Is the Tax Code’s Treatment of Real Estate Worthwhile?
The tax code’s preferences for real estate have been justified on the grounds that they help Americans purchase homes and improve the quality of the nation’s housing stock.
The U.S. housing and commercial real estate stock has been shaped by the variety of real estate preferences, which cost about $836 billion over 5 years. The home mortgage deduction accounts for $420 billion of the total preference. As with the tax subsidy for health insurance, this preference is practically impossible to eliminate, because people are used to it.
Although these preferences are clearly distortionary, encouraging Americans to invest more in housing than they would in the absences of the preferences, international travelers see that these benefits have succeeded.
American homes are lavish compared to those in other countries. Average homes benefit from large refrigerators, so people can go shopping once a week without food spoilage. Americans have large washers and dryers that actually dry clothes, so most do not have to hang clothes outside to dry the way many people have to do in other countries. Even in England, known for its wet weather, it is common to see clothes hanging outside to dry in expensive neighborhoods. U.S. homes feature multiple bathrooms with high-pressure showers and a high share have air conditioning as well as heating.
A better solution would be to lower tax rates and broaden the base, getting rid of as many of these preferences as is politically possible. Republican candidate Donald Trump has proposed lowering the corporate tax rate to 15 percent and trimming many preferences, with details to be worked out in negotiations with Congress. However, no one can deny that these tax preferences have made life easier for Americans, especially American women.
American women are the ones who have been able to move into the workforce in large part because of the labor-saving devices that modern homes provide. Working mothers know better than anyone the convenience of tossing a large load of laundry not only into the washer, but also in the dryer afterwards. Such appliances are included in the value of the home and so their purchase price is subsidized by various preferences for real estate.
What are these preferences, and how much do they cost?
Mortgage interest deduction. Homeowners can deduct mortgage interest and mortgage insurance premiums on their primary or secondary residences from their federal income taxes. Around a quarter of taxpayers claim the mortgage interest deduction. Taxpayers must itemize in order to claim it, and only businesses filing as individuals (i.e., not under the corporate tax code) may claim the deduction.
According to the Joint Committee on Taxation (JCT), the deduction for mortgage interest will cost $419.8 billion over five years, making it one of the most expensive tax expenditures in the tax code.
Deduction of real estate taxes. Taxpayers can deduct state and local property taxes if those taxes are “assessed uniformly at a like rate on all real property throughout the community.” The JCT estimates that this deduction will cost $184.5 billion over five years. This deduction acts as a subsidy to high property tax states such as California, New York, and Maryland, because the federal government effectively pays a portion of these taxes.
Exclusion of capital gains on sales of primary residences. Capital gains of up to $250,000 for individuals and $500,000 for married couples from the sale of an individual’s primary home are not taxed. According to the JCT, this provision costs $149.9 billion over five years.
Like-kind exchanges. The Internal Revenue Code allows property owners—regardless of tax status—to exchange one property for another and defer capital gains taxes on the sale of property under certain conditions. Cash and other assets may be part of the exchange. The properties must be similar (i.e., “like-kind”) and must be used for business or investment purposes. This enables sellers to avoid the transactions costs, including taxes, that come from the sale of real estate.
Real estate investment trusts (REITs). These are essentially mutual funds for the real estate industry. However, they are exempt from corporate tax if they distribute more than 90 percent of their taxable income to shareholders as dividends—an extremely valuable exemption. These dividends are also “qualified dividends,” meaning shareholders may pay the lower capital gains tax rate (20 percent top rate) instead of the ordinary income tax rate (39.6 percent top rate) on dividend income from REITs. An NBER paper by William Gentry, Deen Kemsley, and Christopher Mayer found that the tax preferences for REITs have a positive effect on the REITs’ value.
Low-income housing credit. Owners of buildings which rent units to low-income households can claim the Low Income Housing Tax Credit (LIHTC). Tax credits may be used for the “acquisition, rehabilitation, or new construction” of low income rental housing, according to the Department of Housing and Urban Development. Households with income below a set percentage of the median income in their area qualify as low-income. Rent for these households is capped. The exact numbers vary, as states have wide discretion to design their own LIHTC programs.
The JCT pegs the five-year cost of the program at $43 billion, with the vast majority of that claimed on corporations’ tax returns (not individuals’).
Americans are encouraged to invest more in real estate than they would otherwise. Americans do get something for the preferences—far better housing than is seen in the rest of world. Yet it has to be acknowledged that these preferences come at a cost—some empty office buildings and some second homes that have lost value. As with other tax preferences, the tax expenditure could better be put to use by lowering individual and business tax rates, encouraging work and investment in other areas.
Diana Furchtgott-Roth is a senior fellow and director of Economics21 at the Manhattan Institute. Follow her on Twitter here.
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