Mortgage-Tax Break Curbed by Housing Slump

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A foreclosed home in Islip, New York. Close

A foreclosed home in Islip, New York.

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Photographer: Spencer Platt/Getty Images

A foreclosed home in Islip, New York.

The cost of one of the country’s most expensive individual tax breaks is shrinking as the number of Americans who own homes declines and mortgage rates hover near historic lows.

Federal tax filers claimed almost $71 billion less in mortgage interest deductions for 2009 than for 2007, a 14 percent drop, according to the Internal Revenue Service. That trend continued in 2010, the IRS said in a report last month, as preliminary data showed that lower interest rates, home ownership and home prices curbed use of the tax deduction by 7.2 percent.

“People are walking away and losing their homes and they no longer have the mortgage interest deductions,” said Andrew Hanson, an assistant professor of economics at Georgia State University who has researched the tax break. “That’s got to be a big part of it.”

Tax revenue fell as unemployment rose during the most severe recession since the 1930s, and the housing market was shaken by 16 million foreclosures since 2007. On the flip side were gains from declining use of the mortgage deduction, saving the U.S. government $13 billion to $26 billion from 2007 to 2010, according to an estimate from Hanson.

The effects extend to states, more than half of which allow the deductions either on their own or through use of federal itemization. In Arizona, officials say less use of such deductions was behind an 8 percent rise in tax liability for state residents in 2010 even as unemployment climbed to 10.8 percent that year.

A bank owned sign hangs outside a foreclosed home in Maricopa, Arizona. Photo: Joshua Lott/Getty Images Close

A bank owned sign hangs outside a foreclosed home in Maricopa, Arizona. Photo: Joshua Lott/Getty Images

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A bank owned sign hangs outside a foreclosed home in Maricopa, Arizona. Photo: Joshua Lott/Getty Images

Home Ownership

The home ownership rate in the U.S. dropped from a peak of 69.2 percent in 2004 to 65.9 percent in the second quarter of 2011, according to the U.S. Census Bureau. Median home prices fell more than 30 percent from July 2006 to January, according to data from the National Association of Realtors.

The average interest rate on a 30-year fixed mortgage was 3.90 percent for the week of April 19, down from 6.17 percent in December 2007 at the start of the U.S. recession, according to data provided by Freddie Mac. (FMCC) Average mortgage rates reached a record low of 3.87 percent on Feb. 2, the data show.

The mortgage interest deduction is projected to cost the federal government $464 billion in forgone revenue from 2011 to 2015, according to the congressional Joint Committee on Taxation.

Proposed for Elimination

While popular with U.S. taxpayers, the deduction is often proposed for elimination by those seeking to reduce the federal budget deficit. The fiscal commissions of two presidents in 2005 and 2010 recommended scaling it back and replacing it with a tax credit. President Barack Obama’s budget proposal for fiscal 2013 would impose a cap that would limit the benefit of tax breaks, including the mortgage interest deduction, for high-income taxpayers.

Kansas Governor Sam Brownback, a Republican, and Maryland Governor Martin O’Malley, a Democrat, are among state officials who have called for eliminating or reducing the deduction at the state level. Brownback’s proposal to eliminate the tax break stalled in the state legislature. O’Malley’s plan to reduce the deduction for wealthy taxpayers led to protests from real estate agents, who said such a proposal would make it tougher for people to own a home.

At the federal level, the deduction is allowed for interest on mortgages up to $1 million for both primary and secondary residences. Only taxpayers who itemize can take the deduction. Some economists maintain that the deduction disproportionately benefits the wealthy and spurs people to take on more debt.

Encourages ‘Bigger Homes’

“Most economists don’t like it,” said Kim Rueben, senior fellow at the Tax Policy Center in Washington, a nonpartisan research group, noting that there is little evidence that the tax break spurs home ownership.

“We are effectively encouraging people to buy bigger homes and take out debt because we are allowing them to deduct interest,” Rueben said.

