Inflation, Income Taxes, and Owner-Occupied Housing

Owner-occupied housing receives favorable treatment under current tax law for several reasons. A homeowner's imputed rent is not taxed, and mortgage interest payments are tax deductible. Many past studies have analyzed the effects of these provisions. Inflation's importance in determining the implicit subsidy to owner-occupied housing has received less attention. Since home- owners can deduct their nominal mortgage payments, they do not bear the full cost of higher interest rates. They also receive essentially untaxed capital gains on their homes during periods of high inflation. The after-tax capital gains outweigh the higher after-tax interest payments, so inflation reduces the effective cost of homeownership. This paper develops a simple model to estimate the effect of higher expected inflation rates on the real price of houses and the equilibrium housing stock. Simulation results suggest that the inflation-tax interactions can have a substantial impact on the housing market. The increases in expected inflation during the 1970s could have accounted for as much as a thirty percent increase in real house prices. Over time, builders should respond to higher home prices and increase the amount of new construction. The persistence of current inflation rates could lead ultimately to a twenty percent increase in the housing stock.