JLARC > JLARC Reports > 2015 Tax Preferences > Interest on Real Estate Loans

JLARC Preliminary Report: 2015 Tax Preference Performance Reviews

Interest on Real Estate Loans | B&O Tax

The Preference Provides Tax Type Est. Beneficiary Savings in 2015-17 Biennium
Banks and other financial institutions may receive a business and occupation (B&O) tax deduction for the interest they receive on loans for residential property. B&O
RCWs
82.04.4292;
82.04.29005
$49.8 million
Public Policy Objective
The Legislature did not state a public policy objective.  JLARC staff infer the objectives were to:
  • Stimulate Washington’s residential housing market by making loans available to home buyers at lower cost; and
  • Limit the tax preference to “community banks.”
Recommendations
Legislative Auditor Recommendation: Review and Clarify

Because:

  • The application of different definitions for “community bank” changes the pool of lenders who qualify for the preference; and
  • The original inferred public policy objective of stimulating the residential housing market may no longer apply given the changes in the lending industry and the rise of the secondary mortgage market.
Commissioner Recommendation: Available in October 2015

Banks and other financial businesses may receive a business and occupation (B&O) tax deduction for the interest they receive on loans for residential property.  Three factors determine whether the business may receive the deduction:

  • It must be a qualifying loan
  • From a qualifying lender
  • For qualifying property

Qualifying loans

The loan must be primarily secured by a first lien mortgage or a trust deed.  The borrower may use the loan to purchase property such as a home but may also use it for other purposes such as home improvement or refinancing.

Qualifying lenders

The bank or other financial business making the loan must be located in 10 or fewer states.  Being located in a state means the business or an affiliate must:

  1. Maintain a branch, office, or one or more employees or representatives in 10 or fewer states; and
  2. This state presence must allow borrowers to contact the branch, office, employee, or representative concerning mortgage loans.

Commercial banks, savings and loans associations, and savings banks (referred to collectively as “banks” in this review) qualify as financial businesses eligible for the deduction.  Credit unions have a full exemption from B&O tax under a different preference that JLARC staff reviewed in 2011.

Mortgage companies also qualify if they are classified as “a lending mortgage broker” that uses its own funding source to advance funds to the borrower and bears the risk of interest rate fluctuations.  A mortgage broker that acts as an agent for the lender does not qualify.

Qualifying property

The loan must be for “non-transient residential property” in Washington.  This includes property such as homes, apartments, and construction of residential property.  It excludes property such as hotels and motels.  Exhibit 1 below provides more examples of what property qualifies and what does not.

Exhibit 1 – What Property Qualifies and Does Not Qualify for the Mortgage Interest Deduction?
Qualifies Does Not Qualify
Single family residences Permanent care nursing homes or convalescent homes
Apartments Hotels or motels
Construction of residential property, including trailer park sites Transient apartments where occupants stay less than 30 days
Farmland where the value of the residential structure exceeds the land value Churches
Source: JLARC staff analysis of tax law.

The Legislature attempted unsuccessfully to tax the income of national banks in 1929, 1933, and 1935.  In all three instances, the courts found the tax to be in violation of the U.S. Constitution.  The Legislature consequently decided it would not tax state banks.  As a result, Washington exempted from B&O taxation all bank income of any kind.

1969

Congress reversed long-standing prohibitions and allowed states to tax national banks, but not federally chartered credit unions.

1970

The Legislature repealed the B&O exemption for national and state banks and certain other financial institutions.  In the same bill, the Legislature provided specific deductions to maintain the tax status of certain financial income, such as income covered by this tax preference.

Following enactment of the 1970 statute, the Department of Revenue (DOR) and stakeholders engaged in 40 years of administrative appeals and litigation on the tax preference.  For the most part, subsequent rulings expanded the scope of the deduction.  For a more detailed discussion, see the review of “Interest on Real Estate Loans,” conducted by JLARC staff in 2011.

2010

The Legislature codified many of these previous rulings and clarified which points, loan servicing fees, and other fees may be included when calculating the deduction.

2011

JLARC staff reviewed the B&O tax deduction for first lien mortgage interest and inferred that the 1970 public policy objective was to stimulate the residential housing market by making residential loans available to home buyers at lower cost.  The Legislative Auditor recommended the Legislature review and clarify this objective because it may no longer apply given changes in the lending industry.  An example of a change in the lending industry is the growth in the secondary market for “securitized” mortgages (see Other Relevant Background tab for an explanation of “securitized” mortgages).

2012

In a larger bill to raise tax revenue, the Legislature indicated it wanted to limit the pool of qualifying lenders to “community banks.” The issue remained how to identify a “community bank” in a manner that did not violate the Commerce Clause of the U.S. Constitution.  The Legislature chose to narrow the deduction to apply only to lenders located in 10 or fewer states.  The Department of Revenue advised the Legislature that limiting the deduction in this manner would likely be in conformance with the Commerce Clause.  The change was effective July 1, 2012.

The Legislature also included a requirement that JLARC conduct a second review of this deduction in 2015.

2014

The Washington Supreme Court confirmed in Cashmere Valley Bank v. Department of Revenue that interest from investments on “securitized” mortgages sold on the secondary market are not primarily secured by real estate and are not entitled to the deduction.

Portfolio Versus “Securitized” Mortgages

When a home buyer borrows money from a lender to purchase a home, the borrower gives the lender a mortgage on the home as security for the loan.  The lender then decides what to do with that mortgage.

  1. The lender may retain the mortgage in its portfolio;
  2. The lender may sell the mortgage to a buyer who receives the right to principal and interest payments on the loan and the right to foreclose on the loan if the borrower fails to make payments; or
  3. The holder of the mortgage (the originating lender or the buyer) may also choose to “securitize” a number of mortgages by pooling and packaging them into securities that are sold to investors on the secondary market.

