The week before Thanksgiving the full House passed a tax bill and a committee in the Senate passed a separate but similar tax bill that was sent to the full Senate to consider.

It’s looking like we may end up with the largest changes to the U.S. tax code since 1986.

  1. I’ll go over how the two bills would change federal taxes for homeowners.
  2. I’ll give you my take on the winners and losers. My take is different than anything else I’ve seen.

Please note that I am not a tax expert. I’m a real estate agent and former economist. I am not writing to please an employer (I’m self-employed) or website advertisers (I have no advertisers on this website).

Proposed Tax Changes

The two bills would make a ton of changes but here I just want to focus on three direct changes to taxes on single-family homes and condos.

  • Mortgage Interest Deduction
  • Property Tax Deduction
  • Capital Gains Exclusion

Mortgage Interest Deduction. The House bill would reduce the mortgage interest deduction for homeowners who have large mortgages. It would not change the tax deduction for homeowners with mortgages less than $500,000. And the change wouldn’t affect current mortgages, only new mortgages.

The Senate bill doesn’t reduce the current $1,000,000 cap, so future home buyers would still be able to deduct all of their interest payments on mortgages up to $1,000,000.

The House bill would also limit the mortgage interest deduction to primary residences only.

In either version, landlords would still be able to deduct an unlimited amount of mortgage interest as business expenses.

Property Tax Deduction. The Senate bill would eliminate the federal tax deduction for all taxes paid to state and local governments, INCLUDING property taxes.

The House bill would eliminate for homeowners the federal tax deduction for taxes paid to state and local governments EXCEPT for property taxes, however, the property tax deduction would be capped at $10,000. Only those people who currently pay more than $10,000 a year in property taxes would be affected.

Landlords would still be able to deduct all property taxes as business expenses.

Capital Gains Exclusion. Currently, a married couple doesn’t have to pay any federal tax on the profit they make, up to $500,000 in profits, when selling a home they’ve lived in for 2 out of the last 5 years.

Both the House and Senate bills would increase the time you have to live in the house to get that $500,000 exception to 5 out of the last 8 years. The Senate bill makes allowances for people moving for jobs or health reasons.

Mortgage Interest Deduction

  • Lower Cap
  • Primary Residences Only

Lower Max Mortgage Interest Deduction. The House tax bill would lower the cap on the mortgage interest deduction to the mortgage interest paid on mortgages up to $500,000. Currently, you can deduct from your federal taxes the interest paid on mortgages up to $1,000,000 worth of mortgages.

The change would only apply to NEW mortgages. Current mortgages would be grandfathered in and you would continue to be able to deduct the interest paid on mortgages up to $1,000,000.

If you’re not familiar with it, here’s how the mortgage interest deduction works.

How the Mortgage Interest Deduction Works. You get a mortgage and buy a house. For many years, the vast majority of your monthly mortgage payments will be interest and very little will be principal.

That interest part is currently a tax deduction on your federal taxes, if you don’t take the standard deduction.

Let’s say you make $80,000 a year and you paid $20,000 in mortgage interest last year. If you were itemizing your tax returns, you could subtract or “deduct” that $20,000 from your $80,000 income so now, for tax purposes, you would only have to pay taxes on $60,000 instead of $80,000.

If you were in a 25% tax bracket, that deduction would reduce the taxes you have to pay by $5,000. It could be a $5,000 gain for you. Nice!

If you weren’t familiar with the mortgage interest deduction, it might mean you don’t own a home or you don’t itemize your deductions on your federal tax returns and you just take the standard deduction.

Most people do NOT itemize all their deductions, they just take the standard deduction of ~$12,000.

If all your individual deductions on your 2016 tax return added up to more than $12,000 you would have paid less federal taxes if you had itemized all your individual deductions, like the mortgage interest deduction. Otherwise, you would have paid less federal taxes by simply taking the standard ~$12,000 deduction. Most people are better off just taking the standard deduction.

Neither the House nor the Senate tax bills would change the $80,000 income scenario above now or in the future.

The House bill, however, would reduce the deduction for future home buyers with mortgages larger than $500,000.

The Senate bill would leave the current cap untouched, you could still deduct the interest on $1,000,000 in mortgages.

Mortgage Interest Deduction – Primary Residences Only? Not only do the House and the Senate versions disagree on how high to put the cap on the mortgage interest deduction ($500,000 vs. $1,000,000) but they also disagree on whether second homes should continue to get the mortgage interest tax deduction.

The House bill would limit the mortgage interest deduction to primary residences only. Currently, you can deduct the interest on up to $1,000,000 in mortgages, that’s with an “s”.

If you had a $500,000 mortgage on your primary residence and another $250,000 mortgage on your vacation home, currently you can deduct the interest on both (up to $1,000,000 in mortgages).

The House proposal would change that so you could only take the mortgage interest deduction on your primary residence. The Senate bill leaves intact the tax break for vacation homes.