David Albouy, assistant professor of economics at the University of Michigan, says the deduction along with subprime lending are responsible for pushing people into homes they otherwise couldn’t afford. The decline in homeownership and, subsequently, the drop in the use of the deduction may be the home market righting itself, he said.

‘Fuel the Bubble’

“The mortgage interest deduction helped fuel the bubble,” he said. “As people were buying these giant houses, they were claiming a giant portion of their income in mortgage interest. Now they are losing that. They are now not billing the government indirectly for their risky investment in real estate.”

The use of the mortgage interest deduction peaked at the federal level in 2007 with the tax break showing up on 40.8 million returns. That fell to 36.5 million for 2009, according to the IRS. The amount deducted declined from $491 billion to $421 billion for those tax years.

Preliminary data shows the number of returns on which taxpayers claimed the deduction increased slightly to 36.9 million in 2010. The amount of the write-offs fell to $387 billion.

“One of the most striking things about the itemized deductions in the last few years is the decline in the number of people claiming this deduction,” said Matthew Gardner, executive director for the Institute on Taxation and Economic Policy, a Washington-based nonprofit research group. “You’re seeing five million fewer returns between 2007 and 2009 claiming the deduction -- it is a real drop.”

Confusing Trend

In Arizona, which has had the second highest foreclosure rate in the nation for the past three years, an economist in the Revenue Department stumbled across a confusing trend: income tax liability jumped in 2010 even as joblessness remained high.

“My first thought was: taxable income, why would that be up if people are losing jobs and unemployed?” said Karen Jacobs, a senior economist in the department. She discovered that the value of all itemized deductions, including that for mortgage interest, was down 20 percent.

One Arizona resident, Stephen Buckman, said he saw the effect of losing his home when he figured out his 2011 taxes. Buckman was working in commercial real estate in Phoenix when the market collapsed. His work dried up as the value of his townhouse plunged 75 percent from $196,000 when he bought it in 2006 to less than $50,000. It was foreclosed in December 2010.

“I was shocked about how much I owed,” Buckman, 38, said in a telephone interview about his 2011 tax bill. He owed an additional $1,500, which he attributes to the loss of his mortgage interest deduction. Buckman now rents a townhouse in Tempe, where he is working on his Ph.D. in geography at Arizona State University. “That was a deduction I couldn’t take, so I owed a lot more money than I usually owe.”

Unanticipated State Revenue

Arizona Governor Jan Brewer’s budget director, John Arnold, said fewer deductions led to about $170 million in unanticipated revenue for fiscal year 2011. Arizona closed its budget year in June with a balance of $3.2 million, compared with a $332 million deficit that had been forecast, according to a report by the Joint Legislative Budget Committee.

“We’re in a budget crisis and an extra $170 million shows up,” Arnold said, noting that the state’s total tax revenue fell $3 billion from 2007 to 2010. “We understand that is the result of people losing their homes. If I could say it was the result of people refinancing, we’d be all smiles.”

A detailed breakdown of 2010 deductions isn’t available. The number of Arizona returns on which the tax break was claimed for 2009 fell 8 percent from the peak in 2007, dropping below the 2004 level, Jacobs said. The amount of the write-offs plunged 26 percent, from $13.5 billion to $9.96 billion. Jacobs estimates that this led to $55 million to $65 million a year in revenue for the state.

High Foreclosure States

Other states are seeing similar trends in tax collections, especially those where foreclosures have been high.

In California, which had the third-highest foreclosure rate in the U.S. last year, the number of filers taking the deduction for mortgage interest fell 9 percent while the value of the deductions fell almost 20 percent from 2007 to 2009, according to data from the Franchise Tax Board.

“It’s helping the state governments because they are not giving away as much as they were before in the mortgage interest deduction,” Albouy said.

To contact the reporter on this story: Amanda J. Crawford in Phoenix at acrawford24@bloomberg.net

To contact the editor responsible for this story: Jeffrey Taylor at jtaylor48@bloomberg.net

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