Topic 6: Federal Housing Policy – Income Tax Issues

(Suggested textbook reading: Chapter 8and Chapter 16)

The federal government takes steps to keep housing affordable and home values stable. [Is this an appropriate use of government power and resources?] It does so through various policies, including tax breaks for home owners and subsidies to those who build or occupy low-income housing. For these purposes generally a “home” can be any dwelling place, including a boat or mobile home, that has sleeping quarters and bathroom & cooking facilities.

I. Federal Income Tax Policy

As we noted earlier, mortgage loan interest and property tax payments are deductible from adjusted gross income in reaching the taxable income on which federal income tax is paid. In other words, households are taxed on “income,” but that income measure is an adjusted income that reflects the subtraction of certain expenses.

A. The basic equation for federal income tax computation is:

  • Gross Income (other than excludable items, e.g., some mtg. debt forgiveness)

The dollar amount of debt that is not repaid generally counts as taxable income (there can be exceptions). But theMortgage Forgiveness Debt Relief Act of 2007 allowed someone to exclude from income, for income tax computation, cancellation of up to $1 million ($2 million for joint return filers) of debt that was obtained to buy/build/improve a principal residence, or refinancing of such debt. Debt cancellation could come through a loan restructuring or a “short sale.” So if someone owed $260,000 on a house they could sell for only $200,000 and the bank approveda short sale (perhaps to avoid the even bigger headaches of foreclosing) the $60,000 in forgiven debt was not taxed as income to the borrower.The law was enacted for the 2007 tax year andextended each year through the end of 2016, when it was set to expire for good. A bill proposing a Mortgage Forgiveness Debt Relief Act of 2017 to make the benefit permanent was introduced in Congress in early 2017, but did not pass.

Also, unlike with stocks and bonds sold for prices exceeding the original purchase prices, a married couple that sells a home for more than was paid can exclude up to $500,000 of the excess (singles or married people filing separate returns can exclude up to $250,000) from income (they do not have to pay income tax on this capital gain).

  • Minus Adjustments
  • Equals Adjusted Gross Income
  • Minus Deductions

[Home mortgage loan interest (deductible since 1913, currently on debt of up to $750,000 secured by a first and/or second residence – true for a married couple or a single individual, such that unmarried co-owners of one or two homes can deduct interest on up to $1.5 million), ad-valorem local property tax, mortgage insurance
(FHA, PMI), discount points on a new mortgage loan, state income tax, charitable contributions, medical costs above 7.5% of AGI. Interest paid on a first or second home can be deducted from AGI, but only if the mortgage is recorded at the local courthouse. Penalties the lender charges for a late payment, or for prepayment, count as deductible interest. (Interest the home seller pays on the day when the property is sold cannot be deducted.)

One or more discount points (a “point” is 1% of the loan amount) may be charged by the lender to increase the lender’s effective periodic rate of return in connection with a new mortgage loan, often as a tradeoff for quoting a lower periodic interest rate. Points on a loan to buy or build a principal residence usually are fully deductible by the borrower in the year paid – even if the property seller pays the points on the borrower’s behalf!! (Points paid by a home seller for a buyer/borrower reduce the buyer’s basis in the home, which could under some circumstances result in a taxable gain when the buyer later sells.) To be deductible, the points charged must be reasonable relative to points charged on similar loans in the local community.

Points must be amortized over the loan’s life if they are wrapped into the amount borrowed, they are paid on a loan for a second home, or the borrower is refinancing an existing loan (a refinancer who borrows extra money to improve the home can deduct the points paid on the excess). Points are not deductible if they cover specific loan costs, like appraisal or title search fees, that normally are shown as specific dollar-based costs for a borrower (and the IRS is wise to the possible ruse of paying more in “deductible” points in return for not paying appraisal or title fees). So they must be classified as a general loan origination cost in the loan documents, and IRS form 1098 must be provided by the lender to document how much in points the borrower paid in the year the loan was obtained.

A standard deduction of $24,000 for married couples filing jointly applies to 2018 returns. So if your total of expenses in these areas does not exceed $24,000 ($12,000 for singles), it makes no sense to itemize, and you get no marginal income tax benefit from your mortgage loan interest, mortgage insurance,and property tax. And then, just to make it a little more complicated, for a few years Congress allowed a household that pays property tax on an owned principal residence to claim the regular standard deduction plus an extra amount up to $1,000, but this provision seems to have expired after the 2009 tax year.