Property Tax Deduction

Now let’s look at another housing provision in the tax bills, will local property taxes remain a federal tax deduction?

Now state and local taxes, including property taxes, are deductible in their entirety from your federal taxes, if you itemize instead of taking the standard deduction.

If you paid $10,000 in state and local states, that $10,000 could be “deducted” from your wages and other income and that reduction/deduction would reduce your federal taxes due. That is, of course, if itemizing all your separate deductions is a better deal for you than taking the standard deduction.

The Senate bill cuts out the property tax deduction entirely but the House bill only cuts it back a tiny bit.

The Senate version would get rid of the federal tax exemption for all state and local states, INCLUDING property taxes.

The House version would get rid of the federal tax exemption for all state and local taxes, EXCEPT property taxes. The House version, however, would put a cap on the property tax deduction, a maximum of $10,000 in property taxes could be deducted from your federal income tax return.

Capital Gains Exclusion

Both the House and Senate bills are currently written to increase the amount of time you would have to live in a house to be able to sell it and keep the profit tax-free, from 2 out of the last 5 years to 5 out of the last 8 years. The capital gains exclusion is $250,000 for individuals and $500,000 for married couples. The Senate version makes allowances for people moving for jobs or health reasons.

Doubling the Standard Deduction

One of the biggest changes in the proposed tax bills is they both would double the standard deduction from ~12,000 to ~$24,000.

That means anyone who in 2016 just took the standard deduction and didn’t itemize all their deductions, would very likely pay a lot less federal taxes under either the House or the Senate tax bill.

It also means that a lot of people who did itemize their deductions on their 2016 tax returns – but their total deductions were less than $24,000 – might do better under either of these bills. Some would just take the new, higher standard deduction of $24,000 and not itemize every single deduction.

The point I’m trying to make is that any changes to how the mortgage interest and property tax deductions are handled probably won’t affect the vast majority of people who took the standard deduction on their 2016 tax returns.

Discussion

House Version – Remove Mortgage Interest Deduction on Mortgage Amounts Between $500,000 and $1,000,000

Lowering the cap on the mortgage interest deduction would only affect people with mortgages so big that most Americans would consider them to be huge.

The median home value in the U.S. is only ~$200,000 (Zillow) and, anyway, about one-third of American homeowners own their homes free and clear so this proposed tax change wouldn’t affect the vast, vast majority of American homeowners.

The change might reduce a little bit of the upward momentum of home prices in expensive areas.

House Version – Remove Mortgage Interest Deduction on Second Homes

Eliminating the mortgage interest deduction on second home mortgages MIGHT take some of the wind out of sails of home price increases in areas with a lot of vacation homes. The change might make people a bit less willing to spend as much money on vacation homes.

However, people who buy vacation homes tend to pay all cash (~28%) or have large down payments (~45%) anyway, so people tend not to carry large mortgages on vacation homes. The impact, if any, of this change shouldn’t be large but it would be larger in areas with a large percentage of vacation homes.

I personally don’t think many people punch in the mortgage interest deduction when calculating their budget for buying a vacation home. And remember the proposed tax bills don’t affect current mortgages just new mortgages going forward.

Mortgage Interest Deduction Subsidizes Banks, not Homeowners

A key point in my thinking is that because housing has such inelastic supply, housing subsidies tend to increase home prices more than the subsidy amount and so they end up making homes less affordable for families. That would help explain why homes are so expensive in so many areas.

These housing subsidies also increase home price instability and that in turn increases household wealth instability, especially for middle and lower-wealth Americans.

I think removing the mortgage interest deduction entirely would, over the long-term, make homes more affordable for Americans. Removing the subsidies would tend to make America stronger economically, especially, the household economies of lower and middle-income Americans.

The mortgage interest deduction is more a subsidy for the banks than homeowners. Homeowners, for example, only get the subsidy if they’re paying mortgage interest to banks. Homeowners don’t get the subsidy for just owning a home. It’s a tax break for banks, not homeowners.

The government subsidy helps the mortgage industry sell larger loans but with such an incredibly inelastic supply in housing, the subsidy mainly leads to higher demand, higher home prices, more household debt and less household spending on stuff that creates jobs for other people.

Debt is good if you’re a bank – banks sell debt, it’s their main product – but our high levels of mortgage debt are a drag on the rest of the American economy and help explain why the Great Recession was so deep and so long.

What if homes weren’t so expensive? People would spend more money in the rest of the economy, creating more jobs. Or maybe people would choose to work fewer hours and spend more time with their families.

The homeownership rate is the same today as it was 50 years ago… but with a LOT more household debt.

Now back to the House and Senate tax bills. The proposed changes to the mortgage interest deduction are small. Nationally, they might have a small but beneficial effect on stabilizing home prices, reducing consumer debt and increasing household wealth creation.

