As Karen Jacobs, an economist in Arizona’s Department of Revenue, was reviewing income tax data for 2010, she came across a puzzling trend: Refunds were down and tax liability was up even though the state’s unemployment rate peaked that year, at 10.8 percent. “My first thought was: ‘Taxable income? Why would that be up if people are losing jobs?’ ” says Jacobs.
With new houses sitting vacant in the desert and foreclosures soaring, it didn’t take long to figure out the reason. Home ownership rates, real estate prices, and interest rates were all falling, so fewer people were deducting mortgage interest and mortgage holders had often borrowed less or had refinanced at lower rates. The value of itemized deductions dropped 20 percent for the year—led by a decline in the tax break for mortgage interest. “I was shocked about how much I owed,” says Stephen Buckman, who had to pay the Internal Revenue Service $1,500 when he filed his 2011 taxes. In December 2010, a bank foreclosed on his Phoenix townhouse, which had plunged in value to $50,000 from the $196,000 he paid in 2006.
Like Buckman, people across the U.S. have seen their tax bills increase due to the housing bust. On federal tax returns, claims for the mortgage interest deduction dropped by 14 percent, from 2007 to 2009, IRS data show. For 2010, preliminary data indicate that use of the write-off fell by a further 7.2 percent. The decline saved the U.S. government between $13 billion and $26 billion from 2007 to 2010, estimates Andrew Hanson, an assistant professor of economics at Georgia State University who has researched the tax break. The shift “is not surprising, given what we know happened to the housing market,” Hanson says.
Use of the mortgage interest deduction peaked in 2007 when it showed up on 40.8 million returns. That fell to 36.5 million for 2009, according to the IRS, and the amount deducted declined from $491 billion to $421 billion for those years. Preliminary data show the number of returns on which taxpayers claimed the tax break edged up to 36.9 million in 2010, though the dollar value of the write-offs fell to $387 billion. “You’re seeing 5 million fewer returns between 2007 and 2009 claiming the deduction,” says Matthew Gardner, executive director for the Institute on Taxation and Economic Policy, a nonprofit research group. “It is a real drop.”
In Arizona, the change led to about $170 million in unanticipated revenue for fiscal 2011, a pleasant surprise after a $3 billion drop in tax revenue during the previous three years, says John Arnold, Governor Jan Brewer’s budget director. “We’re in a budget crisis, and an extra $170 million shows up,” Arnold says. “We understand that is the result of people losing their homes. If I could say it was the result of people refinancing, we’d be all smiles.”
Other states, especially where foreclosures have been high, have seen a similar trend. In California, just behind Arizona with the third-highest foreclosure rate in the U.S. last year, the number of filers taking the deduction for mortgage interest fell 9 percent while the value of the write-offs fell almost 20 percent from 2007 to 2009, according to data from the state’s Franchise Tax Board. “It’s helping the state governments,” says David Albouy, assistant professor of economics at the University of Michigan at Ann Arbor, “because they are not giving away as much as they were before in the mortgage interest deduction.”