Will Fiscal Cliff Result In Mortgage Cliff?
December 11, 2012 1 p.m.
Dr. Michael Lea, President, SDSU's Corky McMillin School for Real Estate
Appaswamy "Vino" Pajanor, executive director, Housing Opportunities Collaborative
Related Story: How Would Cutting Mortgage Tax Deduction Impact San Diego?
CAVANAUGH: As the negotiations continue in Washington to avoid the cuts and tax increases known as the fiscal cliff, one idea is getting some serious attention. Lawmakers are considering changing the mortgage tax deduction. Some say there's some support to him Nate it completely. For homeowners in high-value years like San Diego, that possibility is causing concern, and even tinkering with the tax deduction homeowners get from interest may have a ripple effect throughout the real estate and construction industries. My guests, Dr. Michael Lea is president of the SDSU Corky McMillin School of Real Estate. Welcome back to the show.
LEA: Always great to be here.
CAVANAUGH: Vino Pajanor is Executive Director of the Housing Opportunities Collaborative.
PAJANOR: Thanks for having me back.
CAVANAUGH: Home ownerships are kind of baffled as to why with all the tax loopholes there are for corporations and businesses, Washington would aim at the mortgage deduction. How much would the government stand to gain in taxes?
LEA: It's the second largest tax expenditure item that we have. If you eliminated it completely, $110 billion.
CAVANAUGH: For many middle class homeowners, the deduction is the biggest deduction they have on their taxes. What is the sense of how important that is for people looking to buy?
PAJANOR: Home buyers are looking at various aspects. The mortgage interest deduction is not the one and only reason they're looking for a home but it's one of the reasons that enables them to go to the next level of becoming a homeowner. So it is an important factor. As a housing counseling agency, the agencies look at the budget. And at the back end of the budget, when you pay up the interest, some of the interest that come in by deductions on your taxes could be used to balance your budget, to pay for school or daycare or maybe the healthcare benefits or whatever it is.
CAVANAUGH: Michael, can you give us some background on the mortgage interest deduction in the first place?
LEA: Well, if you look at the history, it's accidental. Namely, when we introduced the income tax in 1912, Congress decided that all interests would be deductible. And that was really based on the fact that interest was viewed as a business expense. There weren't that many people with mortgages and that high of a percentage of homeowners. So that maintained itself throughout time, and it really gathered more importance in the mid-19-80s when we got rid of the interest deduction for consumer interests. So for the household, the mortgage interest deduction was the only one remaining that they could take. And what happened was a lot of people scooped up when had been consumer debt now into their housing debt.
CAVANAUGH: Now, wasn't it used also to stimulate home ownership?
LEA: Not directly. It's across the board viewed as not a particularly effective way of stimulating home ownership. It's not targeted to first-time home buyers, for example. It's targeted toward reducing your debt cost. So it certainly does help people, particularly lower low middle income people be able to afford more in terms of getting debt.
CAVANAUGH: The argument that I have read about why people think not that it's time to perhaps eliminate this tax, although that conversation underway, but some legislators seem to think that the provisions have gotten out of hand over the years. Do you think that the mortgage deduction could do with some pruning, some tweaking?
LEA: I think so. I think it could be a more effective stimulus for home ownership if you had a lower cap, from. I think it would not be wise to eliminate it completely. But if you really target it more toward people that are buying more moderate, middle income homes. And the other thing you could do is reduce the progress of that, instead of deducting the amount of interest at your marginal tax rate, you cap that as a lower one, 25%. That wouldn't affect the majority of homeowners.
CAVANAUGH: What is the cap now?
LEA: $1million for primary or second homes, then another $100,000 for a home equity line of credit.
CAVANAUGH: So you can have up to a million dollars in a mortgage.
CAVANAUGH: And the idea would be to cap that at $500,000?
LEA: Or $250,000. The average mortgage size in the country is probably closer to $250,000 than $500,000. So you could maintain the benefits for the middle class and eliminate or reduce them for upper income people who don't need as much.
CAVANAUGH: We have a very high cost of housing here in San Diego. Don't middle class families have rather high mortgage loans?
PAJANOR: Yes. We still have a lot of loans in San Diego that are underwater. And some of the owners have been debating with the equity going down on the mortgage they owe, and they're debating whether they should hold onto these homes. And doctor Lea mentioned about the lower limit, that is something known as conforming loan. Maybe that's a way by which to balances limits on these mortgage interest reductions to equate it to the conforming loans in San Diego and other counties. So in San Diego, the conforming loan goes up to $600,000 for getting an FHA loan or a government-backed loan. If you bring it to that loan, it's a good equating factor. These homeowners who are already underwater are now deciding whether they should be paying their mortgage and hold onto their home. If the deduction goes away completely, these homeowners are going to say I'm going to walk away from my responsibilities or walk away from my home. And that's going to flood the market with our other wave of homeowners walking away from homes and foreclosures.
CAVANAUGH: Do you see that as being a problem across the board in the United States if something like this were to happen? Or is it just pockets of distressed home areas?
LEA: Well, certainly there are pockets in the country, such as Southern California, that have higher percentages of homeowners with mortgages that are underwater. And I agree with your point that that could be the last straw for those people. But there is a differentiate effect. It definitely affects higher cost areas where people have larger loan amounts. One option on this might be to have some regional variation in what the cap is. It doesn't need to be the same in San Diego as it does in Kansas city.
