A Taxing Epiphany: An Unfortunate Defense of Loopholes

As I have been enduring these early not-so-glamorous-or-rewarding experiences of landlording -- which I think come to anyone who tries to do this and have more or less totally consumed all my free time and energy of late -- a sad epiphany has come to me.

I have long been an advocate that taxes be as simple and un-meddlesome as possible and have looked with absolute loathing upon attempts to carve out 'special privelege' by inserting 'deductions' into the tax code.  So, it is with much chagrin and a difficult and embarrassing wince that I must admit that I appear to be very wrong with respect to at least one 'deduction' -- interest.  It seems that, even though I very much dislike this conclusion, it is absolutely necessary that interest payments be deducted from income for the purposes of taxation, otherwise it appears that all hell breaks loose.  And if it is true for interest, it is likely true for many other expenses which I have yet to think through quite as thoroughly.

I arrived at this unfortunate conclusion because I finally realized that income received as rent from a property which must then be paid out to another party with an ownership stake in the property isn't actually income, at least in a strict sense.  Which is to say, according to the abstractions by which one understands the dynamics of the free-market.  So even though those annoying real estate gurus are always trying to sell people on the idea of leveraged investments in real estate by telling them that the interest is deductible, as if they were getting away with something by being in bed with government, actually, it could hardly be any other way.  It is actually a simple acknowledgement of the way things really are.  For once, it seems, the meddlesome bureaucrat eggheads have got something right.

The thinking goes something like this.  The property in question 'produces' various utilities -- shelter, comfort, security, etc. -- which are enjoyed by the occupant.  If the occupant does not own the property, then this utility is purchased through periodic 'rent' payments to the landlord.  Again, strictly speaking, it isn't quite proper to call this payment 'rent,' as rent refers purely to land, and as a dwelling is a heavily improved piece of land requiring maintenance and other costs, the payment actually contains a mixture of elements.  If anything, it would be more proper to call it 'interest,' since the landlord is acting mostly as a capitalist, curtailing his own consumptions and 'advancing' the use of the house to his tenant, so that the tenant does not have to pay for the entirety of the house at once.  The tenant only pays for time in the house -- for use of capital, a bit at a time -- which is the capitalist's interest income.

Therein lies the rub.  In the case of a leveraged investment, the capitalist does not possess full ownership of the asset.  A landlord with a mortgage does not fully own the house, he only possesses limited equity (there's that annoying word you always hear those know-it-all financial guys throwing around...).  So, the interest generated by the capital asset should only accrue to him in proportion to his equity.  The rest goes to the other owners -- in this case, the bank which is the mortgage holder.  And does, actually, except of course as the real rate of interest deviates from the money rate, as I talked about last time.

In an ideal world, this would all be simple enough to resolve by having the tenant write separate checks to each partial owner.  But this is not an ideal world, and the tenant writes only one check to the landlord.  The landlord then remits the bank's 'share' to the bank, the interest portion of which is the income of the bank and not merely an expense of the landlord.  

To count the interest as regular income of both the landlord and the bank would be to tax it twice.  This would probably be no big deal if income tax rates were on the order of, say, 2%.  It would be a rounding error.  But with marginal rates in the 20-30+% range, not to deduct this 'income' would be to shut down the housing market.

This conundrum makes me wonder if the whole notion of a 'flat tax' is nothing more than a ridiculous pipe dream -- for totally non-political reasons.  So long as the income tax is a non-trivial amount, there will necessarily have to be a maze of deductions and adjustments just to keep the economy moving.  Everyone realizes that it would be impossible to tax a business on its total receipts as if it were income, because obviously, income is total revenue minus expenses.  To tax the total money taken in would be a revenue tax -- a completely different animal.

If people are acting as businesses -- by renting houses, among other things -- it would seem that there would have to be deductions for expenses if there is to be an income tax.  Period.  Otherwise, it isn't actually an income tax.  I don't see any way around it, other than a name change.

So...  now who's on board with a national sales tax?