Tax Deductions

    

Many do not understand the rationale behind some of the proposals in the new Republican tax reform bill. In particular, let’s look at two of the most significant changes: the removal of the deduction for interest paid on home mortgages, and the removal of the deduction for state and local income and property taxes.

Proponents of the reform argue that the removal of the deductions is a matter of fairness and simplicity. One commentator argued that only 5% of taxpayer’s actually use the deductions, and that the rest of the taxpayers just use the “standard” deduction which will be doubled in the proposed plan. In addition, residents of states that do not have a state income tax derive no benefit from the deduction of state income taxes.

Also, these tax deductions are worth a lot more to high income taxpayers than to the majority of the population. A $10000 tax deduction saves a taxpayer in the 35% bracket about $3500, but a taxpayer in the 15% bracket only saves $1500. These deductions mainly benefit the upper middle classes.

But those living in wealthy states like California, New York, and Connecticut are up in arms at the reform proposals. Even though these are “blue” states that usually vote Democratic, their leaders seem not to care that the deductions benefit the well-to-do more than anyone else. Politicians from these states are the most strident critics of income inequality, but they now find themselves supporting tax deductions that primarily benefit their upper middle class constituents.

New home builders, realtors, and others complain that the elimination of the mortgage interest deduction will depress the housing market. Here’s the reasoning. When most people decide to purchase a home, they have to consider what they can afford to pay every month. Most of the bill will be made up of the mortgage payment and the real estate tax that is usually paid by the bank that handles the mortgage.

So, if a potential homeowner with a $100000 annual income can pay 24% of that income ($24000 per year) for housing cost, he could either pay a rent of $2000 per month, or a mortgage payment of $2000 per month. But since the great part of the mortgage payment is currently tax deductible, his after tax cost will be less that $2000 per month. What he saves in taxes could theoretically be spent on home improvement, a car payment, or whatever.

But he could also say that because the mortgage payment is deductible, he could afford a more expensive home to begin with. This is one of the reasons why we see smaller, older homes being knocked down all over, and replaced by mega-mansions. On my own street an old eighteenth century farmhouse with a vacant building lot was recently knocked down and replaced by two very large five bedroom homes that both went on the market for around $900000. One was bought by a single man who apparently moved to Connecticut because his property taxes in New York’s Westchester county were too high.

It is true then that the deductibility of home mortgage interest and property taxes have inflated the cost of homes. But while that has benefited higher income earners, it has also priced many members of the middle class out of the market for new homes. For most people, the increase in the standard deduction, as well as the lower tax rate will offset the loss of the tax deductions.

For example, under the current system a single taxpayer reaches the 25% tax bracket on income over $37950. Under the proposed plan, the 25% bracket is reached on income over $45000. The numbers are doubled for a married couple filing jointly. Again, for most people the increase in the standard deduction to $12000 or $24000 will further obviate the need to itemize deductions on the tax return and make the filing process so much simpler.

Ironically, the elimination of the home interest and local tax deductions will have no impact on the very wealthy. Under the current system these deductions have already been phased out for those making over $400000 per year.

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