Up until the mid-1980s, banks generally operated within local regions, soliciting deposits and making loans in their communities.  Banks held mortgages in their own portfolios until the loans were paid off.  The banking industry changed in the mid-1980s with the changes in regulatory laws allowing interstate branch banking and with the rise in the secondary mortgage market.  In the current environment, most lenders sell their mortgages within a year of origination, but others may retain mortgages for various reasons.  One reason is that the loan might fail to qualify under federal guidelines to be resold on the secondary market.  Borrowers seeking loans that don’t qualify to be resold on the secondary market must find lenders willing to retain the mortgage in their portfolios.  Some Washington banks retain 100 percent of their mortgages.

The Extent of the Preference the Lender Receives Depends on the Lender’s Choice to Retain or Sell the Mortgage

A lender’s choice whether to retain or sell a mortgage determines how that lender will benefit from the preference:

  • Lenders that retain mortgages in their own portfolio may deduct the entire interest payment over the life of the loan.
  • Other financial businesses that purchase mortgages may deduct the entire interest payment as long as the mortgage is not securitized.
  • Lenders that sell mortgages in the secondary market receive the deduction on only a portion of the interest payment.  They may deduct points and origination fees that are recognized over the life of the loan and servicing fees that are based on a percentage of the loan interest.

The amount of the exemption that a lender receives may influence the extent to which a lender passes on those savings to a home buyer in the form of a lower-cost loan.  For example, a lender that is able to deduct the entire interest payment over the life of the loan may be in a better position to offer a home buyer a lower-cost loan than a lender that can deduct only a fraction of the interest payment.

What are the public policy objectives that provide a justification for the tax preference? Is there any documentation on the purpose or intent of the tax preference?

The Legislature did not state the specific public policy objective of this tax preference when it created the deduction in 1970.  JLARC staff infer that the original objective was to stimulate Washington’s residential housing market by making loans available to home buyers at lower cost.

In 2012, the Legislature narrowed the deduction to apply to certain types of lenders (those located in 10 or fewer states) and stated its objective to limit the tax preference to ‘community banks.’” In testimony supporting the 2012 legislation, the prime sponsor stated that community banks provided benefits to the local community that large banks do not.  The prime sponsor described a “community bank” as a Washington-based bank:

“[There is] a bank in my district that never sold second mortgages [sold mortgages on the secondary market] and never laid off people even during the depression.  Yet, their [FDIC] taxes have increased because of the need to pay off bad players.  I am not sure why we should not exempt or carve out good players in our state that are home-grown Washington state business.”

Bank representatives testified on a 2011 bill to modify the tax preference that limiting or terminating the deduction would have an impact on portfolio lenders.  They stated that portfolio lenders might need to increase interest rates or decrease residential loans in the future.  They indicated that terms of loans already in place could not be restructured to adjust for the loss of the deduction.  This testimony implies that the portfolio lenders were incorporating the exemption in the structuring of their loans.

In the 2011 review, the Legislative Auditor recommended that the Legislature review and clarify the first mortgage interest deduction given changes in the lending industry.  In the 2012 bill amending the preference, the Legislature identified the type of lenders it intended to benefit.  By limiting the preference to community banks, the Legislature may have been trying to achieve the original public policy objective of stimulating Washington’s housing market by targeting lenders that could pass on the benefits to home buyers through lower cost loans.  However, when the Legislature modified the statute to narrow the beneficiaries in 2012, it did not explicitly clarify the overall policy purpose for the underlying preference.

What evidence exists to show that the tax preference has contributed to the achievement of any of these public policy objectives?

It is unclear whether the preference is meeting the inferred objective.

The Legislature may have tried to limit the deduction to community banks because it anticipated that community banks are more likely to retain their mortgages and use principal and interest payments to make new loans in the local community.  Lenders that retain mortgages benefit from the preference over the life of the loan and could choose to pass these savings on to home buyers.  The availability of lower-cost loans might then stimulate Washington’s residential housing market.

JLARC staff analyzed evidence based on the assumption the tax preference would have a greater likelihood of impacting Washington’s housing market if:

  • Mortgages are retained in the lender’s portfolio rather than sold;
  • Loans are used for purchasing homes instead of other purposes such as refinancing; and
  • Changes in Washington’s housing market are driven by local factors and not national trends.

Are Mortgages Retained or Sold?

More than two-thirds of mortgage amounts are sold.  JLARC staff analyzed detailed data on mortgages originated in Washington.  In 2013, qualifying lenders (those located in 10 or fewer states) retained an average of 29 percent of their first lien residential mortgage amounts within the year after loan origination.  Exhibit 2 below shows that the percentage of mortgage amounts sold varied by the type of lender – bank or mortgage company.  Data is for lenders that operate in 10 or fewer states.

Exhibit 2 – 33% of Bank Loans and 5% of Mortgage Company Loans Are Retained (Loan Amounts for 2013)
Type of Loan Banks
Loans
Mortgage Company
Loans
Total
All WA Loans $14.5 billion $2.3 billion $16.8 billion
WA Loans Retained in
Originating Lender’s Portfolio
$4.8 billion $121.0 million $4.9 billion
Percent Retained by
Qualifying Lenders
33% 5% 29%
Source: JLARC staff analysis of Federal Financial Institutions Examination Council (FFIEC) Call and Thrift Reports, and Home Loan Disclosure Act data.

Are Loans Used for Purchasing Homes?