  • Equals Taxable Income (no personal exemptions after 2017 returns)
  • Times Average Tax Rate
  • Equals Tax Owed
  • Minus Credits
  • Equals Final Tax Liability

[This equation shows the conceptual technique for computing federal income taxes;

the step-by-step procedure on IRS tax forms is slightly different.]

Many of the credits that can reduce individuals’ income taxes relate to caring for dependent children or paying college tuition. But the Energy Policy Act of 2005 reinstated the 1970s idea of “residential energy credits.” A home (house, condo, even houseboat or trailer) owner can claim credits (typically not more than $500 totalduring the years you own for smaller energy improvements, but $2,000 for big things like solar heating or hot water systems) for enhancing home energy efficiency through solar/photovoltaic/geothermal heat systems, air conditioning, windows, water heaters, insulation and caulking, and even fans. But these credits reduce the home’s tax basis,
so in extreme cases they could lead to capital gain taxes later. Also, low-income home owners may get credit instead of/in addition to deduction for mortgage loan interest paid.

A low-income taxpayer that obtains a Mortgage Credit Certificate from a state or local government housing agency can qualify for a federal income tax credit for mortgage loan interest paid. The credit is based on interest paid on a qualifying portion of the debt, and interest amounts applied toward the credit must be excluded from any amount shown as an itemized deduction. If the credit exceeds the amount owed as taxes the difference can be carried forward for up to three years.

A controversial credit instituted as part of the 2009 federal economic stimulus package was afederal income tax credit for first-time home buyers of 10% of the home’s purchase price (maximum of $4,000 for single filers, $8,000 for married couples, so the credit will be $4,000 or $8,000 unless the price is really low). This credit originally was scheduled to terminate on November 30, 2009, but Congress then extended the credit until April 30, 2010 – and added a 10% credit for existing home owners who bought replacement homes (maximum of $3,250 for single filers, $6,500 for married couples).

For either credit an individual buyer’s income could be no higher than $125,000 ($250,000 for married couples),the home could cost no more than $800,000, the home could not be bought from a relative, and the credit had to be repaid if the home was not used as the claimant’s principal residence for at least the subsequent three years. A “first-time” home buyer generally was considered someone who had not owned a home in the previous three years.

While this credit no longer exists, it is interesting to discuss here. First, it shows the type of short-term boost that lawmakers sometimes try to give housing (President Bush #41 proposed something similar in about 1990, but Congress would not pass it). Second, some observers felt people accelerated planned home purchases to meet the April 2010 deadline, thereby merely displacing sales that otherwise would have taken place later.

Note: income tax laws are subject to frequent change, and there are limits on some of the provisions listed above. Current federal income tax law also allows a first-time home buyer who has had an IRA for at least 5 years to make a tax-free withdrawal of up to $10,000 toward the purchase.

B. The “cost of housing” equation

The basic equation textbooks offeris: C = [(1 – t)(i + p) + m + (d – f)] P [Equation 1]

for whichC = annual dollar cost of owning a house instead of renting

t = marginal federal income tax rate

i = interest rate on mortgage loanp = effective property tax rate

m = annual differential maintenance outlay as a % of value (i.e., what an owner would face but a renter would not)

d = annual depreciation as a % of value

f = expected inflation rate that applies to housing

P = price paid for the house

Let’s say the owner paid $200,000 for the house (= P). Also assume that t = 18%,

i = 7%, p = 2%, m = 1%, d = f.

So C = [(1 – .18)(.07 + .02) + .01 + 0] x $200,000

= [(.82)(.09) + .01] x $200,000 = .0838 x $200,000 = $16,760

We would compare this figure with the annual cost of renting a similar housing unit, and choose the option that is cheaper. Let’s say that renting the same (or a very similar) house would cost $1,400 per month; the first year’s annual cost of renting therefore would be $1,400 x 12 = $16,800. Owning would be slightly cheaper in year 1.

