Taxes and Housing Prices
The combination of the recently-passed health care legislation and the President’s proposed rollback of the Bush tax cuts for upper-income taxpayers would sharply boost tax rates on the wealthy. This is great news for the high-end real estate market.
It may seem counterintuitive, but raising taxes on those in the top brackets could increase urban house prices by as much as 10 percent, and even more in east and west coast cities where homes are most expensive. The drivers of this windfall: higher top rates on ordinary income and hikes in capital gains taxes. Obama’s proposal to limit the benefit of itemized deductions to 28 percent could more than reverse this housing windfall, but that measure is unlikely to win congressional approval.
Let’s start with the President’s proposal to restore the 36 percent and 39.6 percent rates on income. This would increase the value of owning a home, since as tax rates rise, so does the value of the mortgage interest deduction. (For example, if a taxpayer’s marginal tax rate rises from 33 to 36 percent, the value of $1 deduction increases from 33 cents to 36 cents.)
The role of the capital gains taxes is less obvious, but high rates also drive up house prices. Here’s why: Taxpayers who sell homes at a profit probably won’t pay any taxes due to the $250,000 exclusion ($500,000 for married taxpayers) for gains on the sale of a home. While the President wouldn’t change this exclusion, he does support higher capital gains tax rates for wealthy households. The health bill increased those rates by 3.8 percentage points starting in 2013 and rolling back the Bush tax cuts would increase the top rate from 15 percent to 20 percent next year.
As capital gains taxes go up, so does the value of the capital gains exclusion on housing. (To put it another way, if capital gains and dividend tax rates were 100 percent, all investors would put their money in tax-favored investments like housing and municipal bonds.) Like the increase in ordinary income tax rates, a higher capital gains rate makes housing more valuable.
In recent research, I’ve found that increases in rates on both capital gains and ordinary income would boost metropolitan housing prices by between 7 and 10 percent, with larger hikes for cities on the coasts.
By contrast, the President’s proposal to limit the tax savings from itemized deductions to 28 percent would depress urban housing prices. The limitation on itemized deductions—including mortgage interest and local property taxes paid—would decrease the tax savings from homeownership, making home-owning less attractive. And with this limitation in place, the increase in ordinary income tax rates won’t affect housing prices. My model of the President’s policies suggests that—relative to current tax policy—this proposal would drive down median long-run metropolitan housing values by between 12 and 16 percent, and even more in most coastal cities.
These results come with lots of caveats, but the lessons are clear. One, limiting itemized deductions might not be the best idea while the housing market is still struggling. And two, higher tax rates might just be a much-needed shot in the arm for our anemic housing market.
The incentive to turnover properties that section 121 seems to promote allows the people who want to shelter their current investment further to have their pick of the litter so to speak. Good to be a buyer in a buyers market I suppose.
Ty
As a mortgage broker, a saw an enormous volume in homes purchased as investments, not as primary residences. This is the key reason our housing market is “anemic.” As with all bull markets, when the supply outweighs the demand, a crash is soon to follow. I agree with you wholeheartedly that we need to get rid of the inventory overhang.
Darren
I could not disagree with this more. Every house transaction has a buyer and a seller. Why are higher house prices necessarily to be preferred? Some might say that lower house prices are exactly what we need to spur sales and get rid of the inventory overhang.
Supporting higher house prices is simply a case of supporting the richer over the poorer.
I suspect that section 121 will be another incentive for market turnover, which increases housing prices. As my income rises and my capital gain in my house approaches the excluded limit, I would wish to realize that gain in a larger house with a higher mortgage, thus increasing my deduction and sheltering the gain. So I sell my current home and buy a larger one with a larger mortgage. The policy will reduce the incentives for long term home ownership and contribute to the breakdown of neighborhoods by encouraging turnover.
Thanks. What about property tax?
mortgage interest on investment properties is only deductible against the profit–as an expense, which it is. If I make $3000 in rents and pay $1500 in interest, my profit (absent other costs of course) is $1500. I pay taxes on that income. The major NON-cash expense that benefits landlords is depreciation, which, in theory, is paid back through “phantom” re-captured capital gains on the sale of the property.
My heart bleeds for millionaire home buyers in a depressed market. At a certain point, people can afford to buy the homes they want, regardless of the tax consequences. This is why there is still debate over whether the tax benefit for mortgages really has an effect. My question is not how it is operational on personal homes, but on investment properties (along with the property tax deduction). It could be that this tax is subsidizing slum lords – or at least high end slum lords. I am just speculating here. I would be interested in the fact on whether the mortgage interest deduction applies equally to investment property and what effect THAT has (and whether this is the dirty little secret of this tax benefit – if it is, I'd love to see a TPC study on how much of the deduction is used by landlords).
I am not at all sanguine about the passage of any tax bill this year. If the Republicans were interested in compromise on this issue, they would have done it before losing the White House (there had to be some realists in the White House who saw a McCain loss coming). My bet is that they will try to hold together against any budget act point of order that makes a higher child tax cut or the 10% bracket truly permanent in order to insist on continued tax cuts for the wealthy. The real question is, will Obama call their bluff or go with an extension of the entire package for a year or two.
What truly amazes me is the fact that I am the only one talking about a possible GOP Dooms Day strategy on the tax bill.
If there is any evidence at all that even one GOP senator is willing to play ball on this, I'd like to see it.
The section 121 exclusion of $250k or $500k has not been indexed for inflation since 1997. High-end homeowners already face the full marginal tax rate when they sell their long-owned homes. A home sale makes these taxpayers “rich” for one tax year. Because of the complete lack of indexing, eventually all long-term homeowners will pay full marginal tax rates on sale of their homes.
With the new Medicare tax plus various phaseouts of credits and deductions plus the AMT and state taxes (nearly 10% in California), the marginal rate on a large long-term gain can exceed 40%. This confiscatory tax rate on an inflationary gain promotes lock-in, whereby the only people who pay the tax are those who do NOT have the financial resources to avoid selling. That's not a progressive policy. It's a policy that favors the rich at the expense of the middle class.
This paper does not appear to consider Section 121 at all. A separate paper looking only at Section 121 might reach the opposite conclusions. Regardless, promoting lock-in is no favor to taxpayers, the economy, or government revenues.