Fannie, Freddie, and the Mortgage Interest Deduction

Tomorrow, the White House will release its ideas for overhauling mortgage giants Fannie Mae and Freddie Mac.  While there is little agreement in Washington over just what to do, there is broad bipartisan support for big changes. In large part that’s because when the implicit government guaranty behind Fan and Fred turned explicit in the wake of the 2008 housing collapse, taxpayers were socked with a bill of $130 billion.

Pols are shocked that we’d add $130 billion to the nation’s burgeoning debt to subsidize owner-occupied housing this way. Except we spend far more than that each year buying down the cost of home ownership through the tax code. The one-time $130 billion cost to taxpayers of the failure of Fan and Fred is a fraction of the $210 billion annual cost of the mortgage interest deduction, the deduction for state and local property taxes, and the exclusion of capital gains taxes on owner occupied housing. Over a decade, those tax subsidies will cost more than $2 trillion.

The single biggest housing subsidy is the mortgage deduction, which will add $130 billion to the deficit in the coming year alone. But even worse, at a time when both Democrats and Republicans claim to worry about the long-term deficit, the MID is a case of government acting as a reverse Robin Hood—the biggest  subsidies go to those who need it least.  The Tax Policy Center estimates that more than 70 percent of the benefit of the mortgage and property tax deductions go to the highest-earning 20 percent of households—those making $104,000 or more.  

This happens mostly because the tax break on home loans is structured as a deduction.  Imagine, for instance, that you and I both pay $1,000-a-month in mortgage interest. If you are in the 10 percent bracket (a married couple with adjusted gross income of $36,000 or less), your after-tax interest  cost  is $900. If my wife and I are in the 35 percent bracket (with taxable income of $379,000 or more), our after-tax cost is just $650. And that’s after federal taxes. The benefit is even more dramatic when you figure state income tax breaks.    

This upside down subsidy also encourages the purchase of more expensive houses. I understand that some communities have very high housing costs. I live in one. But the average sales price in the U.S. last year was just $270,000.

Fan and Fred can guaranty loans up to $729,750 and there seems to be general agreement to allow that cap to fall back to the pre-recession level of $625,500. Yet the mortgage deduction is available for loans up to $1 million (and can even be used for vacation homes). And hardly any politicians are talking about cutting that. 

Oh, and keep in mind that while we are spreading $200 billion-plus in tax largess among the those lucky duckies in their mini-mansions , the feds spend less than one-quarter as much for direct housing assistance (aimed mostly at low and moderate income households). And that spending will almost certainly be frozen or even cut as a part of coming broad reductions in domestic spending.

The chairs of Obama’s fiscal commission proposed addressing the upside down tax subsidy by reducing the limit on deductible mortgages to $500,000, barring the subsidy for second homes,  and turning the deduction into a 12.05 percent credit. With a credit instead of a deduction, homeowners with a $1,000 monthly interest payment would lower their tax bill by $1205, no matter what bracket they were in.    

About these ideas, Obama has said…nothing.   

In a rational world, the president and Congress would sit down and figure out how government should assist home buyers in an era of severe fiscal constraint. I’m no housing expert so just how to do that is far beyond me. But providing the biggest subsidies to the highest income buyers in the biggest homes isn’t where I’d start.