LAT: Tax Reformers Eye Breaks for Housing

Los Angeles Times

Tax Reformers Eye Breaks for Housing
Mortgage deductions and other benefits are costing more than forecast.
With a rising federal budget deficit, they may be scaled back.

By David Streitfeld
Times Staff Writer

October 8, 2005

Just as the nation's housing boom appears to be slowing, debate is
starting among policymakers about reining in one of the most sacred
cows of American public policy: the mortgage-interest deduction and
other generous tax benefits granted to homeowners.

A presidential commission on tax reform will take up the subject for
the first time Tuesday. "Everything's on the table," said Charles
Rossotti, a panel member who was commissioner of internal revenue from
1997 to 2002.

The mortgage-interest deduction saved homeowners $61.5 billion last
year. No one expects the commission to recommend its elimination.

Instead, the panel may consider scaling back the deduction for mortgage
interest on second homes or home-equity loans, and changing the
deduction for property taxes, among other things.

The stakes in such a discussion are huge.

Changing the tax benefits for homeowners, even if done slowly, could
cause short-term convulsions in the market as buyers recalculate what
they can afford. The tumult could be most pronounced for homeowners in
states with the highest home prices, such as California. In the long
term, housing could become more affordable as some of the stimulus that
has sent prices soaring is removed.

Any proposed shift would encounter strong and possibly overwhelming
resistance. But with a rising federal budget deficit, the prospects for
change are much greater than they've ever been, say those involved in
the debate.

Homeownership wasn't initially a favored child. When the individual tax
code was created in 1913, all types of interest were deductible. Most
fell away over time, but housing remained and became even more special.

Eight years ago, capital-gains taxes were eliminated for home sellers
who had profit of as much as $250,000 (for individuals) or $500,000
(for couples). That has created a vast amount of wealth and helped
power a housing boom that has seen prices double or triple in Southern
California and other hot markets.

Some policymakers and analysts are beginning to wonder whether such
breaks are providing the wrong incentives, giving hefty deductions to
millionaires buying Beverly Hills estates as well as to speculators
snapping up Las Vegas ranch houses, hoping to turn a quick profit.

U.S. Comptroller General David M. Walker said provisions such as the
capital-gains exemption were costing the government much more money
than anyone forecast when they were first proposed. In a new study, the
Government Accountability Office calculated that the exemption drained
$29.7 billion from federal coffers last year.

"We need to review the reasonableness, appropriateness and
effectiveness" of such provisions, Walker said in an interview.

Presidents and members of Congress have long proclaimed the importance
of homeownership, saying it gives people roots in a neighborhood and
makes them better, more caring citizens. A home, not a college
education or a fulfilling job, is the embodiment of the American dream.
Politicians also are mindful of the fact that the nation's 74 million
homeowners form one of its largest special-interest groups.

President Bush set up the President's Advisory Panel on Tax Reform in
January to recommend changes in the tax code. The panel, led by former
Sens. Connie Mack (R-Fla.) and John B. Breaux (D-La.), will submit
suggestions to Treasury Secretary John W. Snow this fall. Bush will
choose among the recommendations to propose to Congress.

Bush specifically charged the panel to take account of "the importance
of homeownership and charity in American society."

That led many to conclude that the homeowner deductions were safe.

"The mother of all tax subsidies ... shall remain untouched," wrote
economist and tax expert Martin A. Sullivan in Tax Notes.

This was good news for real estate agents, developers, home builders,
contractors, home-improvement stores and speculators - groups that
heavily support the status quo. But unfortunately for them, the mood
changed over the summer.



"There has been a growing expectation that the framework for taxing
housing could be revised," said National Assn. of Realtors tax counsel
Linda Goold.

One reason for the shift: the expected demise of the alternative
minimum tax. Originally designed to make sure those with high incomes
didn't deduct their tax liabilities away, the alternative minimum tax
is not indexed for inflation.

As a result, the number of people who will have to pay the tax is
expected to increase dramatically over the next decade, eventually
incorporating much of the upper middle class.

At a meeting in July, the nine members of the tax reform panel agreed
unanimously to recommend eliminating the alternative minimum tax as an
unfair and poorly designed parallel tax system. Because their mandate
is to be revenue neutral, that required them to come up with $1.2
trillion in other receipts over the next decade.

"The money has to be found by either raising rates or changing tax
expenditures," panel member Elizabeth Garrett said.

Tax expenditures are the government's term for money it forgoes because
of targeted tax relief. According to the Government Accountability
Office, the number of tax expenditures has risen since 1974 from 67 to
146. The annual amount of lost revenue has tripled during that time, to
$728 billion. That's about twice the size of the current budget
deficit.

The biggest tax expenditure, totaling more than $100 billion in its
various permutations, is to homeowners. Almost as big are employers'
tax-free contributions to their employees' health benefits and the
tax-free status of 401(k) contributions.

"We privilege homeownership as a form of investment by a considerable
amount," said Garrett, a professor of law and politics at USC. "You
always have to ask yourself, is preferential treatment justified?"

She noted that homeowners could deduct interest paid on up to $1
million in mortgage debt on a first or second home, and that the
deduction was worth more to families in higher tax brackets.

"If we were going to subsidize homeownership through a spending
program," Garrett said, "it's not clear this is how we'd design it."

Others are wondering the same thing. Last winter, Congress' Joint
Committee on Taxation recommended repealing the deduction for home
equity loans, contending that it was inconsistent with the fact that
interest on other types of personal loans are not deductible.

In February, the Congressional Budget Office said cutting the
$1-million mortgage deductibility ceiling in half would raise $2.7
billion from 700,000 homeowners.

A sudden drop in the ceiling "would reduce home values, mortgage
lending and home building at the top end of the housing market," the
study's authors acknowledged. Their solution: Phase it in gradually.

A notable feature of the recent housing boom is that it has enriched
many owners but hasn't expanded homeownership, which is supposed to be
the point of the tax benefits.

Four years ago, the homeownership rate was 68.1%. Now it's 68.6%. Even
when the time span is extended to decades, scholars find little
discernible effect from all the homeowner subsidies.

"One could argue that the social benefits of homeownership may not be
worth" the $100 billion-plus in lost tax revenue every year, government
analyst Pamela J. Jackson wrote in an article this summer for the
Congressional Research Service.

Stephen Levy, director of the Center for Continuing Study of the
California Economy in Palo Alto, agreed that tax benefits for housing
had gotten out of whack.

"We ended up providing more of a subsidy than anyone intended, and to
folks we didn't intend to," Levy said.

The 1997 elimination of capital-gains taxes on home sellers' profits is
a particular study in unintended consequences.

"Hands down, bar none, that was the most taxpayer-friendly proposal
I've seen in my career, which is a long one," said Goold of the
Realtors association.

A nonpartisan budget group estimated that the capital-gains measure
would cost the government $5.8 billion in lost revenue over 10 years.
Instead, it's been about 60 times that.

One modification Garrett said the tax panel could consider: raising the
period the homeowner must live in the house to qualify for the
capital-gains exclusion. Currently it is two years.