Wednesday, May 17, 2017

Analyzing The Home Mortgage Interest Deduction

Is the Home Mortgage Interest Deduction really a great deal for the middle class?   Let's crank some numbers and find out.  I was pretty shocked at what I found, and a lot of my assumptions proved to be wrong!

I have to admit that for most of my life I assumed that the home mortgage interest deduction was a great deal for the middle-class.  However, I never actually cranked the numbers to find out if this was true.   President Trump proposes doubling the standard deduction as part of his tax plan, which could have two effects.  First, the very poor would have their taxable income zeroed out by the standard deduction and end up paying no taxes.  Second, the middle-class would find it not worthwhile to itemize deductions as the standard deduction would be just as good, if not better.

And this would affect real estate pricing, as people would no longer factor in any "savings" from deducting mortgage interest.  But it begs the question - does the middle-class benefit from the standard deduction as it is?

This is a hard question to parse as it basically breaks down into an equation with three, four, or even five or more variables, all inter-related.  Here are just a few I can think of:
1.  The amount of the standard deduction.

2.  The interest rate on the mortgage.

3.  The term of the mortgage and how long into the mortgage you are.

4.  Amount of interest paid that year.

5.  Your marginal tax rate.

6.  Your annual income.

7.  How far above the marginal rate breakpoint your are (the standard deduction or itemized deduction could kick you back into a lower bracket, so some of the "savings" would be at a lower rate).

8.  Single or Married, filing jointly or separately.
Obviously I am not being paid enough to figure out multiple scenarios for different people in different situations.  So lets look at married, filing jointly, just to simplify things a bit.

The current standard deduction for a married couple filing jointly is $12,600 which is a lot of money.  Trump proposes raising this to $24,000 as well as reducing the marginal rates to 10%, 25% and 35%, the latter of which could be a huge tax increase for people like me in the 15% bracket, depending on where the breakpoints for these brackets fall (the proposal has no details on this).

So under Trump's plan, if you make $24,000 a year, your taxable income is zero.  But let's not get ahead of ourselves, here, we haven't analyzed the existing tax plan with regard to deductions.

Under current law, your itemized deductions would have to be over $12,600 in order to make itemizing worthwhile.   So, for example, if your mortgage interest and other deductions were only $11,000 a year, it isn't worthwhile to itemize, as the standard deduction is greater.   On the other hand, if you were single, it would be worthwhile, as your standard deduction is about half that of a married couple.

$12,600 in mortgage interest is a lot.  A mortgage of $300,000 for 30 years at 5% generates $14,899 in mortgage interest the first year, and it declines every year thereafter.   Given that this is above the median price of a home in America, you can see that most people don't benefit from the home mortgage interest deduction already.   You have to have a pretty hefty mortgage to get any benefit at all.  And note that since the amount declines every year, about half-way through the mortgage, the amount of interest paid may make it less desirable to itemize - unless you refinanced your home.  So you see, the current system rewards the serial refinancer and penalizes the guy who pays down his mortgage over 30 years.  Funny how that works out - for our friends the bankers.

And what benefit is there by itemzing?   You have to subtract the standard deduction from this to see the actual benefit you are getting.  So $14,899 in interest, only provides an additional $2299 in deductions.  If you are in the 25% tax bracket, this means your tax bill is lowered by $574.75 - not a lot of money.   But of course, this also means that once you start itemizing, you can itemize other deductions, since you have reached the threshold of $12,600.   You can deduct charitable contributions, state and local taxes as well as property taxes and a whole host of other things.  But in order to do so, you usually have to itemize your deductions.

So you see where this is going for the middle-class.  Once you exceed this $12,600 threshold, it makes sense to itemize as you can now go though a laundry-list of deductions, with everything from energy-saving windows, to car registration fees, to property taxes, income taxes, and donations to charity.   This does create a lot of paperwork to do but you do get back that money in terms of lowered taxes.

But it does produce interesting results.   For example, if you live in a State with no income tax, like Florida, itemizing your deductions makes less sense.   And if you are retired in a $150,000 house in The Villages, even if you had a mortgage (which would be stupid in retirement) odds are you wouldn't have enough deductions to exceed the $12,600 threshold.  You'd be better off with the standard deduction.

But you can see where a lot of stakeholders get nervous about this.  Charitable deductions require that you itemize, so there it less incentive to give to charity if you take the standard deduction.  How do you think charities feel about raising the standard deduction to $24,000?

How would tax preparers and tax preparation software people feel about it?   Their sales pitch was that for their $250 to $500 fee, they are saving you thousands in taxes and insuring you are not audited.   But when you can fill out a simple form and never worry about being audited, what is their compelling story to sell?

