California proposal to convert vacation home subsidy to low-income housing one

AB 71 introduced in California for the 2016-2017 session, proposes to repeal the deduction for mortgage interest on a second home (usually a vacation home) and use the savings (and apparently other funds) for low-income housing.

Some people may be surprised to learn that you can deduct interest on a mortgage on a second home. We can find some logic, perhaps, in deducting interest on a mortgage on your principal residence because we think the tax law is encouraging home ownership. But, why would it subsidize/encourage debt on a second home?

The "logic" is mainly historical. Back in 1913 when our modern federal income tax began, all interest expense was deductible. In 1986/1987, to help pay for lower rates, Congress repealed the deduction for personal interest (such as on credit card debt), and limited the mortgage interest deduction to just two home (principal and second) and limited the debt to $1.1 million (which is a lot of debt, even today in California).

Most states follow the federal rules.

The deduction is only available if you itemize your deductions. Only about 30% of individual itemize.  At the federal level, the "cost" of the mortgage interest deduction is about $80 billion per year! (of course, most of this cost is for the deduction related to mortgages on principal residences, not vacation homes).  That is one of the largest costing tax breaks, yet only benefits less than 30% of individuals (not all itemizers have a mortgage).  This is more than the federal government spends on low-income housing.

Several principles of good tax policy support repeal of the interest deduction on a second home. First, equity. This deduction is mostly claimed by higher income individuals (see April 2013 paper of Eric Toder). After all, who can afford a second home (although some use it to buy an RV)? Why subsidize this non-necessity?  Neutrality and economic efficiency are also violated.  The mortgage interest deductions has been shown to result in higher income individuals buying a more expensive home. Thus, the deduction favors housing investment rather than investment in other areas, such as businesses.

So, interesting proposal.  I would suggest a few changes though:

1. Instead of outright repeal, phase-out the deduction over two to three years to address the issue that many of the borrowers made decisions assuming they would get a tax deduction.
2. Do not earmark the savings from elimination of the deduction for interest on a second home. That just ties the hands of the lawmakers. The funds should go to the General Fund to be used for various state needs - including low-income housing.

One more area where lawmakers can help low-income housing ... Federal tax reform will most likely include repeal of the low-income housing credit to help pay for lower tax rates. Well, state and local governments are indirect beneficiaries of this tax credit. They should ask Congress to use some of the tax savings as a transfer to state and local governments for low-income housing projects.

What do you think?