NYU Stern Professor Joshua Ronen and Colleague Julius Cherny Offer Market Solution to the Financial Meltdown

We fear that the government's attempts to solve the "financial and economic crises" are addressing the shadows on the cave wall rather than focusing on the source of the problem.  In short, the financial problem is declining prices for houses, and the related economic problem is the shrinking housing construction sector. We believe both can be solved in a straightforward way by allowing homeowners to deduct depreciation expense from their capital income.

Whether the IRS enacts a new rule or Congress passes a law, by allowing this depreciation deduction from homeowners’ taxable income, similar to what a business is allowed to take on buildings that it owns, there would be an immediate and positive impact on housing prices and on securities backed by home mortgages.  With this proposal, defaults and foreclosures would decrease without the need for immediate funding by the Treasury.  

The proposed tax reform should have at least three significant positive impacts. First, it should raise the nominal price of homes while reducing the effective price of homeownership. This consequence should bolster the value of the existing mortgages and by implication the securities backed by mortgages. This result would convert "toxic" assets into profitable ones with the added benefit of making them liquid. Second, the proposal would make home ownership affordable to those individuals that currently can’t find themselves unable to undertake home ownership. Third, the boost to the economy and job creation from the reinvigoration of  home building and related industries should offset, in part or in whole, the costs to the government from the tax deductions.

The new rule/law would allow homeowners to sell their depreciation and interest deductions if they were of little or no value on their tax return.  The sales of these deductions would be of considerable help to homeowners in the low income group that are at risk of defaulting on their mortgages.  Furthermore, the new rule/law could stipulate that the tax savings or cash received from the sale of these deductions could be used only to pay off the mortgage through direct payments to the mortgage holder.  Additionally, these deductions could cover homes purchased for a specific period of time, say from 2003 to 2013.

Depreciation expense will reduce only the tax basis of the home; when the home is sold, the difference the basis and the proceeds from the sale should be taxable at the capital gains rates.  Allowing depreciation as well as interest expense to be deductible   makes economic sense.  If home ownership is considered to be a worthwhile social objective, then this proposal would promotes it.

Given that the rule/law would also be prospective, it should also have a major positive impact on the housing construction sector.  Home builders would have incentives to notify customers of the potential tax benefits from the sale of the tax deductions. By lowering the effective price of the home through the sale of deductions, homeownership would become more affordable.  Home builders would be able to liquidate their large inventory overhang. Going forward, home builders would, more than likely, enjoy a growing market for affordable homes, giving a major boost to a critical segment of the economy.

We can assume that the mortgage/securities holders would have a substantial incentive to notify the delinquent mortgagees of the benefits of the sale of the tax deductions and would also have an incentive to offer a tax saving product to higher income individuals and business clients.  We also can envision that a market for these deductions where buyers and sellers could transact. This resulting market could generate significant revenue for banks and Wall Street firms at a time when it is most needed.  Accountants, lawyers, tax preparers and estate planners might also be interested in the purchase and sale of these deductions.

Declining home prices triggered the financial crisis; increasing home prices through tax policy is the solution. Overall, our proposal is a market solution to a complex problem.  All of the mechanisms and incentives already exist to achieve the results enumerated above without direct government intervention. Tax policy is an instrument frequently used by the government to re-align incentives and create new ones.  A tax policy approach should be preferred to one based on direct government intervention in the financial system.

Julius Cherny: Lecturer at Baruch College, CUNY.  Dr. Cherny’s professional career spans more than fifty years during which he has held senior positions in Wall Street and well as the accounting profession, and has been an adjunct professor and lecturer.

Joshua Ronen: Professor at the Stern School of Business, NYU. Professor Ronen is widely published in the accounting and economics literature, and while serving in the past as a director of a research institute at the Stern School has hosted several conferences on tax policy. He has also served as a president and research director of a national institute devoted to the study of entrepreneurship.