Real estate agents, as you might expect, have long used the "buy as much house as you can afford" mantra to get people into bigger houses and get them to pay more for them, as this raises the interest above the standard deduction and opens the doors to the itemization game.  If we double this to $24,000 only people with $600,000 homes would find it worthwhile to itemize.

But as I have noted time and time again in this blog, you can't deduct your way to wealth.   Sure, you can itemize on a $300,000 mortgage and cut your taxes.  But, by how much?   Say you live in my house and have a $300,000 mortgage and pay $14,899 in interest the first year.  The property taxes are $2600 a year and your car taxes and registration fees are $250.   Your State income tax is maybe $2500 (let's estimate) and you give $500 to charity - the limit you can do without serious documentation and creating audit-bait.   So we have a total of $20,749 and that's really padding the State income tax.   The net increase from the standard deduction is $8149, which if we pay in the 25% bracket comes to $2037.25 in tax savings.

Gee, that was a lot less than you thought, wasn't it?   Still sure chasing the "American Dream of Home Ownership" is all it's cracked up to be?   And bear in mind, you have to make those onerous mortgage payments every month, too!   Paying $3000 a month in mortgage payments isn't wiped out by saving a couple of grand on your taxes.

Now if Trump has his way and we go to a $24,000 standard deduction, calculating your taxes becomes a lot easier.   You write down your income, subtract $24,000 plus personal exemptions, and then pay taxes on the balance.   A one-page tax form is all that would be needed.   And you would no longer be chasing deductions and wondering whether you are going to be audited about those shirts you donated to charity which you claimed were worth $100 but you know were worth only $10.  It eliminates all this worry that middle-class taxpayers have about "cheating" on their taxes.

It also eliminates the game of chasing deductions in life for all but the very rich.   But there are other effects as well.   If you live in a high-tax State - such as California, New York, Massachusetts, New Jersey, Vermont, etc. which also happen to be Blue States, you end up losing a big tax deduction.   Under Trump's plan, State taxes are just an expense you pay - and you have more incentive to clamor for lower taxes or indeed, to move to a lower-tax Red State.   Funny how that works.  A tax law proposed by Republicans that effectively punishes Democratic-leaning States.  Very clever.

However, this also illustrates why "Blue States" pay more into the tax system than Red States do - they tax themselves a lot as well, providing more social services and government services - so they need less Federal money.   It would be interesting to see how this would affect social policy overall, if enacted.

And you can also see how tax law does affect how people behave.   People would stop chasing houses as tax deductions, but upper class people in higher brackets would still want to itemize.  And investors who buy houses and rent them out would still be able to itemize their deductions, as they are running a business, not taking personal deductions.   Again, when you are running a business, you deduct your expenses from your overall revenue (income) to calculate your net profits and then pay taxes on that.   Because of something called the "depreciation deduction" owning a rental property can knock a lot off your tax bill and defer taxes on income and effectively convert them to capital gains.  When I was in the top brackets, I did this with good effect.  Today, I take the standard deduction!   Owning houses is beneficial - for wealthier people.  For the rest of us, it is just an expense.

By the way, and I digress here, the media loves to report that Millennials are no fun at all, not buying into the "American Dream of Home Ownership" buy purchasing a condo or starter home.  But if you do the math, buying a $150,000 condo or starter home isn't going to change your tax bill much for a married couple - in fact not at all, as it won't create enough interest payments to exceed the standard deduction.  And given the history of housing prices in this country, a $150,000 condo could be worth $100,000 next year, bankrupting you!   Maybe these Millennials are smarter than we give them credit for.  Better off to rent that condo for $1200 a month and take a trip to Europe and eat your avocado toast than to chase deductions!  Particularly when the deductions simply don't exist and houses cost less to rent than to own!

What is fascinating about this proposal to me is that it cleverly eliminates the home mortgage interest deduction for the vast majority of Americans, without actually eliminating the home mortgage interest deduction.  Rather, the increase in standard deduction merely makes it moot for all up the upper middle class.   It is a very clever little puzzle they have created here, all in one page of bullet-point notes.

So, will Trump's proposal mean higher or lower taxes for you and me?   Well, to begin with, it likely will be altered significantly when it goes through the massive sausage-grinder that is Congress.  The Association of Realtors(tm) will lobby hard to preserve the home mortgage interest deduction for the middle-class, as will the banking lobby and even TurboTax and H&R Block.  Guess who has more money and influence than you and me?

And by the way, just get over that because it will never change.  People with money and power have always had, well, money and power, over people who are powerless and have no money.  It has been this way since the dawn of time and has never changed.  Even in Communist countries (especially in Communist countries!) people in power who have influence pull all the strings and the little people have no say in things.   Oddly enough, in the Western World, we have a greater say than in such "egalitarian" socialist and communist countries.  Not a total say by a long shot, but a greater say.  But I digress. Yet again.

