House Proposal Harms Homeowners
The House tax reform proposal (HR. 1) will have large negative impacts for a wide swath of America’s residential real estate. In particular, the cap on deductible mortgage interest, the elimination of the deduction for state and local interest and sales taxes, and the change to the capital gains exclusion will impact large segments of the market. Worse, the current historically low mortgage rates mask the negative effect that these changes will have on home ownership, which will only grow as interest rates and home prices rise in the future.
Capping the MID
Currently, the mortgage interest deduction is capped at a loan balance of $1,000,000. Under the House proposal, the cap would fall to $500,000. Unlike the conforming loan limit, this cap is uniform across the country and does not adjust for high cost areas.
However, the $500,000 cap is not indexed to inflation or home price growth like the conforming loan limits, so that more homebuyers will be pushed into this category over time. If homes rise at the historic average pace of price growth, that share will rise dramatically. A more detailed analysis by NAR Economist Nadia Evangelou can be found here.
State and Local Income and Sales Taxes
As drafted, the House proposal does allow for the deductibility of some mortgage interest and real estate taxes. However, real estate tax deductions are capped at $10,000 and that figure is not indexed to allow for growing home values or tax rates over time.
Worse, the House proposal does not allow for the deduction of state and local sales or income taxes. Typically, a homebuyer will itemize if their total deductions for real estate taxes and mortgage interest, along with the state and local income or sales taxes and charitable deductions, are greater than the standard deduction. By eliminating the state and local income taxes, which vary from 2 percent to 9 percent of income by state, and sales taxes the sum of deductions will be far less likely to be higher than standard deduction for many. While the House proposal includes a near doubling of the standard deduction, these amounts will be well below the current-law deduction for many buyers and the new law would reduce itemized deductions for many owners in higher priced markets or areas with high income or real estate taxes.
As the above example depicts, a couple in Illinois buying a $350,000 home who puts 10 percent down would currently deduct more than $28,000 in MID and state/local taxes, but these itemized deductions would fall to just over $21,000 under the proposal. The buyer would take the standard deduction of $24,000, but would be hurt by the $4,000 short fall in deductions.
Capital Gains: A Bigger Hit Than Many Realize
The House bill also provides for major changes to the current exclusion of capital gains that sellers make when selling their homes. In particular, it changes the tenure rule so that a home seller must have lived in the home for five of the last eight years to claim the exclusion from capital gains. That is a significant increase from the current rule of two of the prior five years.
In 2016, only 4 percent of sellers had held their homes for less than two years, while a significant 12 to 22 percent of home sellers (not investors or vacation home sellers) sold in 5 years or less. This change would be a 3 to 4-fold increase in the number of sellers hit by capital gains and would impact every market and every income bracket. This change would impact trade up buyers, job movers, divorcees, and those in the military, retarding labor mobility and exacerbating historically low supplies.
The Middle Class Tax Cut: Here Today (for some), but Gone Tomorrow
Most analysis of impacts based on current conditions can be misleading. Mortgage rates are historically low, but are forecast to rise in the coming years along with home prices. This combination will cause mortgage interest and taxes paid to rise. As a result, home buying or home owning families that might benefit from the proposal at today’s rates will be hurt in the future.
The chart above depicts the impact of the House reform on homebuyers at different income levels. Under the proposal, many families of four who buy a home would see a modest tax reduction today (blue). However, a simple sensitivity analysis shows that as mortgage rates rise, the benefits of reform decline. What’s more, the proposal temporarily allows each parent to take a $300 family credit. When this provision expires after 5 years and using the CBO’s forecast1, nearly every middle-class home buying family will lose the benefit of reform and will be hit with a tax increase (yellow).
Simplification of the tax code has merit, as does the need to stimulate growth via productivity and regulatory reform. However, the House proposal will have broad consequences for middle class families, homeowners, and future homebuyers. This is especially important since real estate accounts for nearly a fifth of the economy, and changing tax preferences for real estate will have broad, long lasting consequences.
1 June 2017: this analysis incorporated the CBO’s forecast of 10-year Treasury rates, home prices, income, and CPI to adjust tax brackets, itemizations, standard deductions, and child credits