A quarter-century ago, only someone in desperate need of cash would take a second mortgage. Then Congress changed the tax rules, and today, millions of Americans have “home equity” lines.
Banks are losing $30 billion a year on these products, and untold thousands of families stand to lose their homes to foreclosure. Is this another example of a law’s unexpected consequences? Nope. This outgrowth of the Tax Reform Act of 1986 was perfectly foreseeable, and in fact, foreseen. But, then as now, Congress tended to tune out warnings that it preferred not to hear.
Prior to the tax reform, taxpayers could deduct nearly any sort of interest expense, including interest on credit card balances, automobile loans, and life insurance loans. After the tax reform, nearly all non-business interest expense was no longer deductible.
But a few exceptions remained. The most important was (and is) that taxpayers still can deduct the interest on up to $1 million of mortgage debt incurred to buy or improve a principal residence or a vacation home. The real estate industry lobbied hard to keep this benefit in the law.
The tax reform law also preserved a benefit for second mortgages. Taxpayers are permitted to deduct interest payments on up to $100,000 of debt, regardless of the purpose for which the debt is incurred, so long as they put their home up as collateral. The Internal Revenue Service explains: “Generally, home mortgage interest is any interest you pay on a loan secured by your home (main home or a second home). The loan may be a mortgage to buy your home, a second mortgage, a line of credit, or a home equity loan.” So, even if you plan to use the money for a big screen TV or a vacation, if you borrow against your home, you can take the deduction.
In recent years, many home equity lines of credit have greatly exceeded the $100,000 cap. Interest on the excess debt is nondeductible. However, the government has no easy way to know the size of the loan on which the interest is being paid. Over more than two decades in the tax business, neither I nor any of my co-workers have ever been asked to demonstrate that the interest deductions claimed on a tax return are for a loan within the allowable limits. We follow the law anyway, but we can safely assume that many taxpayers do not, either out of ignorance or otherwise. In practice, therefore, taxpayers can end up taking deductions for interest expense on debt well above the limits.
I was just getting into the tax business when the Tax Reform Act of 1986 passed. The rule on interest deductions made no sense to me, so I asked the experienced CPAs who were training me to explain it. It turned out the exception made no sense to them, either. Why would the government want to encourage an explosion of second mortgages, a term once used somewhat derisively? Wouldn’t the rule just prompt people to get into debt over their heads and then lose their homes? The answer was that it would, and it did.
The popularity of home equity debt soared. By 2008, the value of outstanding home equity loans had risen to more than $1 trillion, from around $1 billion in the early 1980s. Banks did their part to promote the trend, rebranding second mortgages with the more positive terms “home equity loan” and “home equity line of credit.”
“Calling it a ‘second mortgage,’ that’s like hocking your house. But call it ‘equity access,’ and it sounds more innocent,” Pei-Yuan Chia, a former vice chairman at Citicorp who oversaw the bank’s consumer business in the 1980s and 1990s, explained to The New York Times in 2008. High property values allowed borrowers to take on large amounts of debt, using their homes as collateral.
Then the recession came, real estate values plunged, and many borrowers were suddenly unable or unwilling to make their payments. Because of the collapse of the housing market, the homes that lenders held as security had, in many cases, lost their value. Borrowers who were unable to pay off the loans by selling their homes frequently had no choice but to default, leaving banks with the often impossible task of collecting the outstanding debt. In 2009, lenders had to write off $11.1 billion in home equity loans and $19.9 billion in home equity lines of credit as uncollectible. Borrowers lost their homes and emerged with damaged credit histories.
Congress claims to be shocked that such a thing could happen, and yet it was absolutely predictable. People did exactly what the tax code encouraged them to do. The system worked just how it was supposed to, but the tax code was encouraging people to behave in a way that, in the end, was bad for them and bad for the country.
To Form 1040 jockeys like me, the only shocking thing is that it took so long for the house of cards to fall.