For the period 2007 to 2013, the percentage of qualifying loan amounts used for home purchases ranged between 26 and 47 percent.  Qualifying loans can be used for other purposes such as home improvement or refinancing.  Loans borrowed for these other purposes ranged from 54 percent to 74 percent of Washington loans originated by qualifying lenders over the same time period.  It is unclear whether refinancing loans or home improvement loans contribute to the inferred public policy objective of stimulating the residential housing market.

Are Trends in Washington’s Housing Market Driven by Local Factors?

Washington housing starts follow national trends, making it less likely that the state’s tax policy can have an influence on the sale of residential mortgages in Washington.  Exhibit 3 below shows that over the years 1970 through 2013, Washington housing starts follow the same pattern of peaks and troughs as national housing starts.

Exhibit 3 – Changes in Washington Housing Starts Follow National Trends Calendar years 1970-2013
Source: JLARC staff analysis of U.S. Census, Building Permit Survey.

To what extent will continuation of the tax preference contribute to these public policy objectives?

To the extent a lender retains its mortgages and to the extent this lender passes on the cost savings from the tax preference to the home buyer, the tax preference lowers the cost of Washington loans.  However, the effect of these cost savings on loan availability and on stimulating Washington’s overall housing market is less likely given that housing markets appear to follow national trends and do not appear to be driven by local factors.

If the public policy objectives are not being fulfilled, what is the feasibility of modifying the tax preference for adjustment of the tax benefits?

In the testimony supporting the 2012 legislation, the prime sponsor referenced home-grown Washington state businesses and banks that never sold mortgages on the secondary market.  DOR counseled the Legislature that limiting the deduction to banks headquartered in Washington would violate the Commerce Clause of the U.S. Constitution, and the Legislature chose to limit the deduction to financial businesses operating in 10 or fewer states.

With this review, the Legislature now has information on the institutions that made loans that qualify for the preference following the 2012 law change and the amount of loans these institutions retained.  If this is not the beneficiary pool the Legislature anticipated when it narrowed the preference, there are other ways to focus the preference that may not violate the Commerce Clause.  Options include adopting either of two federal definitions of “community bank,” or the Legislature could focus on loans that are not sold on the secondary market, but that are instead retained in the lender’s portfolio.  See the “Unintended Benefits” section under the Beneficiaries tab for more detail.

Who are the entities whose state tax liabilities are directly affected by the tax preference?

Beneficiaries of the tax preference are commercial banks, savings and loan associations, savings banks, and certain mortgage companies.

As shown in Exhibit 4 below, from publicly available data JLARC staff estimate that in 2013, a total of 204 banks and 48 mortgage companies made loans that met the criteria to qualify for the preference.

Exhibit 4 – Estimated 204 Banks and 48 Mortgage Companies Made Loans That Met the Criteria to Qualify for the Mortgage Interest Deduction (2013 Data)
Type of Mortgage Lender Number of Institutions
Banks 204
Mortgage Companies 48
Total 252
Source: JLARC staff analysis of Federal Financial Institutions Examination Council (FFIEC) Call and Thrift Reports, and Home Loan Disclosure Act data.

To what extent is the tax preference providing unintended benefits to entities other than those the Legislature intended?

In 2013, based on publicly available data 252 lenders made qualifying loans and met the current criterion for “community bank” (operating in 10 or fewer states).

If the Legislature wants to review how to focus the preference on community banks, below are three other options that may avoid the Commerce Clause concerns raised in 2012:

  1. The Federal Reserve Board (FRB), with supervisory responsibility over a number of commercial banks, thrifts, and bank holding companies, defines a “community bank” for regulatory purposes as a banking organization with assets of $10 billion or less.
  2. The Federal Deposit Insurance Corporation (FDIC) defines a “community bank” for research purposes using a number of factors associated with the services they provide.  According to FDIC, “community banks tend to be relationship lenders, characterized by local ownership, local control, and local decision making.” Among the factors that FDIC uses to define a community bank are asset size, loan to asset ratio, core deposits to asset ratio, number of total offices, and number of states with offices.
  3. The Legislature could focus its definition of “community bank” on portfolio lenders, that is, lenders that retain a threshold portion of their mortgages in their own portfolios for the duration of the loans.

Note that the two federal definitions of “community bank” exclude mortgage companies.  A focus on portfolio lenders would not exclude mortgage companies by definition.  However, the earlier analysis showed that mortgage companies retained only 5 percent of their loan amounts in 2013.

Exhibit 5 below provides summary information comparing the number of lenders using the current statutory criterion for “community bank” with the number of lenders meeting alternative definitions listed above.

Exhibit 5 – Alternative Definitions Would Focus the Pool of Lenders Qualifying For the Mortgage Interest Deduction (2013)
Alternative Ways to Identify a “Community Bank” Number of Lenders Value of 1st Lien
Residential Mortgage
($Thousands)
Bank
Current 10-State Statutory Criterion 204 $14,477,792
Federal FRB Definition of Community Bank 168 $5,762,401
Federal FDIC Definition of Community Bank 138 $3,086,100
Portfolio Lender retains:
  1. At Least 50% of Loan Portfolio
89 $2,656,644
  1. 100% of Loan Portfolio
69 $1,486,014
Mortgage Company
Current 10-State Statutory Criterion 48 $2,334,795
Portfolio Lender retains:
  1. At Least 50% of Loan Portfolio
2 $75,091
  1. 100% of Loan Portfolio
2 $75,091
Source: JLARC staff analysis of Federal Deposit Insurance Corporation (FDIC) Community Bank Study Reference Data, Federal Financial Institutions Examination Council (FFIEC) Call and Thrift Reports, and Home Loan Disclosure Act data.  Mortgage companies do not meet either federal definition of a “community bank.”

Using publicly available data, Exhibit 6 provides the same information for each of the 252 qualifying institutions.

Click on any column heading to sort the information.

