The Second Presidential Debate: Capping Itemized Deductions IS Housing Policy

In the second presidential debate, the candidates did everything they could to avoid talking about housing. In listing what he did over the last four years, Obama didn’t mention any housing accomplishments. And, in listing all the problems that Obama failed to fix, Romney didn’t mention housing, either. Both candidates even avoided the mortgage interest deduction when talking about taxes. Romney suggested capping aggregate deductions at $25,000 without explicitly limiting any particular deduction, and Obama criticized Romney for not specifically calling out which deductions he would limit.

But housing was a part of this debate, even if not by name. Nearly half of the value of itemized deductions is housing-related, and capping deductions at $25,000 would hit many middle-income people. To see what a cap on itemized deductions would mean for housing, we looked at the most recent published IRS data on individual tax returns (2009) to sort out the facts.

First, let’s start by looking at who actually itemizes their tax deductions. The table below shows that only one-third of tax-filers itemize, but this ranges hugely by income. Only 15% of filers with less than $50,000 adjusted gross income (AGI) itemize their deductions, compared with 96% with $200,000 or more AGI. Higher-income filers include a much higher average total of itemized deductions, too. A cap of $17,000 – which is what Romney suggested two weeks ago – is roughly equal to the amount that the typical itemizer with less than $50,000 AGI deducts, so many lower-income itemizers wouldn’t be affected at all by that cap. But even a higher cap of $25,000 would hit many people in the $50,000-$200,000 range and probably most in the $200,000-plus range.

Among all filers, nearly half – 49% — of the value of their itemized deductions is housing-related, which includes home mortgage interest, real estate taxes and a few other small deductions like deductable mortgage points and qualified mortgage insurance premiums. Housing-related deductions account for 56% of the middle-income filers’ deductions – more than the share for lower-income or higher-income filers.

 Note: “housing-related” includes mortgage interest deduction, real estate taxes and a few additional very small deductions.

Next, let’s look and see what people are actually deducting. Housing-related deductions are a larger share of overall deductions for lower-income and middle-income filers than for higher-income filers. Here’s why. Higher-income filers pay a lot more in state and local taxes, since these tax rates often rise with income, and give more in charitable contributions than lower- and middle-income filers, so these deductions account for a larger share of itemized deductions. Among itemizers with $200,000 or more AGI, 36% of itemized deductions are state and local taxes, compared with just 18% for the middle-income filers and 8% for the lower-income filers. In fact, higher-income filers deduct more for state and local taxes than for home mortgage interest – in part because the mortgage interest deduction is limited to interest on the first million of mortgage debt, which would affect higher-income filers most.

At the same time, the home mortgage interest is, by far, the largest deduction for middle- and lower-income itemizers. Lower-income people also rely more on itemizing deductions for expenses that higher-income filers are more likely to get covered by insurance or their employer, including medical/dental expenses and unreimbursed business expenses.

Note: each COLUMN adds to 100%.

Summing it all up: capping itemized deductions would certainly put more of the burden on higher-income filers. Whether this cap would also affect lower- and middle-income filers depends on the level of the cap. Many middle-income filers itemize and deduct more than $25,000, so a cap at that level would snag many in the middle-class. There’s no question, though, that if a cap on deductions is low enough to affect filers with less than $200,000 AGI, the home mortgage interest deduction would be most affected. Together, the mortgage interest deduction, real estate taxes and other small housing-related deductions account for the majority of deductions for filers under $200,000 AGI, even though these housing-related deductions are a smaller share of what higher-income filers itemize.

A low cap on itemized deductions would clearly reduce homeownership benefits for the middle class. The bigger question, of course, is how much that matters. Recent research shows that the mortgage interest deduction increases homeownership for higher-income households in some areas but not for other households. Removing the mortgage interest deduction would lower home prices, particularly at the high end, which would hurt current homeowners (including underwater borrowers), while making homeownership more affordable for lower-income households who might not have itemized in the first place. High-cost areas with high homeownership benefit most from the mortgage deduction. Younger, higher-income households in expensive homes benefit most from the mortgage interest deduction. Here’s why: being younger and therefore in the earlier years of a mortgage, more of their mortgage payments are interest rather than principal and therefore deductible. Also, higher-income households are in higher tax brackets and therefore benefit more from deductibility, and people in more expensive homes have larger payments to deduct.

However, even in the absence of the mortgage interest deduction, homeownership today would still be more affordable than renting. Trulia’s Rent vs. Buy report shows that it’s 45% cheaper to buy a home than to rent today, assuming itemized deductions in the 25% tax bracket. But even without any itemizing, it’s still cheaper to buy than to rent in every large metro – check out our data visualization illustrating this point.  Thus, even without the tax deduction, low mortgage rates and years of post-bubble price declines have made buying much cheaper than renting.