A Tax Windfall From the Housing Bust

As Karen Jacobs, an economist in Arizona’s Department of Revenue, was reviewing income tax data for 2010, she came across a puzzling trend: Refunds were down and tax liability was up even though the state’s unemployment rate peaked that year, at 10.8 percent. “My first thought was: ‘Taxable income? Why would that be up if people are losing jobs?’ ” says Jacobs.

With new houses sitting vacant in the desert and foreclosures soaring, it didn’t take long to figure out the reason. Home ownership rates, real estate prices, and interest rates were all falling, so fewer people were deducting mortgage interest and mortgage holders had often borrowed less or had refinanced at lower rates. The value of itemized deductions dropped 20 percent for the year—led by a decline in the tax break for mortgage interest. “I was shocked about how much I owed,” says Stephen Buckman, who had to pay the Internal Revenue Service $1,500 when he filed his 2011 taxes. In December 2010, a bank foreclosed on his Phoenix townhouse, which had plunged in value to $50,000 from the $196,000 he paid in 2006.