Exhibit 6 – Institutions with Loans Qualifying for the Mortgage Interest Deduction in 2013 – Would They Meet Alternative Definitions of “Community Bank”? (Loan Amounts in $Thousands)
Institution Name (State)     WA 1st Lien
Residential Loans
Asset Size
$10B or Less

(FRB Regulatory Definition)

Community
Bank

(FDIC Research Definition)

Amount of
Loans Retained
Percent Retained
in Lender Portfolio
Homestreet Bank (WA) $3,142,428 No No $568,109 18%
Sterling Savings Bank (WA) $2,318,184 No No $636,875 27%
Flagstar Bank (MI) $1,022,878 Yes No $46,232 5%
Washington Federal (WA) $670,060 No No $670,060 100%
USAA Federal Savings Bank (TX) $626,050 No No $34,604 6%
Union Bank, N.A. (CA) $490,413 No No $479,407 98%
Peoples Bank (WA) $474,295 Yes Yes $99,552 21%
Banner Bank (WA) $431,660 Yes No $122,561 28%
Umpqua Bank (WA) $331,749 No No $82,666 25%
Everbank (FL) $308,455 No No $63,897 21%
Washington Trust Bank (WA) $261,649 Yes No $116,353 44%
1st Security Bank of WA (WA) $259,359 Yes Yes $33,710 13%
Cole Taylor Bank (IL) $253,673 Yes Yes $12,085 5%
The Bank of the Pacific (WA) $251,488 Yes Yes $37,328 15%
AmericanWest Bank (WA) $219,789 Yes No $73,993 34%
Morgan Stanley Private Bank (NY) $184,189 No No $163,573 89%
Colorado Federal Savings (CO) $172,184 Yes No $5,164 3%
Whidbey Island Bank (WA) $163,543 Yes Yes $32,333 20%
Ally Bank (UT) $142,851 No No $35,258 25%
Cashmere Valley Bank (WA) $139,234 Yes Yes $60,599 44%
Opus Bank (CA) $120,768 Yes No $119,328 99%
Timberland Bank (WA) $115,773 Yes Yes $45,820 40%
Sound Community Bank (WA) $114,362 Yes Yes $41,377 36%
Luther Burbank Savings (CA) $111,504 Yes No $111,504 100%
Yakima Federal S&L (WA) $110,940 Yes Yes $110,940 100%
Glacier Bank (MT) $94,491 Yes No $9,242 10%
Columbia State Bank (WA) $92,655 Yes No $92,655 100%
First Federal Savings Bank (WA) $75,335 Yes Yes $40,731 54%
First Savings Bank Northwest (WA) $70,337 Yes Yes $70,337 100%
Heritage Bank (WA) $69,971 Yes Yes $63,185 90%
State Farm Bank (IL) $68,183 No No $39,735 58%
Farmers Bank & Trust Company (KS) $64,154 Yes Yes $2,563 4%
Olympia Federal S&L (WA) $60,150 Yes Yes $60,150 100%
UBS Bank, USA (UT) $56,028 No No $56,028 100%
East West Bank (CA) $52,974 No No $52,974 100%
OneWest Bank (CA) $51,028 No No $205 0%
First Republic Bank (CA) $50,918 No No $45,750 90%
Inland Northwest Bank (WA) $50,818 Yes Yes $7,520 15%
North American Savings Bank (MO) $49,331 Yes Yes $1,918 4%
National Bank of Kansas City (KS) $47,284 Yes Yes $843 2%
Seattle Savings Bank (WA) $45,598 Yes Yes $0 0%
Bofi Federal Bank (CA) $45,588 Yes No $14,876 33%
BNC National Bank (AZ) $45,507 Yes Yes $255 1%
Beech Street Capital LLC (MD) $45,382 No No $0 0%
Riverview Community Bank (WA) $40,566 Yes Yes $17,160 42%
Baker Boyer National Bank (WA) $37,440 Yes Yes $3,758 10%
Proficio Bank (UT) $35,394 Yes Yes $935 3%
Kitsap Bank (WA) $30,027 Yes Yes $14,018 47%
Third Federal S&L (OH) $29,471 No No $29,471 100%
Banc of California, NA (CA) $27,710 Yes No $130 0%
BNY Mellon, N.A. (PA) $26,441 No No $25,291 96%
Charles Schwab (NV) $26,430 No No $26,430 100%
Colonial Savings (TX) $26,183 Yes Yes $1,752 7%
Willamette Valley Bank (OR) $25,289 Yes Yes $0 0%
Pacific Crest Savings Bank (WA) $24,908 Yes Yes $24,908 100%
Coastal Community Bank (WA) $23,065 Yes Yes $23,065 100%
Grand Bank (NJ) $21,864 Yes Yes $4,767 22%
First Internet Bank of Indiana (IN) $21,268 Yes Yes $1,333 6%
Mariner Bank (MD) $21,138 Yes Yes $486 2%
Anchor Savings Bank (WA) $20,260 Yes Yes $14,182 70%
Capital One, NA (VA) $20,223 No No $12,356 61%
Kansas State Bank Of Manhattan (KS) $20,035 Yes Yes $0 0%
Boston Private Bank & Trust (MA) $18,207 Yes No $0 0%
The Federal Savings Bank (KS) $16,741 Yes Yes $749 4%
Goldman Sachs (NY) $16,552 No No $16,552 100%
Peoples Bank (KS) $15,820 Yes Yes $0 0%
CertusBank, NA (SC) $15,427 Yes No $0 0%
Skagit State Bank (WA) $15,387 Yes Yes $15,387 100%
Goldwater Bank, N.A. $14,554 Yes Yes $0 0%
NCB, FSB (OH) $14,221 Yes Yes $2,417 17%
Cathay Bank (CA) $13,287 No No $10,630 80%
Business Bank (WA) $12,746 Yes Yes $12,746 100%
First Century Bank, N.A. (GA) $11,724 Yes Yes $0 0%
Barrington Bank & Trust CO.NA (IL) $9,521 Yes No $0 0%
Panhandle State Bank (ID) $9,397 Yes Yes $6,682 71%
North Cascades Bank (WA) $9,317 No Yes $9,317 100%
West Town Savings Bank (IL) $8,621 Yes Yes $0 0%
Grandpoint Bank (CA) $8,492 Yes No $8,492 100%
