David R. Henderson  

Dianne Feinstein's Misunderstanding of the Mortgage Deduction

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UPDATE BELOW:

Many tweeters have been making fun of the following Dianne Feinstein tweet:

The Republican tax bill caps the mortgage interest deduction at $750,000 for new mortgages. In California, seven counties have average home prices that are more than $750,000: Alameda, Marin, Orange, San Francisco, San Mateo, Santa Clara and Santa Cruz counties. #GOPTaxScam

They point out, probably correctly, that this is not the usual messaging that the Democratic Party uses. I'll let you read some of the comments.

But my criticism is more on the straight economics, not the politics.

Feinstein's point pretty clearly, or else she wouldn't have hash tagged #GOPTaxScam, is that this tax bill is really bad for people whose houses are worth more than $750,000.

She's wrong.

First, the drop in the mortgage deduction cap from its current $1 million to $750K is grandfathered. So the vast majority of owners of expensive homes will not be directly affected by this reduction of the cap at all.

Second, not that many people who will buy houses for more than $750K will finance them with all debt. Most of them will pay a substantial down payment. Take someone who buys a house for $1 million. That person will likely pay at least 10% down. So the mortgage would be, at most, $900K. Of that, the buyer could deduct interest on $750K. So with an interest rate of, say, 4%, the buyer couldn't deduct 4% of $150K annually, which is $6,000. At the old marginal tax of, say, 28%, the buyer loses $1,680 in extra federal taxes. That's not a large amount, especially for someone who can afford a million dollar home.

Third, I've overestimated the loss in the second point above, because that person's marginal tax rate is likely to be lower. The person who is currently in the 28% bracket is likely to be in the 24% bracket. So, although he or she loses on the mortgage deduction, he/she gains from the lower tax rate.

Now you might say, "What about the person who buys a house for $1.5 million? There are lots of those in the counties that Feinstein names and in many other counties in California. Won't that person be badly hurt by the reduction in the cap?" Answer: No. Remember that it's a reduction in the cap from $1 million to $750K, not an introduction of a cap where there was none before. So the maximum hurt is the reduction of the mortgage interest amount on the $250K difference between $750K and $1 million. 4% of $250K is $10,000. So the increase in taxes is $2,800. Again, this would be offset by lower marginal tax rates.

UPDATE:
Commenter Vivian Darkbloom notes a mistake in my post. Rather than go through and correct all the arithmetic, I'lll leave that as an exercise for those who are interested. Vivian points out that the maximum mortgage loan on which interest was deductible before the tax bill was not $1 million, but $1.1 million, because of the maximum $100K of home equity loan on which interest was deductible. So it falls from $1.1 million to $750K.


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CATEGORIES: Tax Reform , Taxation




COMMENTS (16 to date)
gabe writes:

Perhaps, Ms Feinstein's time, as would that of her constituents, would be better spent were she to advance policy prescriptions that DO NOT limit housing supply, nor increase the regulatory burden upon builders / developers AND would exhibit equal concern for her human constituents as she does for some obscure water borne insect / fish / fowl (whatever the latest *endangered* critter is).

Frankly, the mortgage interest deduction is a "gift" from the peoples representatives (no doubt, the preference for which is sustained by generous campaign contributions from real estate lobbyists) to the average citizen. It is a facet of positive law NOT a "natural right" - so please Dianne, et al, get over yourselves!

I am happy to take my deduction for as much as I can.

A Happy Christmas to all, or so says the GOP leadership with this new tax bill.

In any event, Merry Christmas and Happy Chanukah!!!

WalterB writes:

Thank you. In all the coverage on this, I haven't seen a story before now that bothered to explain this change.

Daniel Kuehn writes:

On point #2 do you honestly think she misunderstands that people make down payments, or do you think its more likely that instead she just thinks 750K is the reference point people have (and a perfectly adequate reference point, I'd add) and that running through the algebra using an average down payment rate to get an alternative figure would distract from the point?

The idea that she really "misunderstands" #2 seems wildly implausible. The idea that she misunderstands any of these seems implausible, but that she misunderstands #2 seems especially implausible.

David R Henderson writes:

@Daniel Kuehn,
do you think its more likely that instead she just thinks 750K is the reference point people have (and a perfectly adequate reference point, I'd add) and that running through the algebra using an average down payment rate to get an alternative figure would distract from the point?
If so, then what do you think is her point?

Vivian Darkbloom writes:

"Answer: No. Remember that it's a reduction in the cap from $1 million to $750K, not an introduction of a cap where there was none before. So the maximum hurt is the reduction of the mortgage interest amount on the $250K difference between $750K and $1 million. 4% of $250K is $10,000. So the increase in taxes is $2,800. Again, this would be offset by lower marginal tax rates."

Not really. Remember that the current "cap" on the maximum mortgage on which interest can be deducted is $1.1 million, not $1 million. See, Revenue Ruling 2010-25. The extra $100K is for the maximum "home equity loan" which the IRS ruled can be treated as part of the maximum acquisition indebtedness. In a good move, the tax bill eliminates the ability to deduct interest on "home equity" loans. Therefore, for new home acquisitions, the maximum is decreased from $1.1 million to $750K. The limits under current law and the GOP bill are not indexed for inflation. So, the GOP bill accelerates a process that was already (intentionally) built into the Code.

Feinstein also doesn't mention the favorable effects the tax bill has for many California homeowners: both the doubling of the exclusion amount of the AMT and the elimination (subject to "sunset" after 10 years) of the Pease phase-out rule (IRC section 68) on itemized deductions in some cases may even help homeowners more than the lowering of the overall mortgage cap hurts them.

Vivian Darkbloom writes:

"doubling of the amount of the AMT *exclusion*..."

robc writes:

One of the other sites I frequent is strongtowns.org.

It has been pointed out there that most properties are built out to a 9:1 ratio of total value to land value. When the ratio drops below 3:1, it becomes profitable to improve the property (build up, add on, etc, etc) back to the 9:1 ratio.

In large parts of CA, the ratio is below 1:1. In SF, it is something like 1:4.

If there was something even remotely resembling a free market in construction, most of SF proper would look much more like Manhattan, and less like single family dwellings.

And guess what, housing prices across the entire region would collapse as the new supply of multi-unit condos relieved the demand.

robc writes:

Just a quick edit to post above for those who are paying too much attention to the math.

The CA numbers are structure value:land value, not total value:land value, because below 1:1 would imply negative structure value with the latter.

But otherwise, the point still stands.

Alan Goldhammer writes:

@robc - the same ratio of structure:land values exists here in Bethesda MD where I live. My 1955 split level home has a ratio of 1:4 and basically is a tear down and rebuild when it will be sold. there is no reason for me to do anything other than sell to a builder and avoid the real estate commission because of this.

All new housing in our area is being built at price points > 1M regardless of whether it is condominium or single family. Within a 1 mile radius of our home all new single family homes start at $1.5M. One wonders what will happen 'if' there is a dramatic rise in interest rates.

Daniel Kuehn writes:

David Henderson -
re: "If so, then what do you think is her point?"

Her point is that the cap is too low, right?

750K is a nice reference point for prices because that's the cap. The fact that she doesn't apply some average down payment percent to get a random dollar value with little context doesn't seem like very good evidence at all that she doesn't understand people make down payments.

David R Henderson writes:

@Daniel Kuehn,
Her point is that the cap is too low, right?
Right. That’s her point. And what I’ve shown is that it’s a hard point to make. So the math, which you said in your first comment would distract from her point, does distract from her point: it shows that her point has little to it.

fralupo writes:
First, the drop in the mortgage deduction cap from its current $1 million to $750K is grandfathered. So the vast majority of owners of expensive homes will not be directly affected by this reduction of the cap at all.

"At all" seems too strong here. Current homeowners may be thinking of moving from their current home either in the near term or at some point in their lives. Even if current homeowners try to sell their home and move into a rental they'll be dealing with potential buyers who will value their home less because it will be taxed more heavily.

I presume this will also affect refinances, which is a common enough thing for high-value homes.

The reduction in the mortgage interest deduction negatively affects every homeowner with a home at or above the new cap, regardless of whether they are grandfathered or not.

David R. Henderson writes:

@gabe,
Yes, if California state and local governments deregulated sufficient to allow lots of new housing, then many more people could afford it. Ed Glaeser of Harvard and Joseph Gyourko of Wharton have written about this, showing that the high prices are not due to a scarcity of land, but to a scarcity of building permits. Their article in Regulation early last decade is excellent.
@robc,
Yes. See my comment to gabe above.
@WalterB,
You’re welcome.
@Vivian Darkbloom,
Thanks for that correction. I’ve updated accordingly.
@gabe,
Merry Christmas and Happy Hanukkah to you too. This year we remembered to light the candles 5 out of 8 times. Worse than last year but better than our average. :-)

David R. Henderson writes:

@fralupo,
Good point. My “at all” was too strong. I would point out, though, that your refinancing point is not strong. The vast majority of people currently owning such homes are unlikely to want to refinance, given that they probably have already done so in the last 3 years or so, with mortgage interest rates being at or close to their lowest level ever.

Mark writes:

David, do you mean Ed Glaeser?

David R Henderson writes:

@Mark,
Oops. Yes. Thanks. Correction made.

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