Need to cut deficit will transform home financing
The way we buy and finance real estate is evolving.
Real estate has always been subject to pendulum-like swings in value and attractiveness as an investment. Traditional assumptions underlying the buying decision have already started to change and will continue to do so. The recent national debate over the elimination of the long-sacred mortgage interest deduction is just the latest example of how this evolution in real estate is occurring. If the mortgage interest deduction is reduced or eliminated, the day-to-day cost of our existing homes will increase, possibly dramatically.
Currently, under federal tax law, if you itemize your deductions you are allowed to deduct mortgage interest paid on the first $1 million in mortgage debt covering your principal residence, one second home and the interest payments on home equity loans up to $100,000.
In place of these deductions, the National Commission on Fiscal Responsibility and Reform's recently proposed a 12 percent nonrefundable tax credit to all taxpayers regardless of whether they itemize. This credit is capped at the interest you pay on $500,000 of mortgage debt, and only for mortgage debt secured by your principal residence, not for mortgage debt you pay on a second home or home-equity lines of credit.
By way of comparison, under current law and 2011 tax rates, a taxpayer in the highest tax bracket, 39.6 percent, paying $25,000 in mortgage interest per year on a $500,000 mortgage would be able to reduce his tax liability by $9,900. Under the commission's proposal, that same taxpayer would reduce his tax liability by only $3,000. In effect, his mortgage payments would have just increased by a whopping $575 per month.
Part of the commission's justification for this change is that it proposes a maximum tax bracket of 28 percent. So, theoretically, the taxpayer would have more take-home pay to accommodate his mortgage payment.
Other evidence of this evolution is the way we finance real estate. As a result of the bursting housing bubble, financial industry meltdown and current foreclosure disasters, lenders have returned to a far more conservative approach to mortgage lending. We are already seeing mortgage lenders requiring larger down payments of 20 percent or more. Credit scores in the 600s are no longer enough to qualify for favorable loans. Loan officers are rigidly enforcing rules on documentation of employment, assets and income. Lenders' underwriters are applying the traditional mortgage debt-to-income ratios of 28/36. What this means is that no more than 28 percent of your gross income should be spent on your mortgage principal, interest, taxes, insurance (known as PITI) and condo or homeowners' association fees if applicable. No more than 36 percent of your gross income should be spent on PITI plus all other debt, including car payments, student loans and the like.
If your debt-to-income ratios do not work for a particular home, and you cannot afford to increase your down payment, you will not qualify to buy that home.
The national debate over the proposals to eliminate the mortgage interest deduction, adjust the capital gains and ordinary income tax rates ignited by the commission's report is not likely to abate any time soon. Although the report did not garner the necessary votes to force congressional consideration, it did win the votes of 11 of the 18 commissioners, an impressive tally. The bipartisan nature of those voting to approve the report all but ensures that many of the commission's proposals will be reintroduced and debated in Congress.
With deficit reduction being the goal, all government policies affecting the real estate industry are now fair game. In addition to the mortgage interest deduction, favorable capital gains treatment of real estate investments, and possibly even the deductibility of real property taxes may be eliminated. If these proposals make their way into established policy, the short-term value of our homes - and our ability to buy or sell them - will be diminished, at least in the near future.
Anyone facing a real estate decision today should carefully analyze their buy/sell/refinance decisions, keeping in mind the possible impact of these proposed changes on the deductibility of mortgage interest and real property taxes and the capital gains treatment on any future appreciation. There are many online mortgage calculators that can assist you in determining how much you can really afford.
No longer can a homeowner count on Uncle Sam to pay part of his mortgage each month. The decision to buy will now need to be based solely on the economics of the particular home and the financial condition of the buyer, without regard to traditional tax-favored policies.
Harvey S. Jacobs is a real estate lawyer in the Rockville office of Joseph, Greenwald & Laake. He is an active real estate investor, developer, landlord, settlement attorney and lender. This column is not legal advice and should not be acted upon without obtaining your own legal counsel.