Stifel Bank & Trust (MO) $8,003 Yes No $417 5%
First National Bank of Layton (UT) $7,397 Yes Yes $0 0%
Mountain Pacific Bank (WA) $7,384 Yes Yes $7,384 100%
American Bank (MD) $7,274 Yes Yes $0 0%
Bank Of Washington (WA) $7,215 Yes Yes $7,215 100%
First Federal Bank, FSB (MO) $7,090 Yes Yes $672 9%
First Federal Bank of Florida (FL) $6,249 Yes Yes $0 0%
Zions First National Bank (UT) $5,905 No No $3,481 59%
Silicon Valley Bank (CA) $5,606 No No $5,606 100%
Security State Bank (WA) $4,969 Yes Yes $4,969 100%
Community 1st Bank (ID) $4,852 Yes Yes $4,852 100%
CBC National Bank (FL) $4,628 Yes Yes $0 0%
South Sound Bank (WA) $3,968 Yes Yes $3,768 95%
BOKF NA (OK) $3,963 No No $0 0%
Raymond James Bank (FL) $3,915 No No $3,680 94%
Dubuque Bank & Trust Co.  (IA) $3,762 Yes No $254 7%
Bank2 (OK) $3,741 Yes Yes $0 0%
Access National Bank (VA) $3,670 Yes Yes $0 0%
Celtic Bank Corporation (UT) $3,521 Yes No $0 0%
Toyota Financial Savings Bank (NV) $3,303 Yes No $3,303 100%
Peoples National Bank (CO) $3,218 Yes Yes $0 0%
RBC Bank (GEORGIA), NA (GA) $3,178 Yes No $3,178 100%
Wheatland Bank (WA) $3,135 Yes Yes $3,135 100%
Foundation Bank (WA) $3,129 No No $3,129 100%
Prime Pacific Bank, N.A. (WA) $2,989 Yes Yes $2,989 100%
Community First Bank (WA) $2,985 Yes Yes $2,985 100%
Commerce Bank of Washington (WA) $2,980 Yes No $2,980 100%
MBank (OR) $2,948 Yes Yes $2,468 84%
The Huntington National Bank (OH) $2,903 No No $486 17%
Commerce Bank (MO) $2,884 No No $2,884 100%
Puget Sound Bank (WA) $2,795 Yes Yes $2,795 100%
Heartland Bank (MO) $2,679 Yes Yes $685 26%
Pacific Mercantile Bank (CA) $2,674 Yes No $0 0%
Compass Bank (AL) $2,607 Yes Yes $2,397 92%
Bank of Fairfield (WA) $2,433 Yes Yes $2,433 100%
Riverbank (WA) $2,339 Yes Yes $2,339 100%
Fife Commercial Bank (WA) $2,333 Yes Yes $2,333 100%
Pacific Continental Bank (OR) $2,225 Yes Yes $2,225 100%
Idaho Independent Bank (ID) $2,150 Yes Yes $154 7%
Regal Financial Bank (WA) $2,085 Yes Yes $2,085 100%
State Bank Northwest (WA) $1,886 Yes Yes $1,886 100%
Barclays Bank Delaware (DE) $1,820 No No $1,820 100%
Commencement Bank (WA) $1,819 Yes Yes $1,819 100%
Bank of Manhattan (CA) $1,811 Yes No $0 0%
Lewis & Clark Bank (OR) $1,799 Yes Yes $1,799 100%
The National Bank (IL) $1,739 Yes Yes $0 0%
Liberty Bay Bank (WA) $1,738 Yes Yes $1,738 100%
Capital Bank, NA (MD) $1,695 Yes Yes $0 0%
Georgia Banking Company (GA) $1,475 Yes Yes $0 0%
Century Bank, NA (CA) $1,300 Yes Yes $1,300 100%
BBCN Bank (CA) $1,300 Yes No $1,300 100%
Washington Business Bank (WA) $1,178 Yes Yes $1,178 100%
The PrivateBank and Trust Co.  (IL) $1,151 No No $0 0%
Twin City Bank (WA) $1,098 Yes Yes $1,098 100%
Twin River National Bank (WA) $1,042 Yes Yes $1,042 100%
Legacy Bank (OK) $1,007 Yes Yes $1,007 100%
Community Bank (OR) $1,005 Yes Yes $1,005 100%
Nationwide Bank (OH) $1,003 Yes Yes $1,003 100%
Sterling National Bank (NY) $1,001 Yes Yes $0 0%
Alerus Financial, N.A. (ND) $986 Yes Yes $0 0%
First State Bank of St Charles (MO) $963 Yes Yes $0 0%
Regents Bank, N.A. (CA) $946 No No $946 100%
Greenchoice Bank, FSB (IL) $918 Yes Yes $0 0%
Astoria Federal Savings & Loan (NY) $860 No No $860 100%
Bank of Blue Valley (KS) $842 Yes Yes $0 0%
Allied First Bank, SB (IL) $813 Yes Yes $0 0%
Mountain West Bank, N.A. (MT) $809 Yes Yes $0 0%
First Choice Bank (NJ) $799 Yes Yes $135 17%
Stockman Bank of Montana (MT) $769 Yes Yes $769 100%
Bank of Utah (UT) $769 Yes Yes $0 0%
Canyon Community Bank, NA (AZ) $716 Yes Yes $0 0%
Prime Bank (IA) $711 Yes Yes $711 100%
American B & T C N.A. (IA) $687 Yes Yes $475 69%
UMB Bank NA (MO) $687 No No $545 79%
Comerica Bank (TX) $675 No No $675 100%
Albina Community Bank (OR) $630 Yes Yes $630 100%
EagleBank (MD) $585 Yes Yes $0 0%
Golden Pacific Bank, NA (CA) $584 Yes Yes $0 0%
Bank of American Fork (UT) $573 Yes Yes $0 0%
Mutual of Omaha Bank (NE) $565 Yes No $0 0%
Oregon Pacific Bank (OR) $528 Yes Yes $355 67%
MWA Bank (IL) $528 Yes Yes $528 100%
HBank Texas (TX) $525 Yes Yes $525 100%
Wolverine Bank FSB (MI) $506 Yes Yes $0 0%
Syringa Bank (ID) $459 Yes Yes $0 0%
First National Bank of Layton (UT) $417 Yes Yes $0 0%
Illinois National Bank (IL) $417 Yes Yes $0 0%
Oakstar Bank (MO) $417 Yes Yes $0 0%
Great Western Bank (SD) $412 Yes No $412 100%
Millennium Bank (IL) $401 Yes Yes $0 0%
Central Trust Bank (MO) $376 Yes No $376 100%
