have the mortgage interest deduction for individual homeowners.
Home ownership has been a primary part of the American Dream for one hundred years (since 1913 when the 16th amendment was ratified and the modern federal income tax was enacted). It certainly is part of mine. I rented apartments for seven years after graduating from college before I saved enough for a down-payment to buy my first home. According to a Harris (the pollster) & Trulia.com (the real estate search engine) survey, I belong to the 70 percent of Americans who view home ownership as part of the American dream.
That dream has many components:
- Privacy and ownership of four walls and a yard that belong to you.
- Financial security with the cost of housing going toward home equity rather than rent
- Creating a retirement nest-egg.
- Being part of a neighborhood
This dream is alive and part of the fabric of who we are as a nation.
When the tax deductibility of interest on a mortgage was put in place, it helped facilitate the dream of private home ownership, strengthen families and the communities in which they reside and fundamentally build our nation.
It also levels the playing field. Because on the flip-side – those in the business of offering rental housing are able to deduct interest as a business expense. They’re also able to deduct the cost of the building and the cost of maintenance. Homeowners cannot.
Those renting properties also must pay taxes on real estate earnings, still… it’s easy to see that interest deductibility for homeowners makes a huge difference in keeping the playing field level from an economic perspective.
Some media pundits and academic economists have very recently said that if the mortgage interest deduction were to end or even sunset over a three to five year time period that it would not make a difference in homeownership. I beg to differ and here’s the math to prove it -- first the tax rates.
Federal tax rates for 2013:
Minnesota current tax rate (2012):
For illustration purposes, we choose a Married Joint Filer so the 25 percent federal and 7.05 percent state marginal tax rates apply [see the highlighted boxes above]. Also for simplicity, we keep the deductibility of state from federal rate, the marginal rate is additive or 32.05 percent.
Next the proportion of a mortgage payment that is interest.
A mortgage payment has two parts with the interest paid first against the outstanding balance and the remainder of the payment applied against paying off the principle. The amount of the payment is calculated so the mortgage is paid off within the length of the mortgage - say 30 years. But as everyone who takes the deduction knows, for the early years most of the payment is interest and therefore tax deductible.
Using the example of the purchase of a $163,356 home (the median sales price for homes in Minneapolis last quarter of 2012) and an 80 percent mortgage of $130,684:
As you can see, the first payment is almost 70 percent interest. At five years, the payment is still over 63 percent interest.
With a 32.05 percent federal and Minnesota tax rate, the after tax payment cost of the mortgage payment is almost $140 per month less or $484.29 because of the tax deduction. Here’s the kicker that makes the point about deductibility.
If interest was not deductible, then the entire payment is after-tax which mean the current payment “costs” $140 more per month. Or the homebuyer is effectively making almost two extra monthly payments per year because of the elimination of the tax deductibility.
Most homebuyers stretch to buy the most house they can afford within the limitations imposed by lenders and their own cash flow. I certainly did. So, if interest is no longer deductible, the homeowner is now paying almost 23 percent (140/623) more per month than he stretched to make the home purchase in the first place.
Since interest is more than 50 percent of a mortgage payment for over 12 years in this case, that much of an increase in cost might push more homeowners into mortgage default and bankruptcy and further devastate the housing market more than the recent Fannie Mae and Freddie Mac induced crisis ever did.
Besides, it’s just wrong.
John J. Alexander
John J. Alexander is President of Business Development Advisors, Founder and Chair of the Twin Cities Angels, and business author of the Angel Investment Tax Credit. Email him at: John@BusDevAdvisors.com