The Impact of the 3.8% Tax on Rents

As part of the health care legislation, a new 3.8 percent tax will be imposed on some people starting in 2013.  Contrary to rumors among some real estate practitioners, this is not a tax on the sale of a home.  Neither a home-buyer nor home-seller will have to fork over $3,800 to the federal government on the sale of a $100,000 home.

This tax, however, will impact some landlords and some homeowners who have significant housing equity.  Rental incomes will be subjected to this 3.8 percent tax on landlords who earn more than $200,000 a year.  For example, a corporate lawyer who has a high salary but who also owns a rental property will likely be subject to this tax.  But as with most taxes, those who have to fork over the money to the federal government and those who actually suffer the burden of the tax will not be the same.  The right question to ask is: how much of this tax on rental income will get shifted to tenants as a rent hike?

As an illustration, consider a simple sales tax.  Retail stores are the ones sending the tax dollars to the government, but the consumers are the ones who get squeezed.  A $100 bag of groceries without tax suddenly becomes a $104 bill with a 4 percent sales tax.

Now consider the following example where consumers do not get hurt because tax shifting is impossible.  Georgia is the Peach State but to its dismay South Carolina overtook Georgia last year in peach production.  Surely South Carolina producers must have cheated in some way.  So let’s impose a tax on peach growers in South Carolina and only for this state.  This hypothetical law, though clearly unconstitutional, provides a good illustration of the tax shifting impact.  If the peach price at your grocery was $2 per pound before this tax, then the peach price after the tax will still be $2 per pound because consumers will have shifted to buying Georgia peaches.  South Carolina farmers who try to raise the price to $2.50 will attract no buyers and will go bankrupt.  So they have to match the price of Georgia peaches while cursing the federal government.  Consumers are not impacted but South Carolina producers are.

Going back to our original question: how much of the 3.8 percent health care tax on rental income will get shifted to tenants as a higher rent?  It will depend on what economists call elasticity of supply and demand curves.  The possibilities are:

• If tenants have many options – like living in their parent’s basement or taking on a third roommate - then the tax burden will reside with landlords and not renters.
• If tenants do not have many options – after getting tired of parent’s nagging or the loud third roommate – then landlords will witness a strong demand for their rental properties and can raise rent.
• If landlords have many options – like getting out of the rental property business and buying stocks instead – then fewer rental properties will be built over time and fewer rentals will be available, thereby resulting in higher rent for tenants.
• If landlords do not have many options – because of an unwillingness to dump properties on to the market in order to avoid the capital gains tax or because of an historic attachment to the property – then the landlord will bear the tax.

The actual outcome will depend on the above four possibilities.  It is very hard to quantify the actual magnitude of the tax shift.  However, as can be seen, we should not assume that the 3.8 percent tax is only for top income households.  Some of the lower income renters could easily face higher rents.

Details of the 3.8 percent tax are provided here (PDF).  It contains only the incidence of the tax and does not feature any particulars of the tax shifts into rents.