Proposed Tax Reforms Not Harmful for Real Estate

Mike Cooke November 25, 2017 Selling

Proposed Tax Reforms Not Harmful for Real Estate

Many analysts are alarmed that tax reform proposals under consideration by the U. S. House of Representatives, if adopted, will have significant negative impact on home owners and home prices. Examples include:

  • National Association of Realtors: The average homeowner will pay $815 more in federal income tax and house values will decline by 10%, according to a NAR study done by Big Four accounting firm PWC.
  • Forbes: A limitation on the mortgage interest deduction for homeowners, but not for investors, will cause more people to become renters and further depress home ownership rates that are near a 50-year low at 63.7%.
  • Mark Zandi, Chief Economist for Moody’s Analytics, predicts 10% price drops in some areas and a nationwide decline in home values of 3% to 5%.

We largely disagree.

Except for one proposed provision of the new tax law, the likely impact seems minimal for most areas of the country, including metro Denver. However, a select number of very affluent communities may see more significant changes to their housing market.

What follows is not political. We take no position for or against tax reform. Instead, we provide an economic analysis of the current proposal as it relates to its impact on house prices and taxes paid by homeowners.

The three major provisions of the House of Representatives proposal related to real estate are:

  • The mortgage interest deduction would be limited to the interest paid on the first $500,000 of a home loan. The current limit is $1,000,000.
  • The property tax deduction is limited to the first $10,000 of taxes paid while current law allows actual property taxes to be deducted without limit.
  • The first $250,000 of capital gains from the sale of a house for a single person or $500,000 of gain for a married couple filing a joint tax return would be exempt from any income taxes but only if the owner has lived in the property as a primary residence for five out of the last eight years. Current law only requires you to live in the property for two of the last five years.

Let’s look at each of these proposed changes in turn.

An excellent study by United for Homes campaign as reported in the Denver Post reveals that only 6% of mortgages nationwide have a balance larger than $500,000. Combine this with the fact that only 64% of Americans own a home and that 35% of homeowners own their homes free and clear of any mortgage and you find only 2.5% of all households in the U. S. affected by this lower mortgage interest deduction limit.

The same study claims that only 3.7 million homes in the 50 states have a property tax bill that exceeds $10,000 per year. This is 2.9% of the 126 million households in the U. S. The number is even lower for metro Denver homeowners. Only 300 homes out of the 52,000 plus sold in the greater Denver area over the last 12 months had a property tax bill exceeding $10,000 … a minuscule 0.6% of all homes.

Bottom line, the number of people losing some tax deductions will be small if the current tax reform proposal passes. With a small number of people affected, the impact will be minimal.

Furthermore, households affected by the changes may see an overall reduction in their federal tax liability.

Let’s work through an example.

Take a family living in a million-dollar home with an $800,000 mortgage and a $12,000 annual property tax bill. This household is paying $5200 per month for its mortgage payment and property taxes.

Under the proposed new law, this household still gets a tax deduction of $24k for interest paid on the first $500k of the mortgage and can deduct the first $10k of the property tax bill. The overall deduction of $34k is $16k less than the $50k they receive under current tax policy.

If nothing else was changing in the tax reform proposal, this family could be facing higher federal taxes of $5,986 ($499 per month) due the loss of $16k in deductions. However, other things are changing. Another big change is the seven tax brackets under the current law are reduced to just three tax brackets under the new law.

This gets a bit wonky because tax brackets and marginal tax rates are a confusing topic. The actual rates and floors at which each rate applies are different between the two laws. We can, however, see what happens by following through on the example of the family with the million-dollar home:

  • Say the family deducts all mortgage interest and property taxes of $50k under current tax law and ends up with $260,000 of taxable federal income. Income tax paid to the Feds is $59,684.
  • Under the new tax law, the family only gets to deduct $34k for interest and taxes. Their taxable income goes up to $276,000. Tax paid to the federal government on this higher income under the new tax low goes down to $58,580 due to changes in the tax brackets. The family pays $1,104 less to the Feds even though their taxable income is higher.

Overall, few homeowners are affected by changes to real estate related deductions and many households that are affected will stay pay less in federal taxes. The resulting impact on house values should be negligible overall.

Select markets will not be affected more significantly. Extremely affluent markets in California, New York and resorts areas like Aspen or Vail will see significant impacts. These also tend to be areas with high state income taxes and high local property taxes. We expect very high-end markets to be affected adversely if the new proposal becomes law.

The third aspect of the tax bill is more problematic. Exempting owners from capital gains after five years of occupancy instead of two will keep some people from moving more often.

A person paying $400k for a house in Denver on January 1, 2014 is likely in sitting on a home worth $530k by the end of 2017. Right now, she can sell and pay no tax on the $130k in capital gains as she has been living there for more than two years.

If that owner faces a big tax bill on the $130k capital gain, she is less likely to sell. With the new tax laws in effect, she is more likely to wait another two years until she has five years of ownership and gets to keep all her capital gains without tax liability.

Many markets in the U. S. suffer from low inventory. Making owners wait five years instead of two to qualify for capital gains exemptions may exacerbate the low inventory problem as it discourages people from moving more frequently.

The reforms under consideration in the U. S. House of Representatives, or any tax reform proposals at all, are a long way from becoming law. If the House version passes, most of you will pay less in federal taxes and see no negative impact to home price appreciation.