12/23/2017 | Casey Fleming | Now that the ink is drying on the 2017 Tax Reform Act, you may be wondering if the GOP tax bill is going to affect you. The answer is yes. Since I write about real estate, and real estate financing in particular, I will cover aspects of the 2017 Tax Reform Act that are likely to impact you if you have a mortgage, own real estate, or are thinking of buying real estate. Here we go:
Major Tax Provisions that are Changing
Homeowners get some major tax breaks currently. Property taxes, mortgage insurance and interest on your mortgage (with certain limitations) have all been deductible in the past. These tax breaks were intended to encourage home ownership by making it more affordable to working Americans.
While the National Association of Realtors (one of the most powerful lobbies in the U.S.) would never allow elimination of these tax advantages, many significant changes made it through to the final version of the bill. Here are the ones that might impact you the most, both in the short run and the long run.
For an excellent summary of the tax bill provisions, click here.
Mortgage Interest Deduction in the Tax Bill
We’ll start with the most obvious one. Previously, mortgage interest was deductible on financing up to $1 million, whether this financing was on your primary residence or a second (or third, or fourth) home.
There was also a limitation on how much you could deduct if you pulled cash out of your home. If the cash was used to improve your home you could deduct the interest attributable to it. If not, then you could deduct only the interest attributable to the principal equal to your purchase (acquisition) mortgage, plus $100,000.
Under the GOP tax bill, you will be limited to the interest attributable to the first $750,000 in debt. It will still apply whether the debt is secured by your personal residence or a vacation home. However, if you pull cash out with an equity line – regardless of the reason – the interest on that debt will not be deductible. The $750,000 debt limit is permanent, while the loss of the home equity line provision is temporary. The treatment reverts back to the current levels after 2025.
Clearly, the mortgage interest deduction change only impacts high-cost areas where large mortgages are common. Areas with lower priced home will obviously not be impacted, and ultra-high-cost areas (where it is rare for ultra-wealthy homeowners to need financing) will generally also not be affected.
Capital Gains on Sale of Residence
Early versions of the tax bill tried to change the way capital gains on the sale of your personal residence was treated. These provisions were eventually stricken, so there is no change to this law.
For more information on capital gains upon the sale of your home, click here.
State and Local Tax Deduction
Homeowners pay property taxes, which help fund your state and local governments. All taxpayers pay state and local income tax and / or sales taxes, too. Tax law has always let you deduct these expenses if you itemize deductions; this has been one of the features that encourages home ownership by making it more affordable.
There are two provisions of the new bill that will affect these deductions. You can still deduct these expenses, but between the three categories you are limited to an aggregate deduction of $10,000. This will impact homeowners in states with high property values with high property tax rates, and all consumers in states with high sales tax rates, or higher-than-average incomes and high personal income tax rates. This potentially could make all real estate more expensive to own.
Treatment of rental real estate income
If you own rental property (or any other small business), on the other hand, there’s a nice little gift for you in the 2017 Tax Reform Act.
Individuals with business or rental income will still have their net income taxed at the individual rates, not the corporate rates. This could be as high as 37% in the new bill.
However, according to Lance Cothern, of Money Manifesto, moving forward you will be able to deduct 20% of net income from business and rental real estate before it becoming taxable income. So, after deducting all your expenses, you can knock another 20% off the top to calculate your taxable income on it.
There is some disagreement on whether this clause applies to passive income, such as Limited Partnerships and Real Estate Investment Trusts (REITs.) At this point it appears that it does, so investing in a REIT may be a very smart way to buy into real estate before you can afford to buy your own home.
There are a lot of provisos in this section, so you’ll want to wait until the dust settles and then consult with a qualified tax advisor before making any decisions about how to invest.
In any case, these changes expire at the end of 2025.
While the standard deduction doesn’t appear to be related to real estate, there is one way in which it has always been. If the standard deduction is greater than your individual itemized deduction, then it makes no sense to itemize deductions. One of the financial selling points for buying a home rather than renting is that some of the costs – notably the mortgage interest and property taxes – are tax-deductible, so the government pays you some of your costs.