Union Savings Bank (IL) $372 Yes No $0 0%
Nexbank SSB (TX) $368 Yes Yes $368 100%
Presidential Bank (ND) $364 Yes Yes $0 0%
First Merchants Bank, NA (IN) $357 Yes No $0 0%
American Midwest Bank (IL) $354 Yes Yes $0 0%
Grand Bank (TX) $352 Yes Yes $0 0%
Cache Valley Bank (UT) $342 Yes Yes $0 0%
Bank of The Cascades (OR) $340 Yes Yes $340 100%
TIB The Independent Bankers Bank (TX) $339 Yes No $0 0%
Santander Bank N.A. (DE) $334 No No $0 0%
Commercial Bank of Texas, N.A. (TX) $320 Yes Yes $0 0%
The First Bexley Bank (OH) $320 Yes Yes $0 0%
Landmark Bank (MO) $302 Yes Yes $0 0%
Cross River Bank (NJ) $302 Yes Yes $0 0%
FirstOak Bank (KS) $268 Yes Yes $0 0%
The Citizens National Bank (OH) $236 Yes Yes $0 0%
Bank'34 (NM) $217 Yes Yes $0 0%
Carrollton Bank (IL) $210 Yes Yes $0 0%
First Montana Bank (MT) $203 Yes Yes $203 100%
First Federal Savings Bank (WA) $195 Yes Yes $0 0%
North Valley Bank (CA) $194 Yes Yes $0 0%
People's Bank of Commerce (OR) $191 Yes Yes $0 0%
Citizens Bank Minnesota (MN) $186 Yes Yes $0 0%
First National Bank (SD) $181 Yes Yes $181 100%
Bank of Canton (MA) $150 Yes Yes $150 100%
MidFirst Bank (OK) $142 Yes No $142 100%
Main Bank (NM) $130 Yes Yes $0 0%
First National Bank of America (MI) $123 Yes Yes $0 0%
Midwest Bank (MN) $112 Yes Yes $112 100%
First State Bank (IL) $110 Yes Yes $0 0%
1st Constitution Bank (NJ) $107 Yes Yes $0 0%
Five Points Bank (NE) $93 Yes Yes $93 100%
Bank of Whittier, NA (CA) $83 Yes Yes $83 100%
Bank of Stockton (CA) $80 Yes Yes $80 100%
Mohave State Bank (AZ) $55 Yes Yes $0 0%
Evergreen Moneysource Mortgage (WA) $455,141 NA NA $21,236 5%
Mortgage Master Service Corp (WA) $230,182 NA NA $490 0%
Directors Mortgage Inc.  (OR) $227,117 NA NA $6,301 3%
Mortgage Investors Corp (FL) $200,732 NA NA $885 0%
Mortgage Broker Services Inc.  (WA) $170,496 NA NA $0 0%
Roundpoint Mortgage Company (NC) $115,346 NA NA $395 0%
Summit Mortgage Corporation (OR) $111,345 NA NA $0 0%
Network Mortgage Services (WA) $101,448 NA NA $0 0%
Westwood Mortgage, Inc.  (WA) $76,506 NA NA $506 1%
Northwest Mortgage Alliance (WA) $50,987 NA NA $50,987 100%
Wallick and Volk, Inc.  (WY) $50,591 NA NA $0 0%
First Financial Services, Inc.  (NC) $50,327 NA NA $0 0%
First Priority Financial Inc.  (CA) $46,141 NA NA $243 1%
Mortgage Express, LLC (OR) $38,810 NA NA $0 0%
Northwest Mortgage Group, Inc.  (OR) $36,649 NA NA $0 0%
Military Family Home Loans, LLC (IA) $31,533 NA NA $10,014 32%
Pacific Residential Mortgage (OR) $30,432 NA NA $0 0%
LPMC LLC (OR) $30,360 NA NA $216 1%
American Southwest Mortgage (OK) $26,326 NA NA $506 2%
Central Banc Mortgage (WA) $24,986 NA NA $0 0%
Equity Home Mortgage, LLC (OR) $24,104 NA NA $24,104 100%
Residential Mortgage, LLC (AK) $24,067 NA NA $0 0%
American Interbanc (CA) $20,565 NA NA $0 0%
Premier Mortgage Resources LLC (OR) $20,507 NA NA $1,050 5%
Shea Mortgage Inc.  (AZ) $18,679 NA NA $2,016 11%
Golden Empire Mortgage Inc.  (CA) $17,560 NA NA $0 0%
Residential Finance Corp (OH) $16,952 NA NA $0 0%
University Islamic Financial (MI) $15,319 NA NA $202 1%
Mortgage Trust, Inc.  (OR) $15,119 NA NA $0 0%
Crossline Capital Inc.  (CA) $12,688 NA NA $0 0%
HighTechLending Inc.  (CA) $12,301 NA NA $0 0%
Legacy Group Capital LLC (WA) $8,189 NA NA $0 0%
South Pacific Financial Corporation (CA) $4,522 NA NA $0 0%
Community Mortgage Funding (CA) $3,968 NA NA $1,352 34%
Affiliated Mortgage Company (LA) $3,363 NA NA $386 11%
LHM Financial Corporation (AZ) $3,006 NA NA $0 0%
Summit Mortgage Corporation (MN) $2,424 NA NA $417 17%
JMAC Lending, Inc.  (CA) $1,528 NA NA $0 0%
Manhattan Financial Group, Inc.  (CA) $820 NA NA $0 0%
Allen Mortgage LC (AR) $655 NA NA $0 0%
JFK Financial Inc.  (NV) $548 NA NA $0 0%
Mountain west financial, Inc.  (CA) $501 NA NA $0 0%
A. K. T.  American Capital, Inc.  (CA) $482 NA NA $0 0%
Coast 2 Coast Funding Group (CA) $390 NA NA $0 0%
Sacramento 1st Mortgage, Inc.  (CA) $363 NA NA $0 0%
BM Real Estate Services Inc.  (CA) $283 NA NA $0 0%
American Lending (CA) $260 NA NA $0 0%
Veritas Funding (UT) $177 NA NA $0 0%
Source: JLARC staff analysis of Federal Deposition Insurance Corporation (FDIC) Community Bank Study Reference Data, Federal Financial Institutions Examination Council (FFIEC) Call and Thrift Reports, and Home Loan Disclosure Act data.  Mortgage companies do not meet either federal definition of a “community bank.”

