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Tax Reformers Eye Breaks for Housing

Times Staff Writer

Just as the nation’s housing boom appears to be slowing, debate is starting among policymakers about reining in one of the most sacred cows of American public policy: the mortgage-interest deduction and other generous tax benefits granted to homeowners.

A presidential commission on tax reform will take up the subject for the first time Tuesday. “Everything’s on the table,” said Charles Rossotti, a panel member who was commissioner of internal revenue from 1997 to 2002.

The mortgage-interest deduction saved homeowners $61.5 billion last year. No one expects the commission to recommend its elimination.

Instead, the panel may consider scaling back the deduction for mortgage interest on second homes or home-equity loans, and changing the deduction for property taxes, among other things.

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The stakes in such a discussion are huge.

Changing the tax benefits for homeowners, even if done slowly, could cause short-term convulsions in the market as buyers recalculate what they can afford. The tumult could be most pronounced for homeowners in states with the highest home prices, such as California. In the long term, housing could become more affordable as some of the stimulus that has sent prices soaring is removed.

Any proposed shift would encounter strong and possibly overwhelming resistance. But with a rising federal budget deficit, the prospects for change are much greater than they’ve ever been, say those involved in the debate.

Homeownership wasn’t initially a favored child. When the individual tax code was created in 1913, all types of interest were deductible. Most fell away over time, but housing remained and became even more special.

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Eight years ago, capital-gains taxes were eliminated for home sellers who had profit of as much as $250,000 (for individuals) or $500,000 (for couples). That has created a vast amount of wealth and helped power a housing boom that has seen prices double or triple in Southern California and other hot markets.

Some policymakers and analysts are beginning to wonder whether such breaks are providing the wrong incentives, giving hefty deductions to millionaires buying Beverly Hills estates as well as to speculators snapping up Las Vegas ranch houses, hoping to turn a quick profit.

U.S. Comptroller General David M. Walker said provisions such as the capital-gains exemption were costing the government much more money than anyone forecast when they were first proposed. In a new study, the Government Accountability Office calculated that the exemption drained $29.7 billion from federal coffers last year.

“We need to review the reasonableness, appropriateness and effectiveness” of such provisions, Walker said in an interview.

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Presidents and members of Congress have long proclaimed the importance of homeownership, saying it gives people roots in a neighborhood and makes them better, more caring citizens. A home, not a college education or a fulfilling job, is the embodiment of the American dream. Politicians also are mindful of the fact that the nation’s 74 million homeowners form one of its largest special-interest groups.

President Bush set up the President’s Advisory Panel on Tax Reform in January to recommend changes in the tax code. The panel, led by former Sens. Connie Mack (R-Fla.) and John B. Breaux (D-La.), will submit suggestions to Treasury Secretary John W. Snow this fall. Bush will choose among the recommendations to propose to Congress.

Bush specifically charged the panel to take account of “the importance of homeownership and charity in American society.”

That led many to conclude that the homeowner deductions were safe.

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“The mother of all tax subsidies ... shall remain untouched,” wrote economist and tax expert Martin A. Sullivan in Tax Notes.

This was good news for real estate agents, developers, home builders, contractors, home-improvement stores and speculators -- groups that heavily support the status quo. But unfortunately for them, the mood changed over the summer.

“There has been a growing expectation that the framework for taxing housing could be revised,” said National Assn. of Realtors tax counsel Linda Goold.

One reason for the shift: the expected demise of the alternative minimum tax. Originally designed to make sure those with high incomes didn’t deduct their tax liabilities away, the alternative minimum tax is not indexed for inflation.

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As a result, the number of people who will have to pay the tax is expected to increase dramatically over the next decade, eventually incorporating much of the upper middle class.

At a meeting in July, the nine members of the tax reform panel agreed unanimously to recommend eliminating the alternative minimum tax as an unfair and poorly designed parallel tax system. Because their mandate is to be revenue neutral, that required them to come up with $1.2 trillion in other receipts over the next decade.

“The money has to be found by either raising rates or changing tax expenditures,” panel member Elizabeth Garrett said.

Tax expenditures are the government’s term for money it forgoes because of targeted tax relief. According to the Government Accountability Office, the number of tax expenditures has risen since 1974 from 67 to 146. The annual amount of lost revenue has tripled during that time, to $728 billion. That’s about twice the size of the current budget deficit.

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The biggest tax expenditure, totaling more than $100 billion in its various permutations, is to homeowners. Almost as big are employers’ tax-free contributions to their employees’ health benefits and the tax-free status of 401(k) contributions.

“We privilege homeownership as a form of investment by a considerable amount,” said Garrett, a professor of law and politics at USC. “You always have to ask yourself, is preferential treatment justified?”

She noted that homeowners could deduct interest paid on up to $1 million in mortgage debt on a first or second home, and that the deduction was worth more to families in higher tax brackets.

“If we were going to subsidize homeownership through a spending program,” Garrett said, “it’s not clear this is how we’d design it.”

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Others are wondering the same thing. Last winter, Congress’ Joint Committee on Taxation recommended repealing the deduction for home equity loans, contending that it was inconsistent with the fact that interest on other types of personal loans are not deductible.

In February, the Congressional Budget Office said cutting the $1-million mortgage deductibility ceiling in half would raise $2.7 billion from 700,000 homeowners.

A sudden drop in the ceiling “would reduce home values, mortgage lending and home building at the top end of the housing market,” the study’s authors acknowledged. Their solution: Phase it in gradually.

A notable feature of the recent housing boom is that it has enriched many owners but hasn’t expanded homeownership, which is supposed to be the point of the tax benefits.

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Four years ago, the homeownership rate was 68.1%. Now it’s 68.6%. Even when the time span is extended to decades, scholars find little discernible effect from all the homeowner subsidies.

“One could argue that the social benefits of homeownership may not be worth” the $100 billion-plus in lost tax revenue every year, government analyst Pamela J. Jackson wrote in an article this summer for the Congressional Research Service.

Stephen Levy, director of the Center for Continuing Study of the California Economy in Palo Alto, agreed that tax benefits for housing had gotten out of whack.

“We ended up providing more of a subsidy than anyone intended, and to folks we didn’t intend to,” Levy said.

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The 1997 elimination of capital-gains taxes on home sellers’ profits is a particular study in unintended consequences.

“Hands down, bar none, that was the most taxpayer-friendly proposal I’ve seen in my career, which is a long one,” said Goold of the Realtors association.

A nonpartisan budget group estimated that the capital-gains measure would cost the government $5.8 billion in lost revenue over 10 years. Instead, it’s been about 60 times that.

One modification Garrett said the tax panel could consider: raising the period the homeowner must live in the house to qualify for the capital-gains exclusion. Currently it is two years.

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