There’s been a lot of talk about the House Tax Reform Plan (TRP) released last week. The headline in the LA Times said “Plan would be a blow to state’s home buyers.” The National Association of Realtors states the plan is “eliminating or nullifying the incentive for homeownership” and “[it] would cause a 10 percent drop in home values and raise taxes on middle-class homeowners by an average of $815.” In my opinion that goes too far. Saying the market will correct 10% is assuming consumers and homebuyers are entirely motivated by taxes. It certainly is a factor, but let’s step back and look at the big picture.
What do you need to know and should you be concerned?
It’s important to note that the Tax Reform Plan has a long way to go before it passes, but for now, here’s what the it proposes in terms of real estate:
- Repeals the Estate Tax
- Eliminates the State and Local Tax deduction
- Keeps the 1031 Exchange
- Reduces the Mortgage Interest deduction to a $500,000 limit
- Caps the annual Property Tax deduction at $10,000
- Eliminates Mortgage Interest deduction on second homes
Why Did You Buy Your Home?
If you own a home, take a minute and think about why you bought your home? Was it because you liked the neighborhood? Did you want a place of your own to raise a family? Were you tired of paying rent? Did you want to build wealth and have an asset in your name? Or did you buy it because it was a tax shelter? The odds are that it was probably a little bit of all of the reasons above. However, I bet the last reason was for the tax deductions. Most of the buyers I work with today are more motivated to buy as a result of increasing rents, wanting to build wealth, or moving to a neighborhood with good schools for their growing family. In fact, the tax deductions is more like an extra layer of frosting on the cake, not the cake itself. So it seems like a huge stretch to say it “nullifies the incentive for homeownership.”
It is highly unlikely that you like paying taxes. And if you’re like me, any tax deduction is a good one. So it goes without saying that reducing a tax deduction seems like a negative thing – that’s at least the knee jerk reaction to it. But consider a few other points. It wasn’t much more than 5 years ago that the economy was struggling as the result of the mortgage debt crisis which led to the Great Recession. Many homeowners speculatively purchased homes with little or no money down, obtained loans on stated income, and basically had little skin in the game. When those loans went bad, the entire economy suffered (of course it wasn’t all the borrowers fault, but they played a roll). I see the $500,000 limit as not all that bad considering it takes away some of the incentive to carry lots of mortgage debt. I’m not sure of the lawmakers intent, but I have to think this has something to do with engineering the public’s love of debt.
Rent or Buy? Let’s Compare
Let’s consider the alternative to buying a home. Most people still need a place to live if they don’t own a home, so that assumes they are going to pay rent. That rent usually helps cover the landlord’s mortgage, property taxes, and expenses. The renter gets $0 in tax deductions for renting, while the landlord deducts all of those costs as expenses against income. On the other hand, when you buy a home, paying down the principle on your loan is like a big piggy bank that you get to live in. After 30 years, there’s a pretty good odds that your home will be worth more than you paid for it, plus you didn’t just throw away all the rent money had you rented instead. Then, if you later decide to rent out your home because you moved and bought a new one, you can eventually sell that asset and defer paying taxes as long as you buy a similar income generating property. It seems to me like there are plenty of reasons to buy a home despite the reduction in mortgage interest and property tax deductions.
Finally, until the supply of homes increases to meet buyer demand, I don’t think the reduced tax deductions will have a significant negative impact on home prices in Southern California. According to CAR President Geoff McIntosh, “A lack of available homes for sale continues to be the largest single factor influencing California’s housing market.” If current homeowners, in particular baby boomers, have less incentives to move, then supply will be restrained and buyers will be left with limited purchase options until new homes are built.
I think the bigger concern we have, especially in California, is the elimination of the state and local tax deduction. For the majority of buyers in Southern California, this has much larger ramifications come tax time. Sure, the standard deduction is going to double, but when you factor in all the deductions if you own a home and have kids, the larger standard deduction isn’t going to cut it. I have high hopes this will be one of the changes we see before the plan passes.
What no one else seems to be talking about is the nomination of Powell to be the next Fed Chair. A new Fed chair is a bit of a wildcard when it comes to raising interest rates. A rise in interest rates will have a greater effect on house prices than a reduction in tax deductions. Most buyers consider the monthly payment when buying a home long before the yearly tax benefits, so a significant bump in interest rates would likely have the greatest negative effect on the residential real estate market. For example, a 30 year $500k loan today at 4% equals a payment of $2387/month. At 4.5% that same loan jumps to $2,533/month, or an extra $1,752/year in mortgage interest. At 5% it will cost you nearly $300 more per month for the same home. That’s a car payment or a vacation that consumers will have to live without.
The Likely Effects of the Tax Plan on Housing
So what will likely happen in the housing market? First time home buyers, rents are showing no indication of dropping, so homeownership will remain appealing to those that can come up with a down payment. The most price sensitive buyers will have second thoughts about moving up to a larger home if that means a larger mortgage and will likely stay in their existing homes longer. If this tax plans jolts the market and prices drop, buyers will likely welcome the first decline in prices in 5 years, but I believe that drop will be short lived. Those that will benefit from the tax plan the most will likely be landlords. Interest expense will remain a “deduction” against rental income, and if people do in fact feel less incentivized to buy a home, an increase in the demand on rental units will lead to an increase in rental rates. The one area that I do have some concern is in the vacation or second home markets, as all mortgage and property tax deductions on second homes would be eliminated. Plus, with the rise of VRBO, the incentive to own a vacation home is becoming more and more of a luxury.
Time will tell how this all shakes out, but for now, I’m not too worried. The Senate reportedly has a rival tax plan, so it should be politics as usual, and things will change from where they stand today. Stay tuned . . ..