What are the past and future tax revenue and economic impacts of the tax preference to the taxpayer and to the government if it is continued?

JLARC staff estimated the beneficiary savings for this preference by matching records from DOR, federal Home Loan Disclosure Act (HMDA) data, Call and Thrift Reports from the Federal Financial Institutions Examination Council (FFIEC), and data from the Conference of State Bank Supervisors (CSBS).  Deduction detail from DOR tax returns is incomplete and must be supplemented with HMDA data which provides information on first lien residential mortgages originated in Washington identified by lender.  FFIEC Call and Thrift Reports provide information on depository institutions that operate in 10 or fewer states.  The CSBS provides information on mortgage companies making mortgage loans in Washington and that operate in 10 or fewer states.

The beneficiaries of the preference, including banks and mortgage companies, saved an estimated at $23 million in Fiscal Year 2014 and will save an estimated $49.8 million in the 2015-17 Biennium.  See Exhibit 7 below.

Exhibit 7 – Estimated 2015-17 Beneficiary Savings from the Mortgage Interest B&O Tax Deduction
Fiscal Year Depository Institutions Mortgage Companies Total
2012 $24,144,000 $2,242,000 $26,386,000
2013 $21,247,000 $1,973,000 $23,220,000
2014 $21,074,000 $1,957,000 $23,031,000
2015 $21,379,000 $1,985,000 $23,365,000
2016 $22,251,000 $2,066,000 $24,317,000
2017 $23,272,000 $2,161,000 $25,433,000
2015-17
Biennium
$45,523,000 $4,227,000 $49,750,000
Source: JLARC staff analysis of Department of Revenue tax returns, the Conference of State Bank Supervisors, and the Federal Financial Institutions Examination Council (FFIEC) Call and Thrift Reports, and Home Loan Disclosure Act data.

If the tax preference were to be terminated, what would be the negative effects on the taxpayers who currently benefit from the tax preference and the extent to which the resulting higher taxes would have an effect on employment and the economy?

If the tax preference were terminated, lenders would have to pay B&O tax on the interest received from loans for first lien mortgages.

Lenders that retain a larger portion of their loans in their own portfolios could be affected more than lenders that sell their loans.  Lenders that retain portfolio loans would not be able to restructure existing loans on their books.  Some of these loans lock in interest rates for long periods and cannot be adjusted for the loss of the deduction.  Representatives of the banking industry testified to the Legislature that portfolio lenders might need to increase interest rates or decrease residential loans if the preference were terminated.

It is not known how loan availability and Washington’s housing market would be impacted by this change given that Washington’s housing market appears to follow national trends.

Do other states have a similar tax preference and what potential public policy benefits might be gained by incorporating a corresponding provision in Washington?

States imposing a personal income tax have the ability to allow a mortgage interest deduction that provides tax relief directly to the homeowner.  Washington has no personal income tax and instead provides tax relief to the mortgage lender.

Washington is the only state to offer a deduction from state taxes for income derived from interest on loans secured by first mortgages or trust deeds.  West Virginia has a similar deduction for municipal business and occupation taxes.  Almost all other states use net income or net worth to tax financial institutions and do not provide a deduction for mortgage interest.

Of the 41 states that impose a personal income tax, 31 allow a deduction for interest paid on mortgages for homeowners that itemize deductions.

RCW 82.04.4292

Deductions - Interest on investments or loans secured by mortgages or deeds of trust.

