The Good, The Bad, The Ugly – New Tax Law Impact on Residential Real Estate
June 28, 2018
Like any classic “Spaghetti Western”, the recent major tax law has some “good” elements with regards to residential real estate, some “bad” outcomes, and some “ugly” aspects, too … with the “u” in ugly standing for unclear, unknown, and unresolved. These various factors are laid out below. But the main overriding feature of the law is probably its dramatic reduction in the corporate tax rate—plus the incentive for corporations to repatriate, or bring back profits from overseas —and while neither provision is directly related to housing, they are nonetheless designed to stimulate the economy and create jobs, and a growing economy tends to help the housing market. So, these corporate impacts should be relatively good. There are concerns, though, that there could eventually be ugly consequences in the future due to possible inflation and economic overheating, along with increased Federal borrowing and greater national debt, and this in turn could adversely affect interest rates, and thus hurt housing. These issues are discussed at the end.
On top of the significant reduction in the corporate tax rate, personal tax rates will also drop, even though the highest brackets will now kick in at lower income levels. In general, these personal changes appear to be a net positive or “good” outcome for most taxpayers, and thus this also provides further potential support for economic activity, which in turn can benefit housing prices. However, the so-called “marriage penalty” shifts a little bit and still affects dual high-income earners, so this might have a slightly adverse effect on such couples in affluent areas like Silicon Valley where salaries are high and so are home prices. This possible impact will take some time to play out.
Beyond the above explicit corporate and personal tax rate changes, some of the other more meaningful good outcomes from the recently passed law are what it did not change. Specifically, some of the beneficial existing housing-related tax provisions, like the full step-up in cost basis at the death of an individual or first spouse (in community property) and the generous capital gain exemption on the sale of a primary residence. One of the most tax friendly features of the code is the step up in cost basis on a house, which means that highly appreciated home values get adjusted to current prices at death, and thus the surviving spouse (or estate) could then effectively sell that same property right away with no realized capital gain tax due. Because of this step-up rule, many homeowners often avoid selling their home until at least the death of the first spouse—even if the property is too big or inconvenient to maintain. Ironically, this phenomenon can also tend to reduce available inventory for sale, especially in more desirable locations, due to lower turnover and inherent lower housing supply, and this, in turn, might further exacerbate high housing prices in certain areas. Obviously, whether this is good or bad is in the eye of the beholder—that is, whether seller or buyer. Furthermore, the new tax law did not alter the capital gains tax rate—including the so-called Obamacare surtax of 3.8% –so this too might further impact the above reasoning about selling or not, and this might also be considered bad for those sitting on sizable housing gains.
And yet, another good thing that did not change in tax law that uniquely favors the primary residence, is the ability to exempt up to $500,000 in gain for married couples (and half that amount for individual filers). Like the above step-up feature, this substantial gain exclusion was under serious attack for elimination in both the House and Senate bills, but it avoided repeal in the final law. Still, a future Congress might still take it away, and that is somewhat ugly, in not knowing such terms for future planning purposes. But for now, this sales gain exclusion offers a very favorable benefit to home ownership, especially if one is apt to move frequently but still enjoy good price appreciation. Note: to qualify for this exclusion, the homeowner needs to have owned the property for two or more years, and have lived in it for at least two of the past five years.
As Sergio Leone might have directed it, though, when you swing those saloon doors open after rejoicing inside about many of the above good (housing related) times, there is often something bad lurking in the alley outside. The new, dramatic limitation on the deductibility of state and local taxes (known by its abbreviation as SALT) is probably the most severe bad outcome from this new tax law, especially for residents in higher income and property tax states like California. Taxpayers are now only permitted to deduct up to $10,000 from their Federal taxes. As a trade-off, the standard deduction is now increased to $24,000 (married); but for many people, their combined state and local (property) taxes are much higher than this—again, especially in expensive housing markets like the San Francisco Bay Area—and thus many such taxpayers who were used to benefitting from itemizing these deductions will lose them. As a result, this effective elimination of the deductibility of property taxes might reduce the incentive to buy residential real estate and/or might cause firms to relocate executives or key personnel elsewhere (to states with low or no income or property tax), and this could potentially impact housing prices, particularly at the higher end.
Then again, many such taxpayers also previously fell under the Alternative Minimum Tax (AMT), and this parallel tax system already disallowed many preference items—like income and property taxes—from its calculation. In other words, many taxpayers were not previously getting the benefit of “SALT” anyway, because of AMT, so they may not be any worse off now in this regard with the new tax law. Ironically, the AMT was not repealed for individuals—although it was just repealed for corporations in this new law—but this new law did significantly increase the income level at which the personal AMT exemption is phased out, and this, coupled with the decrease in available deductions, should result in far fewer taxpayers paying AMT. So, generally-speaking, this is probably a good thing.
But one additional bad outcome for many homeowners—and especially new homeowners—is the new law’s reduction in the applicable mortgage interest deduction. It used to be that one could deduct the interest on mortgage loans up to $1 million, plus the additional interest on up to $100,000 of any home equity line of credit (HELOC). The new law reduces the applicable mortgage loan amount to a maximum of $750,000 borrowed, and eliminates altogether the deductibility of any new HELOC interest. There are exceptions, such as the interest deductibility on the refinancing of existing loans will still be allowed up to $1 million, as will the interest on any refinanced HELOC’s if used for housing-related purposes. However, these types of details should be carefully and individually examined for each taxpayer’s own situation. Plus, of course, the new higher standard deduction might make all of this moot. But the bottom line is that this new mortgage interest provision is slightly bad for homeowners, especially new home buyers; then again, persistent low interest rates might offset this impact, at least for the time-being.
But “time-being” is the operative word. In time, the net decrease in Federal tax revenue now, despite still increasing Federal spending, is projected to result in an estimated rise in the annual deficit this coming year to almost $1 trillion (with a “t”) and a steady rise in the total national debt in coming years. While this is all the subject of a different analysis, it is reasonable to assume that this—plus other data relevant points—may further contribute to the Fed’s future actions to possibly raise interest rates even more than currently signaled, and the bond market may force similar reaction on the long end of the curve. All of this would eventually affect borrowing capabilities and associated costs, and this would ultimately be bad for (or at least harder on) housing … if not ugly, too. For now, though, the immediate net benefits of the new tax law, coupled with existing good economic conditions— especially in hot real estate markets like the Bay Area— should further support residential real estate.
One final and decidedly ugly aspect of this “once in a generation” type of legislation is the temporary—and thus long-term unresolved —nature of this major new tax law. Especially on the individual tax side. While the corporate changes are permanent, the personal income tax changes “sunset” after 2025. That is, they eventually revert to the way things were prior to its passage. This was mainly the result of an inability to get enough Congressional votes (i.e. a required supermajority of 60 votes) to make permanent changes involving the deficit beyond ten years; and therefore, it was instead procedurally handled differently, by simple majority, and hence only temporarily. In due course, a future Congress could similarly extend these changes beyond the current 2025 deadline; but then again, a future Congress—in different hands—could also do something completely opposite. Hence this ugly and increasingly common non-permanent nature of our tax laws will likely linger over much ongoing personal planning. Kind of like that proverbial scary character in the shadows of the old saloon! Waiting, menacingly, outside. But ugly is not always bad, and there is still plenty of potential good to be had in the moment for most homeowners … and maybe even a fistful of dollars too.
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