CAVANAUGH: What is the argument? Besides bringing this infusion of cash into the federal government, what is the argument that eliminating or limiting the deduction would be a good idea?
LEA: It's a question of capital allocation. And we want to let markets efficiently allocate capital. Some goes into plant and equipment, some of it goes into the housing stock. Economist argue that we as a country put too much of our capital into housing and not enough into plant and equipment. So reducing the subsidy to home ownership would lead to a bit less in the way of capital into housing and perhaps more into other areas.
CAVANAUGH: This is sort of like the -- a different take though. We have been hearing for quite some time from our leaders that home ownership is good, that we should aspire to home ownership, that it is a fundamental American dream to own your own home. So are we getting -- is this a mixed message do you think from our leaders in Washington if indeed they were to make this choice and severely limit the mortgage tax deduction?
PAJANOR: The pendulum swung one way, toward home ownership.
PAJANOR: Now the leaders are trying to swing it the other way, being more toward a renter-based society or community. So we have to have a balance. We need to bring it to the center. We have to give the credit or the deduction to homes or families that have an income that fits within the middle class budget. $200,000; whatever the magic number is. We have to look at are we going to encourage home ownership? Many leaders and experts are agreeing that we should give a first-time home buyer tax credit or something like that to increase home ownership or encourage it. At the same time, at the back end, maybe give renters credit so that they can also be benefited through the tax deductions that are available. But let's bring a balance to the whole thing, not just have it lopsided one way or the another. That's where the leaders are sending a confused message out to the community, and that's where the whole home prices are not bottoming out, or people are not getting into the market. We are seeing people having hit rock bottom, is this home ownership the next real cream of the Americans who are here? It's been very confused. So we have to bring in a process that is more balanced.
CAVANAUGH: How would you assess San Diego's real estate market now?
PAJANOR: It's still fragile. It's a very -- the home buying side, we have home buyers still looking for homes. It's not an investor-based market out there. So investors are buying out properties over home buyers. And the equity side, there are a lot more homes in San Diego than prior to 2007 that are underwater. So we have to be -- we are not out of the woods. We are still in the woods with regarding to home prices and foreclosure. So we have to be very careful in dealing with any subject that would affect home ownership.
MAUREEN CAVANAUGH: Would you agree?
LEA: I would agree. I think one implication if you really sharply reduced or eliminated it is that you would have an immediate price effect. And that would drive more people underwater, about 25% or so of our current homeowners with mortgages have negative equity in their properties. But San Diego is still a high-cost area, one of the top-10 most expensive housing markets in the country. We're more dependent on a mortgage interest deduction which is why I think some consideration to regionalization should be done if we are going to start limiting it.
CAVANAUGH: We heard for the last couple months kind of good news coming out of the construction industry. I believe that home starts were up, and even some good news here in Southern California. I'm wondering, do you think that if the mortgage tax deduction were eliminated that it would impact the construction industry in any significant way?
LEA: I think it would have some effect, but not a major effect. If you eliminate it completely, you affect the affordability of housing for a lot of households, and that's going to affect either their desire to be homeowners or how much they can afford. Even the latter perspective, builders would adjust is probably produce smaller, less expensive homes. So I think other issues such as land slide affect our home building industry more than the mortgage interest reduction.
CAVANAUGH: I know that realtors, when they're trying to get someone who may be on the fence about whether or not it's time to buy, have used the mortgage tax deduction as sort of a kind of carrot on the stick that that is going to be a good thing for you. Considering how people scrimp and save to come up with the down payment for a house, they go there to get some equity and this deduction, but we've seen what happened to equity in recent years, right? Now if the tax deduction is eliminated, what do you believe is the actual incentive to buy?
PAJANOR: The incentive is having a roof over your head that you call your own.
CAVANAUGH: Your own.
PAJANOR: That has been the first incentive and the primary incentive of home buyers, those being tenants searching for a home, to buy. But that alone doesn't push the prospect of homeowners across the line. It's the tax credit, it's the mortgage interest deduction. It's also other layering of other benefits that comes into play. But the main factor that decides or makes the home buyer become a homeowner having a roof that they call their own. And that's been the American dream.
CAVANAUGH: I see you shaking your head on that.
LEA: I was just going to point out that you look at other country, including our neighbor Canada, Australia, the UK, a number of European companies do not have a mortgage tax deduction, yet they have home ownership levels that are comparable if not greater than ours that. Underscores your point. There's more things going on that drive people to want to own their own homes than a tax deduction.
CAVANAUGH: Got it. What would you think that the legislators in Washington are going to do if you had a crystal ball? Do you think this is going to be part of their fiscal cliff deal or something they're going to address as they look at the larger budget issues as 2013 unfolds?
LEA: Well, they're kind of two sides of the same coin.
LEA: We have to do something short-term and long-term. And probably not a good idea to do major changes to the tax code within the next 20 days. So I don't think that's going to happen. But I do think that the mortgage interest deduction would be part of a reform of the tax code and dealing with our fiscal cliff issues, and I think we're going to see a reduction in the benefits, though not an elimination.