(1) In computing tax there may be deducted from the measure of tax by those engaged in banking, loan, security or other financial businesses, interest received on investments or loans primarily secured by first mortgages or trust deeds on nontransient residential properties.

(2) Interest deductible under this section includes the portion of fees charged to borrowers, including points and loan origination fees, that is recognized over the life of the loan as an adjustment to yield in the taxpayer's books and records according to generally accepted accounting principles.

(3) Subsections (1) and (2) of this section notwithstanding, the following is a nonexclusive list of items that are not deductible under this section:

(a) Fees for specific services such as: Document preparation fees; finder fees; brokerage fees; title examination fees; fees for credit checks; notary fees; loan application fees; interest lock-in fees if the loan is not made; servicing fees; and similar fees or amounts;

(b) Fees received in consideration for an agreement to make funds available for a specific period of time at specified terms, commonly referred to as commitment fees;

(c) Any other fees, or portion of a fee, that is not recognized over the life of the loan as an adjustment to yield in the taxpayer's books and records according to generally accepted accounting principles;

(d) Gains on the sale of valuable rights such as service release premiums, which are amounts received when servicing rights are sold; and

(e) Gains on the sale of loans, except deferred loan origination fees and points deductible under subsection (2) of this section, are not to be considered part of the proceeds of sale of the loan.

(4) Notwithstanding subsection (3) of this section, in computing tax there may be deducted from the measure of tax by those engaged in banking, loan, security, or other financial businesses, amounts received for servicing loans primarily secured by first mortgages or trust deeds on nontransient residential properties, including such loans that secure mortgage-backed or mortgage-related securities, but only if:

(a)(i) The loans were originated by the person claiming a deduction under this subsection (4) and that person either sold the loans on the secondary market or securitized the loans and sold the securities on the secondary market; or

(ii)(A) The person claiming a deduction under this subsection (4) acquired the loans from the person that originated the loans through a merger or acquisition of substantially all of the assets of the person who originated the loans, or the person claiming a deduction under this subsection (4) is affiliated with the person that originated the loans.  For purposes of this subsection, "affiliated" means under common control.  "Control" means the possession, directly or indirectly, of more than fifty percent of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting shares, by contract, or otherwise; and

(B) Either the person who originated the loans or the person claiming a deduction under this subsection (4) sold the loans on the secondary market or securitized the loans and sold the securities on the secondary market; and

(b) The amounts received for servicing the loans are determined by a percentage of the interest paid by the borrower and are only received if the borrower makes interest payments.

(5) The deductions provided in this section do not apply to persons subject to tax under RCW 82.04.29005.

(6) By June 30, 2015, the joint legislative audit and review committee must review the deductions provided in this section in accordance with RCW 43.136.055 and make a recommendation as to whether the deductions should be continued without modification, modified, or terminated immediately.

[2012 2nd sp.s. c 6 § 102; 2010 1st sp.s. c 23 § 301; 1980 c 37 § 12.  Formerly RCW 82.04.430(11).]

RCW 82.04.29005

Tax on loan interest - 2012 2nd sp.s. c 6.

(1) Amounts received as interest on loans originated by a person located in more than ten states, or an affiliate of such person, and primarily secured by first mortgages or trust deeds on nontransient residential properties are subject to tax under RCW 82.04.290(2)(a).

(2) For the purposes of this subsection [section], a person is located in a state if:

(a) The person or an affiliate of the person maintains a branch, office, or one or more employees or representatives in the state; and

(b) Such in-state presence allows borrowers or potential borrowers to contact the branch, office, employee, or representative concerning the acquiring, negotiating, renegotiating, or restructuring of, or making payments on, mortgages issued or to be issued by the person or an affiliate of the person.

(3) For purposes of this section:

(a) "Affiliate" means a person is affiliated with another person, and "affiliated" has the same meaning as in RCW 82.04.645; and

(b) "Interest" has the same meaning as in RCW 82.04.4292 and also includes servicing fees described in RCW 82.04.4292(4).

[2012 2nd sp.s. c 6 § 101.]

Legislative Auditor Recommendation 1: Review and Clarify

The Legislature should review the detailed information on the lenders that make loans that qualify for the preference compared to other “community bank” definitions and determine whether the preference is focused on the pool of lenders the Legislature intended.

In its 2012 deliberations, the Legislature indicated it wanted to limit the preference to lenders that were “community banks.” Potential violation of the federal Commerce Clause was a concern.  The Legislature chose to identify community banks as lenders located in 10 or fewer states.

If the Legislature determines after its review of qualifying institutions that this is not the lending pool it intended, this review provides other options for identifying “community banks” that may avoid Commerce Clause concerns.  Options include using either of two federal definitions of “community bank” or focusing on lenders that retain a threshold portion of their loans in their own portfolios.  Identifying community banks using one of these other options would further limit the pool of qualifying lenders.

Legislation Required: Yes.

Fiscal Impact: Depends on legislative action.

Legislative Auditor Recommendation 2: Review and Clarify

The Legislature should review and clarify the public policy objective of the mortgage interest deduction because the original inferred public policy objective of stimulating the residential housing market may no longer apply given the changes in the lending industry and the rise of the secondary mortgage market.

Evidence presented in this year’s review indicates that:

  • Qualifying lenders sell more than two-thirds of their loan amounts within one year of the loan origination;
  • Borrowers use qualifying loans more for uses such as refinancing than for purchasing homes; and
  • Washington housing starts follow national trends and appear not to be driven by local factors.

The Legislative Auditor’s guidance document for drafting performance statements provides a framework for identifying policy objectives and linking these to performance metrics.

Legislation Required: Yes.

Fiscal Impact: Depends on legislative action.

Available December 2015.

Available December 2015.

If applicable, will be available December 2015.

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