Housing: Time to Halt Taxpayer Subsidies

Even with the housing market declining, it's bad policy to give homes preferential tax treatment over stocks and other investments

by Chris Farrell

Homeownership has long been a vibrant part of achieving the American Dream. But these days owning a home is more like starring in a horror flick, perhaps called Nightmare on Main Street. The numbers are frightening. Home prices are falling nationwide, and the foreclosure rate is at record levels. The delinquency rate for subprime adjustable rate mortgages is an astonishing 20%, and the Federal Reserve's home equity measure is at its lowest level in 60 years. Indeed, Moody's Economy.com estimates that more than 10% of the nation's homeowners were "upside down" on their mortgages by the end of March. In other words, the value of their mortgage is greater than what their home is worth.

It's a safe bet with both the housing market and the economy deteriorating that more federal money (as well as state funds) will go toward supporting housing this year. But once the downward trajectory moderates, the government should learn from recent experience and take a radical stance: Forget propping up housing. Instead, eliminate taxpayer subsidies for housing. Yes, you read that right.

The Bubble: No Coincidence

There's no question the U.S. tax code is full of special tax provisions that favor housing. Among the biggest breaks are the mortgage interest deduction, the deduction for state and local real estate taxes, and the capital gains exclusion for homes. (The first $250,000 in profit is exempted from capital gains taxes for individual filers, and $500,000 profit for couples.) The federal tax code funnels more than $100 billion annually into the housing sector, estimates the Tax Foundation in Washington D.C.

This figure doesn't include the mammoth subsidized institutions that support the housing and mortgage markets. This includes Government Sponsored Enterprises like Fannie Mae (FNM) and Freddie Mac (FRE) , to name only two of the best known players. The Congressional Budget Office estimated that in 2003 the benefit of the explicit and implicit ties to the federal government for GSE such as Fannie Mae and Freddie Mac amounted to a federal subsidy of more than $23 billion, according to economists William G. Gale, Jonathan Gruber, and Seth Stephens-Davidowitz in their 2007 paper, Encouraging Homeownership Through the Tax Code.

Yet in a modern, dynamic high-tech economy, why should homes get preferable tax treatment over stocks and other investments? The tax gap in treatment is significant. Take capital gains. Say you'd invested in a basket of high-tech stocks three years ago and now you sell the portfolio for a $500,000 profit. Well, you'll pay a 15% capital gains tax rate on the gain, writing a $75,000 check to Uncle Sam. But you and your husband also sell the home you bought three years ago for a $500,000 profit. Guess what? The Internal Revenue Service gets nothing.

By the way, the tax break for capital gains on housing was signed into law in 1997. Is it a coincidence that home prices soared 79% in the time between the first quarter of 1997 and the first quarter of 2005, with home prices not just going up but rising at an increasingly rapid rate, as calculated by Peter Bernstein, a long-time advisor to institutional investors and author of Against the Gods: The Remarkable Story of Risk. It's doubtful.

Lessons of the Past Decade

What's more, the mortgage interest deduction is simply bad tax policy. It's sold as a middle-class subsidy, but since the value of the deduction goes up with the size of the mortgage, the biggest break is enjoyed by the highest-income households. For instance, the President's 2005 Advisory Panel on Federal Tax Reform calculated that individuals making more than $200,000 a year received more than eight times the benefit of those earning between $50,000 and $75,000 a year.

These days, no one can doubt that a home is an investment. It's an asset class, like stocks and bonds. Indeed, one reason why housing prices hit such stratospheric heights was the potent combination of owners treating homes as an investment, and the capital markets shoveling huge sums of money into real estate through such innovations as collateralized debt obligations (CDOs). For awhile, the net effect was to increase the liquidity of real estate "investments," supporting an unprecedented degree of speculation.

The tax code shouldn't bias investment money to favor one kind of investment over another—certainly not in an intensely competitive global economy. Let the economic fundamentals dictate where investors place their financial bets on the future rather than the tax-writing prejudices (and campaign contribution solicitations) of Congress and the White House.

The History of Subsidies

To be sure, calling for the end of housing subsidies is at best reminiscent of tilting at windmills. After all, governments have long favored housing. The world's first subsidy for single-family homes may have been under Constantine I in the capital city of Constantinople, speculates David Smith, founder and head of the Affordable Housing Institute in Boston. The subsidy was a perpetual grant of a ration of bread—the panes aedium. It was given to anyone that built a home in the city, and the panes aedium was passed along to the new homeowners at sale. "Strikingly, the panes aedium was not just a first-time home buyer incentive, but an ongoing property asset, in much the same way as real estate tax abatements or exemptions are intrinsic property rights in the modern," writes Smith.

That said, the lesson of the past decade is that too much investment money goes to real estate in modern America. At a time when companies from China, India, South Korea, Brazil and other emerging markets are competing with American firms for markets and profits, it's time to stop the madness.

Farrell is contributing economics editor for BusinessWeek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace. His Sound Money column appears on BusinessWeek.com.