There are many benefits to a first-time homebuyer tax credit, such as the one proposed by President-elect Joe Biden. However, the transition from the current deduction- or exclusion-based system of homeownership support would not be simple. Here are some of the issues that Congress would need to address:
Is there still a need for a mortgage interest deduction and, if so, for whom?
Limiting the home mortgage interest deduction (MID) reduces the current tax benefit from homeownership only for those with interest payments on a home mortgage. For any net equity in a home (asset value in excess of loan value), the “return” in the form of rental saving remains fully excluded from income or tax-exempt. Rent payments, on the other hand, are made entirely from after-tax income.
As a consequence, while the MID adds to the unequal treatment of homeowners relative to renters, it creates a more equal treatment of homeowners with mortgages relative to those with higher amounts of equity in a home. Yet, on average those with mortgages are younger and have fewer assets than those with substantial home equity. Perhaps those younger taxpayers are more worthy of a homeownership subsidy.
There’s no easy answer to the question of which equity concern to address. However, it’s not necessarily an issue of progressivity, as Congress can keep the overall tax code progressive through changes to the tax rate structure or to provisions like the standard deduction. But that still would not resolve the problem of equal treatment of equals—in this case, between homeowners with mortgages and those without.
Should those who take a first-time down payment tax credit also get the MID?
While a case can be made for allowing some mortgage interest deduction for low- and middle-income homeowners, the 2017 Tax Cuts and Jobs Act nearly doubled the standard deduction and thereby eliminated the benefits of itemizing for nearly all those taxpayers. That strengthens the case for gradually displacing the remaining MID for higher-income households who claim a down payment tax credit.
How much of a difference would it make to these higher-income households? That depends on their financial portfolio. If higher-income households used some assets in taxable accounts to buy down mortgages and increase their home equity, any tax increase due to loss of the MID would be modest. These taxpayers would simply replace one tax benefit (deducting mortgage interest) with another (getting a tax-free return on their home equity). However, many wealthier households hold financial assets largely in tax-favored or tax-free retirement accounts. If they increase home equity by, say, decreasing retirement account assets, the loss of the MID would still raise their lifetime tax burden even in the presence of a homebuyer tax credit.
Should the credit be confined to first-time homebuyers?
Though called a “first-time” homebuyer tax credit, the credit available from 2008 to 2010 often subsidized those who previously had owned a home. For example, it was available to those who didn’t own a home in the three years prior to a new purchase.
Without some form of recapture (discussed below), allowing a tax credit for second- or third-time homeowners would be both an inequitable and inefficient way to encourage homeownership. A permanent homebuyer tax credit (in contrast to the temporary version of a decade ago) can multiply subsidies for taxpayers who move the most, hardly the desired purpose of the credit. House-flippers who live temporarily in each house they buy could benefit the most while adding little to total societal homeownership over time.
How could recapture work?
To prevent churn and turnover, a recapture rule could link the down payment subsidy to the period of homeownership. The temporary 2008-10 credit had varying recapture rules that I won’t delve into here, but suffice it to say that a permanent credit would require IRS to put in place an administrative reporting system for home sales. If the credit were to be fully recaptured at its nominal value upon sale, up until that time it would act as an interest-free loan from the federal government, which effectively pays the interest on the additional mortgage that would be required in absence of the credit. Thus, the incentive under a full recapture rule is almost perfectly related to the period of ownership. And, the full amount of the credit recaptured upon sale would be available to the taxpayer for a future home purchase.
If the credit is recaptured only in part, the recapture amount might be reduced over time, say, by 1/20th for each of the following 20 years. In this case, the recaptured amount could be made available for future home purchases.
In sum, federal government could create a homebuyer tax credit and, through steps to significantly improve equity among homeowners, provide a higher level of down payment assistance without adding to the long-term cost of the tax expenditures for homeownership. Those steps include limiting the home mortgage interest deduction, confining the credit to first-time homebuyers, and recapturing the credit upon sale but extending recaptured amounts to future home purchases.
This is the second in a two-part series on President-elect Biden’s proposal for a first-time homebuyer tax credit. The first part can be found here.
