Each year when tax time rolls around, I develop a bad conscience. It’s not because I’m hiding cash receipts, putting money into an offshore account, or failing to file a return.
It’s because I get a perfectly legal tax break that’s completely unfair: the mortgage interest deduction for second homes.
In Washington, there’s periodic talk of eliminating or reforming the mortgage interest deduction. Most economists hate the deduction because it distorts the economy to favor investment in housing over investment in businesses. It’s also outrageously regressive—the congressional Joint Committee on Taxation estimates that it will reduce federal tax revenue by about $104 billion this year. In 2008, 75 percent of the total deduction went to people with incomes of more than $100,000. It’s even unclear that it promotes home ownership—Canada, Australia, and England have just as many homeowners per capita as does the U.S., but no mortgage interest deduction.
The interest deduction is also one of those sacred cows—like earmarks, Social Security, and farm subsidies—that politicians consider untouchable. Witness the Obama administration’s attempt to trim it in the 2011 budget. The administration proposed to limit the deduction for people in the over-$200,000 tax bracket to 28 cents instead of 35 cents on every dollar of interest paid. But the majority of Democrats have already said they’re concerned about what the proposal will do to the housing market. Those who defend the deduction argue that home ownership is good for communities. When people own the home they live in, they take care of their properties, don’t move as much, and become more active citizens.
But those assertions fall apart when it comes to second homes. Second homes that are rented out by definition aren’t owner occupied. With the right property, landlords do well because tenants pay the mortgage while the landlord builds equity. But deducting mortgage interest fattens those gains at the expense of other taxpayers. My 2009 deduction on two investment property mortgages will add $3,000 to already positive cash flow.
Vacation homes are only slightly better since they’re occupied some part of the year. But vacation homes in rural areas can drive up the cost of living and property taxes for full-time permanent residents. And vacation homes were more likely to be foreclosed on than owner-occupied properties during the housing bust, according to the Federal Reserve.
Because the government treats second homes that are rented out like businesses for tax purposes, it might be argued that their owners should be allowed to continue to deduct mortgage interest just as does any other business. But rented second homes are different from other businesses in significant ways. The most important is that unlike other industries, in real estate the investors compete directly with the public: would-be landlords bid for properties against would-be owner occupants, driving up prices for the second group. If someone is to get a mortgage deduction, it should be the owner occupants, not the investors.
The government doesn’t track how much revenue is lost to the second-home mortgage interest subsidy. But the idea of eliminating it has come up before. In 2005, President George W. Bush’s federal tax reform advisory panel recommended ending the deduction for non-income-generating second homes, as part of a package of reforms designed to distribute more of the home ownership tax breaks to lower income people. Unfortunately, the fallout from Hurricane Katrina derailed the administration’s chances for getting the panel’s advice enacted into law.
So with politicians from both parties scrambling for ways to appear fiscally responsible, Congress could do itself a favor by ending the deduction. Of course, realtors and mortgage bankers will scream. Landlord associations will be furious. The members of my local real estate investment club will call Congress and pass around petitions.
But it would be the right thing to do. And it would let me file my taxes guilt free.
Steve Yoder is a real estate investor and journalist based in Woodstock, New York, who has written for In These Times magazine and the Albany Metroland.