If, however, the standard deductions exceeded the tax-deductible expenses, buying a home had no tax-advantaged value to you, since it would be smart to simply use the standard deduction.
In the 2017 Tax Reform Act, the standard deduction is being raised from $6,350 to $12,000 for individuals, and from $12,700 for married couples to $24,000. This means that unless your itemized deductions total more than $24,000 for a married couple, they don’t really matter because you won’t use them – you’ll use the standard deduction.
The tax-advantage of owning your own home will thus be diminished, if not eliminated, for most homeowners. This will be especially true in low-cost areas, where the itemized deductions (between mortgage interest and state and local taxes) are unlikely to exceed the standard deduction.
The GOP tax bill will thus tend to encourage renting. On the face of it, it could benefit lower-income families. However, lower-income families have low tax rates, so a deduction means very little in the way of savings.
The changes in the standard deduction expire after 2025, at which time the law will revert back to 2017 rules.
Up-front financing fees
No reviews of the new tax bill have mentioned changes in how financing fees are treated, so we assume for now that they will remain the same. Current law provides that points paid when acquiring a loan to purchase a property are deductible in the year in which they are incurred, and points paid on a loan when refinancing the property are deductible, but must be amortized over the life of the loan.
This section may be updated as new information comes in.
For a good discussion of what closing costs are tax-deductible and when, click here.
Increase the deficit and national debt
The 2017 Tax Reform Act is estimated by numerous non-partisan sources to add as much as $1.5 trillion to the national debt within 10 years. Yes, trillion.
You might ask how increasing the deficit and the national debt would impact mortgage financing. I’m glad you asked.
The price of all things is influenced by the dynamics of supply and demand. The price of renting a home goes up when the supply is constricted or when demand jumps. Similarly, the price of renting money (aka the interest rate) also increases when demand jumps. Think of the consumers of money-renting as being all borrowers – this is your competition for the money, and the more borrowers the greater the demand. All things being equal, more competition for the money means higher interest rates.
You’re beginning to see it now, aren’t you?
Who is the biggest borrower in the world? You are. Well, that is, you and everyone you know, and me, and everyone else in the United States, because we (through the U.S. Treasury) collectively owe the world right now about $20.6 trillion. Collectively, this means a little over $211,000 for every single U.S. citizen.
The debt has been increasing steadily for decades, except for a brief few years during the Clinton administration when we were running a surplus and actually paying down the debt.
If the U.S. Government is competing against you for money-renting, well, you can guess the results – interest rates will rise. As interest rates rise mortgage payments go higher, and homes become less affordable. And, remembering our discussion above, with a reduction in the deductibility of certain other expenses like property taxes, other costs associated with homeownership will also rise.
Eventually the pace of the increase in home prices will slow down as homes become less affordable, so the tax bill will, eventually, make it more expensive for you to buy and own a home, and will reduce the equity appreciation you will realize from home ownership.
Finally, not on a real estate note, but eventually all that debt is going to have to be paid back. Now that you know you, personally, owe $211,000+, who do you think is going to pay that back? If you need help with this answer, go find a mirror.
Inflation Will Affect Homeowners, Too
We know that the three most important factors in real estate are location, location and location. What most folks don’t realize, however, is that the three most important factors in interest rates are inflation, inflation and inflation. In order to see this clearly this you need to understand that a money-lender (the investor) has a choice – spend his money now on something he wants, or invest it so that it will buy more of what he wants later when he gets it back.
If a nice meal costs $100 today, but I can lend money out at 5% for one year and then get it back plus interest (giving me $105) it does me no good if the cost of a nice meal a year from now costs $105. I could enjoy the same meal today for the same amount of money (relatively) as I could one year from today. There’s no reason for me to give up the use of my money and rent it to someone else for a year, unless I get back more money that what I’ve lost through inflation.