But this approach may be too simplistic, in that it requires the home value to equal the loan amount; note that in Equation 1 we could factor out the term (1 – t)(i)(P), meaning that we treat the purchase price as being 100% financed. It is much more realistic to assume that the borrower takes money from savings to make a down payment and thus borrows only part of the purchase price. Complications that enter the analysis are

  • 1) the interest rate the borrower pays to borrow is sure to be greater than the interest rate given up on the savings account the down payment comes from and
  • 2) the income tax treatment of borrowing and saving are different. Interest paid on a home mortgage loan generates a federal, but not state, income tax benefit for a borrower who itemizes, but interest earned is taxed at both the federal and state levels. State income tax is based on adjusted gross income shown on the tax payer’s federal income tax return, and that AGI figure includes interest earned on savings but is not reduced by interest paid on a home mortgage loan.
  • Also, 3) an Illinois home owner gets a slight state income tax break for property tax paid; we will approximate that break by treating it as a deduction even though the break actually comes in the form of a state income tax credit.

Let’s assume the interest rate that could be earned on dollars saved is 4%/year, and the state income tax rate is 3%/year. We can restate our cost of home ownership (first year) equation as

C = [L/V (1 – tF) iL + (1 – L/V)(1 – tSF) iS + (1 – tSF) p + m + (d – f)] P [Eq. 2]

for whichtF = marginal federal income tax rate,

tSF = marginal combined state + federal income tax rate

iL and iS are the interest rates paid on loans and earned on savings

C = [.8(1 – .18)(.07) + .2(1 – .21) (.04) + (1 – .21)(.02) + .01 + 0] x $200,000

= (.04592 + .00632 + .0158 + .01) x $200,000 = .07804 x $200,000 = $15,608.

This analysis shows an even lower cost for ownership. With a 20% down payment the borrowed amount would be .80 x $200,000 = $160,000. Note what happens:

  • At a loan interest rate of 7% per year the interest paid is .07 x $160,000 = $11,200, but if this borrower itemizes deductions the interest payment is accompanied by a federal income tax savings of (.18 x $11,200) = $2,016, so after-tax cost of interest paid is ($11,200 – $2,016) = $9,184.
  • Borrower also loses interest on the money that is taken from savings to make the down payment. If the interest rate that would be paid on savings is 4% per year, then the borrower loses (.04 x $40,000) = $1,600 in interest. But that’s also $1,600 of income that is no longer taxed at the 21% federal-plus-state marginal rate, (18% federal + 3% state of Illinois), so theafter-tax cost of interest given up is ($1,600 x .79) = $1,264. Net cost of interest, if $160,000 is borrowed, thus is $9,184 + $1,264 = $10,448 (vs. .82 x .07 x $200,000 = $11,480 in prior example).

Now buying a house of the type in question (with its $200,000 purchase price) is even cheaper, relative to renting, because if you pay rent and leave your $40,000 in the bank, it earns low interest and is heavily (state + federal) taxed, and we are also recognizing a state income tax benefit to owning that a renter does not receive.

A couple of points to note: First, the computed C figure is, as indicated above, the first year’s cost of owning the home. It changes slightly in each subsequent year; note that the L/V ratio changes as principal is repaid. Also we have treated term (d – f) as zero, meaning that the depreciation rate and the inflation rate are treated as being equal
(so that any gain through inflation is exactly offset by a loss through aging of the improvements). If the two aren’t equal, then

C rises if d exceeds f

C falls if f exceeds d.

II. Other aspects of federal housing policy

Affordability is promoted by the government through many programs. Those not discussed elsewhere in our coverage are:

A. Grants to allow communities to help low-income families obtain homes. An example is the HOPE program, a HUD plan to transfer public housing ownership to tenants. Also the state of Illinois has down-payment grants of $7,500 for first-time home buyers – but only if they are purchasing in Boone, Cook, DeKalb, Fulton, Kane, Marion, McHenry, St. Clair, Will or Winnebago counties!!

B. Laws

1. Consumer Credit Protection Act (“Truth in Lending Act”) – Passed in 1968. Implemented Regulation Z; requires lenders to state annual percentage rate (APR) measures on mortgage loans and other consumer loans that factor in points and other loan costs separate from the stated interest rate, to help borrowers compare the overall costs of borrowing across different loans.

2. Real Estate Settlement Procedures Act (RESPA). Passed in 1974. It was designed to provide information (it did), and to hold borrowers’ costs down (it didn’t). Among RESPA’s provisions:

a. Disclosure – borrower must be given a good-faith estimate of all closing costs (stuff like credit report fees, title insurance premiums) after applying for loan, and must be given exact figures 24 hours prior to closing.

b. Impounds for property taxes and insurance are restricted to 2-month cushions.

c. Lender can not receive kickbacks for referring borrower to providers of various loan-related services, though allowing a lender to offer a package of loan-related services has been proposed.

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