But assuming Trump's plan goes through intact, we don't know what this will mean for you and me as the plan is incomplete.  Without knowing the all-important income breakpoints for the marginal rates, we don't know whether the new rates and new standard deduction will make a difference, positive, negative, or neutral.

From Wikipedia, the marginal rates for 2017 as as follows:

Marginal tax rates for 2017
Marginal Tax Rate Single Taxable Income Married Filing Jointly or Qualified Widow(er) Taxable Income Married Filing Separately Taxable Income Head of Household Taxable Income
10% $0 – $9,325 $0 – $18,650 $0 – $9,325 $0 – $13,350
15% $9,326 – $37,950 $18,651 – $75,900 $9,326 – $37,950 $13,351 – $50,800
25% $37,951 – $91,900 $75,901 – $153,100 $37,951 – $76,550 $50,801 – $131,200
28% $91,901 – $191,650 $153,101 – $233,350 $76,551 – $116,675 $131,201 – $212,500
33% $191,651 – $416,700 $233,351 – $416,700 $116,676 – $208,350 $212,501 – $416,700
35% $416,701 – $418,400 $416,701 – $470,700 $208,351 – $235,350 $416,701 – $444,550
39.6% $418,401+ $470,701+ $235,351+ $444,501+
(Beginning in 2013, an additional tax of 3.8% applies to net investment income in excess of certain thresholds.)

As you can see, the current rates have a HUGE breakpoint between 15% and 25% and if you can keep your combined income below $75,000 or so (comfortably within the middle class) you can pay 10% less in taxes on that last dollar of income.   Where the breakpoints for Trump's new 10/25/35 rates will be is anyone's guess.  It could bump a lot of middle-class people into the 25% bracket - neatly offsetting their $24,000 standard deduction, meaning their tax bill could be a wash.

For the upper middle-class - people making $500,000 a year, such as doctors, lawyers, or dentists or small businessmen (the successful kind, not me) it could mean a 4.5% decrease in marginal rate, plus the ability to itemize deductions still.   However, the benefit of itemizing would only be for those deduction above $24,000.   It would be a tax cut, but not a huge one, and the benefit offset by the increase in the standard deduction.

The very, very rich would be unaffected - they pay at the 15% capital gains rate - which is what Mitt Romney, Warren Buffet, and Donald Trump pay, if they pay that much at all.  But since the GOP also proposes eliminating the estate tax (which only affects people with more than $5,000,000 in assets) it will be easier to hand-off wealth to children and create dynastic wealth.   But of course, there were already tax dodges in place to avoid this tax, such as the Crummy Trust (generation-skipping trust).  Fortunately, most heirs squander wealth within a generation or two.  The Koch brothers may have increased their father's fortune, but I suspect their children will squander it all on yachts and nonsense in due course.

For me personally, it would be a wash.  This year, my taxable income was so low, I took the standard deduction, which pretty much zeroed out my taxable income.  I am living off after-tax savings, which as the name implies, are not taxable.  Mortgage interest, state taxes, and all that bullshit means nothing to my tax bill.  The standard deduction pretty much wiped out my tax bill entirely, except for my "self-employment" tax, which is the social security and medicare taxes you pay, times two (because I have no employer to pay the other half).

Going from $12,600 to $24,000 won't make a difference this year but would be a big help to me by age 59 when I start spending taxable 401(k) money.   This might also wipe out my tax bill, but again, since we don't know the breakpoints on these new brackets, it might also increase it.  Once I am collecting Social Security and paying ordinary income tax on my 401(k) deductions, I could have a sizable taxable income in retirement, which was supposed to be at 15% when I planned for retirement 30 years ago (when they sold us on this idea of 401(k) plans).   If Trump Bumps me into the 25% bracket, it will all be for naught.

Playing with the tax code is like playing with fire, and politicians do and can get burned if a lot of people even just perceive that their taxes went up.   Sadly, a lot of people in the lower classes will like the new plan, even if it means higher taxes, if they can file a simpler form with the new standard deduction.   Their main gripe with the tax system is the complexity of it, and the uncertainty they have every year whether or not they paid the least amount or whether their neighbor paid more or whatnot.   That, and the guilty feeling they get over taking deductions for sketchy things like charity, even if their odds are being audited are infinitesimal.

* * *
SUMMARY - the home mortgage interest deduction today really isn't that great unless you have a mortgage for $300,000 or more and are in the early stages of that mortgage.   Trump's plan to double the standard deduction could mean that more than half of all taxpayers will stop chasing deductions, but could end up paying more in taxes.   The upper middle-class will get a small tax break, but the very rich will still end up paying 15% or so in capital gains - changing nothing for them (other than to eliminate the estate tax, making it easier to create dynastic wealth).