Therefore, when determining what kind of yield investors want to earn for the use of their money, they first try to guess what inflation is going to look like in the near term and – in the case of long-term debt like a 30-year mortgage – in the distant future. It is uncertain, but there are generally laws of economics that the economy follows most of the time.
The reason this point is important is because one of the possible unintended consequences of the GOP tax plan is hyper-inflation. Let me explain.
One of the prime selling points of the tax plan by the GOP has been that by dramatically increasing cash flow to the wealthy they will create jobs. If they are right – and admittedly there is disagreement among economists about this – then who will fill those jobs?
The unemployment rate today at 4.1% is the lowest reading since the end of 2000, at the height of the dot-com boom. This number is generally thought to be as close to full employment as we can get. So, if jobs are created, one of two things must happen: either we expand immigration to attract workers from other countries (which seems unlikely in the current environment) or employers will start to compete for workers, driving wages up sharply.
The rising cost of labor will, of course, drive up the cost of making things, which of course will be passed on to consumers in the form of higher prices.
If inflation does increase, then interest rates absolutely have to increase as well, adding further pressure to the cost of home ownership.
On the other hand, real estate (particularly owning your own home) has historically been one of the best hedges against inflation that there is. So, while owning a home may become more expensive (in terms of the monthly cost of ownership) it may also become an even better forced savings plan.
On the other, other hand, remember our discussion above – if real estate becomes more expensive to own, fewer will be able to buy and prices will be suppressed. In economics there is never only one factor pushing prices around.
Tax Bill Sunset Clauses
Most of the provisions in the tax bill contain sunset clauses, meaning that the provisions expire after 2018 or 2025. The reduction in the corporate tax rate and the top personal income tax tier, however, remain permanent.
Investors tend to make their investing decisions based on long-term views of what they believe will happen. Individuals, on the other hand tend to make decisions on what is happening today. In the short run almost everyone will pay a little less in taxes, but after the changes in tax law expire the lower and middle income taxpayers will actually pay more than they do now.
The savings from the tax law changes will show up for us immediately, but they will disappear after the next two presidential election cycles. When you make decisions about whether to buy a home or not, whether to invest in income-producing real estate or not, or whether to refinance for any reason, remember to factor that in.
Tax Bill – The Summary
It is impossible to guess all of the ramifications of the tax bill – we can only speculate and base our decisions moving forward on what we believe is most likely to happen. Here are my predictions:
- Interest rates will move up – sharply. It is impossible to imagine a scenario where they don’t.
- Your after-tax cost of homeownership will rise, unless you have a mortgage under $750,000 and a very low tax base.
- Housing prices will level off, especially in very low-cost areas and very high-cost areas.
- Prices of income-producing real estate will rise, possibly sharply. This is most likely to show up in properties that are specifically designed to produce income, like multi-family apartment buildings.
- Shares of REITs will rise sharply after the market digests the ramifications of the tax bill.
So, if you are thinking about refinancing, get it together now. if you are thinking of selling your home, it may be time to get it ready. If you are thinking of buying a home, make sure it fits into your long-term plans. If it does, get moving before interest rates pop up. If you are thinking about investing in rental properties, learn about the different ways you can do this, and get in as soon as you can.
And if, for any reason, you don’t like this tax bill, for goodness sake get active. Write your Congressman, volunteer for the candidate that best represents your beliefs, and VOTE. What Washington politicians do in Washington takes money directly out of your pocket.
The following articles were used to research this analysis:
This article represents the opinions of Casey Fleming, and not necessarily those of C2 Financial Corp. This analysis was prepared with the best information available at the time it was written. Neither Casey Fleming, nor C2 Financial Corp., have any magical insider information about bond markets, real estate markets or mortgage markets that would make economic projections any more reliable than any other source. No warranty is made that the outcome will reflect the projections in this article, and neither Casey Fleming nor C2 Financial Corp. are responsible for decisions that you make regarding your own choices about your real estate or mortgage or those of your clients.
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