If they pass into law (don’t hold your breath), the main effect might be to show the mortgage interest deduction can be changed, even if the changes aren’t large.

Senate Version – Remove Deduction on All Property Taxes Paid

Removing the property tax exemption entirely would have zero impact on most Americans because most Americans are going to take the standard ~$24,000 deduction in whatever new tax bill goes into law.

FYI, an IMF study from 2016 found that higher property taxes led to less speculation and more stable home prices.

To the small degree this proposed change leads to higher after-tax property taxes, it would also mean more stable home prices, household wealth and a stronger economy.

Again the change wouldn’t increase the federal taxes paid by most Americans.

House Version – Remove Deduction on Property Taxes Paid Over $10,000

Extremely few Americans pay more than $10,000 in property taxes in a year and those who do tend to have very expensive homes in states that have very high property taxes like New York, New Jersey and California.

Very few people nationally would get a smaller tax deduction if this became law and those who do would tend to be quite wealthy by national standards.

I was surprised that the Senate tax bill was more strict than the House bill. I think the fact that few states would be affected, that is, few Senators would be affected, helps explain why the Senate version is more stringent than the House version on property taxes.

With my interest in affordable and stable home prices to create household wealth, I prefer the Senate bill. It removes the deductions for all state and local property taxes and compensates in part by doubling the standard deduction.

The net effect would be lower taxes for most people. The vast majority of Americans will just take the standard deduction of $24,000 and pay less in federal income taxes.

People will continue paying their property taxes like they have in the past and when it comes time to do their federal taxes, most people will pay less because of the doubling of the standard deduction.

Removing the property tax deduction might slow down luxury home price increases in high-cost areas but I doubt it would have an impact nationally.

Senate & House Versions – Increase How Long You Have to Live in a House to Get the Capital Gains Exclusion of $250,000/$500,000

I don’t see this having a huge impact either, especially the Senate version that allows for exemptions for job moves and health reasons.

The median length of home ownership is pushing 10 years now anyway, which is up from 7 years not that long ago

This change may affect a few investors who do slow motion, live-in flips but that’s not a huge number of people. They would just have to ride the appreciation wave longer before they can sell and cash out tax-free. Or, with capital gains taxes at only 15% to 20%, it’s not the end of the world if the live-in flippers only keep 85% to 80% of their capital gains. That tax rate is less than some people pay on their wage income.

And the Winner is… Landlords!

Landlords will still be able to deduct all of their mortgage interest as business expenses.

Landlords will still be able to deduct all of their property taxes as business expenses.

Landlords don’t get the capital gains exclusion homeowners get but landlords do get huge deductions for (imaginary) depreciation that allows them to defer some taxes indefinitely.

If the tax deductions are reduced for homeowners but not for landlords, that gives landlords an advantage when bidding against homeowners to buy homes.

Some people are making scare predictions about how these proposed tax changes would reduce home prices. They aren’t taking into account the changes will have zero impact on ~20% of the market, investors/landlords in single family homes and condos.

[And don’t get me started about the depreciation deduction that landlords take on their federal taxes, a deduction homeowners can’t take. The U.S. federal tax code thinks single-family homes depreciate! They don’t. Single-family homes and condos do the exact opposite, they appreciate. This imaginary tax code depreciation allows investors/landlords to defer paying some taxes indefinitely and that shifts the playing field greatly in favor of investors and speculators, and against homeowners. And then 1031 Exchanges allow investors and speculators to continue to defer paying those taxes indefinitely, even after they sell an investment house!]

Reducing tax breaks for homeowners but not investors and speculators would reinforce the shift of single-family homeownership away from households and toward landlords. Again, remember, the U.S. homeownership rate is the same today as it was 50 years ago.

Macroeconomic impact on tenants. Landlords should also benefit from the proposed tax bills because their renters will likely pay less federal taxes. Maybe fewer tenants will be late on their rents. Maybe more after-tax income for tenants means it’ll be a bit easier for landlords to raise their rents.

In addition, it may be slightly easier for tenants to save up money for down payments to buy their own homes.

And the Losers are…

Homeowners because they will be at a disadvantage when biding against landlords when buying homes.

Banks are slight losers because in some cases (people with mortgages between $500,000 and $1,000,000) the federal government would pay a bit less of the interest fees those homeowners pay to banks (if House version language is included in the final bill). The federal subsidy to banks would be reduced very slightly.

Real estate agents might be hurt to a slight degree. Some current homeowners with mortgages above $500,000 might be slightly less willing to sell their current homes and buy new homes because the mortgage interest tax deduction would be less on the new home/new mortgage.

And to the degree that the changes slow down home price increases, if any, it would slow down the increases in real estate agent commissions per house sold.

I’m not a political analyst but my expectation is that the current proposals will get further watered down and there’s a real possibility that no tax bill will pass at all.

See Also

P.S. Feel free to disagree with me in the comments. This is more of a “working paper” and my opinions may change.