The real tax subsidy for homeowners has nothing to do with mortgage interest

The federal tax code rather famously subsidizes debt-financed home buying by making mortgage interest payments tax-deductible. This almost certainly does not achieve its stated policy objective of encouraging home ownership, but probably does subtly encourage Americans to live in larger houses than we otherwise would. But as Prashant Gopal writes for Bloomberg, the mortgage interest tax break ain’t what it used to be, with interest rates now far lower than they were a generation ago.

Consequently, in most cases this deduction is no longer worth very much.

Which is just as well, because the truth is that the real tax break for homeownership in the United States has nothing to do with interest. It’s the total non-taxability of what economists call “imputed rent” — the rent that homeowners collect from themselves in their capacity as their own landlord. It’s a slightly mind-bending idea, but once you understand it you’ll see that it’s a big deal.

Consider two people, Jose and Eliana. Jose bought a house in Chicago but has since moved to Philadelphia for work. Conveniently, Eliana owned a home in Philly but then moved to Chicago for work.

Jose pays Eliana $15,000 a year in rent to live in her house in Philadelphia, and Eliana pays Jose $15,000 a year in rent to live in his house in Chicago.

Now both Jose and Eliana are landlords, and they both need to report $15,000 in rental income to the IRS — likely paying a 25 percent marginal tax rate on the proceeds.

Fortunately, Jose reads Vox.com and comes up with a better idea. Rather than each paying the other $15,000 a year and then handing over $3,750 to the government, they could each just quietly allow the other one to live rent-free. Jose and Eliana each still live in a home that is worth $15,000 a year to live in. And they each still own a home that generates $15,000 a year of income. But because no money is changing hands, they each get to avoid $3,750 in taxes that would be paid on an explicit exchange.

This is basically the situation that every owner-occupied home in America is in. In my capacity as landlord, I allow myself to live rent-free in my own home rather than explicitly charging myself rent that would be taxed as income.

The particulars of the Jose and Eliana scenario are a bit weird, but it illustrates a larger point: If you own a home in the United States, it really pays to live in it rather than to use it as an income-generating asset that helps you afford to rent to live somewhere else.

A handful of countries — Iceland, Luxembourg, the Netherlands, Slovenia, and Switzerland — among OECD members attempt to tax this imputed rental income. In those places, tax write-offs for mortgage interest make sense. In effect, it’s treated as a business expense. But in the US, you get to write off the business expense without paying taxes on the revenue.

If we switched to the Swiss model, we would still have plenty of homeowners, but at the margin it would make a real difference.