More on Subsidies for Homebuyers

August 13, 2009

Homeownership is one of the pet causes of the federal government. The tax code contains various well-known and highly-utilized provisions such as the mortgage interest deduction (MID), the first time homebuyer credit, and the deduction for real estate taxes paid (this is even ignoring the non-taxation of imputed rental income).

In an attempt to give a boost to the housing market and encourage first-time buyers, New York State has announced a new program that will allow certain first-time home buyers to receive a home mortgage interest tax credit on their federal tax return (not to be confused with the mortgage interest deduction, or the first time homebuyer credit). Other states participate in the program as well, and a quick Google search turns up programs in Texas, Mississippi, Hawaii, Washington, West Virginia, Ohio, Arizona, Michigan, Colorado, and Illinois (there may be many more).

It works like this: states issue Mortgage Credit Certificates to qualifying homebuyers. The rules seem to vary from state to state, but there are always household income limits and limits on the purchase price of the home. The limits vary by household size and even geographic location. In Cattaraugus, New York for example, the income limit is $67,900 and the home price limit is $258,690. However, those limits are relaxed for homes in Target Areas, or areas designated by the federal government as economically distressed. For taxpayers who purchase in these areas the first-time buyer requirement is also waived.

With the Mortgage Credit Certificate in hand, a portion of the mortgage interest the taxpayer paid during the year can be taken in the form of a federal tax credit, or a dollar for dollar reduction in their tax liability. That portion, called the credit rate, is determined by the state and is 20% for New York homebuyers. If the credit is greater than the taxpayer’s tax liability, the extra credit can be applied to the next three years’ tax returns. Beside simply being worth more than the MID, the credit amount can also be counted by lenders as monthly income to help the homebuyer qualify for a loan. The remaining 80% of mortgage interest can still be deducted from federal adjusted gross income under MID.

An example might be in order. Say I purchase a home and pay $10,000 in mortgage interest. In the absence of the mortgage interest credit, MID allows me to deduct that $10,000 from my income before I calculate the tax on my income (essentially the government ignores that portion of my income). So the actual reduction in tax due that I receive from the MID depends on my tax bracket. Assuming my marginal tax rate is 25%, the $10,000 deduction translates into a $2500 tax savings.

Now add in the mortgage interest credit, which says that 20% of my interest paid, or $2000, can be taken as a credit. So that $2000 dollars is subtracted directly from my final tax liability, plus I still get to deduct under MID the remaining $8000 of interest that was not used in determining the mortgage interest credit. At the same 25% marginal tax rate as before, the $8000 MID has a value of $2000. The combined effects of the deduction and the credit have reduced my income tax liability by $4000. Better than the paltry $2500 I got from the MID. This doesn’t even include the one-time first-time homebuyer credit, worth up to $8000.

What is the point of all these details? Just to point out the ridiculous lengths to which politicians will go to get more people to own homes. The four provisions described above combine to provide a substantial government subsidy for homeownership. I would also note that the tax benefits from MID, one of the largest federal tax expenditures, flow largely to higher income taxpayers. While this Mortgage Credit Certificate program is targeted at low and middle income tax payers (and is rather small in the grand scheme of things), it is still not an economically justifiable policy. Why homeowners are deserving of subsidies and not renters only a politician can explain. These types of special interest carve-outs only serve to narrow the tax base and force up everyone’s tax rates.

As we have written before, it is widely acknowledged by economists that homeownership is greatly over-subsidized. Provisions like MID favor investment in housing over other investments and artificially pump more money into housing than is warranted or advisable. The purpose of taxes is to raise revenue for essential government services, not micromanage the housing market. In an age when it has become abundantly clear that too many people have purchased homes who could not afford them, it is hard to believe governments are still pushing homeownership.

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The marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax.