From our Company Chief Economist, Selma Hepp
Proposed tax changes that impact individual ownership of real estate include:
- Eliminating deductions for state and local income taxes
- Lowering the cap on mortgage interest deductions on newly issued loans totaling no more than $500,000, down from the current $1 million
- Senate’s revised proposal released yesterday aims to keep the $1 million mortgage interest cap
- Ending deductions on second homes or vacation homes
- A new cap of $10,000 on property tax deductions
- Limits to the capital-gains exemption used by homeowners when they sell
- The impact would be particularly severe for households with incomes between $100,000 and $200,000 –; though most income groups stand to lose.
- Limiting the mortgage interest deduction to $500,000 impacts 46 percent of Los Angeles metropolitan area home sales.
- With MID cap at $500,000, buyers with a new mortgage of $1 million would lose $20,000 in deductible mortgage interest in the first year.
- Putting caps on the new buyers and placing further limits on capital gains exemptions would discourage current homeowners from selling, further intensifying the inventory shortages that are plaguing the region.
Last week, the House Republicans released their much-anticipated tax reform proposal. The plan proposes to cut the corporate tax rate to 20 percent from 35 percent and reorganize individual tax rates from seven brackets into four. Taxes are a complicated subject, and with any sweeping change such as the proposed reform, the devil is in the details. While the proposal promises to save an American family an average of $1,182 per year, some of the proposed changes could be devastating for current and future California homeowners. While, Senate version of the tax bill changes some of the provisions, many of proposed changes would still challenge California housing markets.
To understand the impact of these proposed changes on Californians, let’s examine the distribution of tax filers, as well as what type and the amount of itemized deductions they take. Figure 1 contains 2015 IRS Individual Income and Tax Data for California tax filers.
Since the tax proposal increases the standard deduction from $6,350 to $12,000 for individuals and $12,700 to $24,000 for married couples, we’ll focus on the filers who itemize their deductions and will consequently be affected by the proposed changes. Thirty-four percent, or about 6.12 million, California taxpayers itemized their deductions in 2015, with average total itemized deductions equaling about $36,800. Thus, for those 34 percent of tax filers, losing some of the proposed deductions would make a notable difference in their adjusted gross incomes.
Source: IRS, Statistics of Income Division, Individual Master File System, August 2017.
Admittedly, things are little more complicated than the numbers suggest. For filers with adjusted gross incomes of less than $75,000, who comprise 35 percent of all itemized returns, averages of total itemized deductions (row f) do not exceed the $24,000 proposed deduction for couples. Nevertheless, those filers are more likely to be single, (row b), in which case the proposed standard deduction of $12,000 would apply. Interestingly, only 35 percent of all California tax-filers are joint returns. That share increases to 50 percent and higher among adjusted-gross incomes (AGI) above $75,000.
Thus, even for single-filers with AGI below %75,000, their average total itemized deductions, if they itemize, exceed $12,000. Hence, they stand to lose some of the deductions from proposed changes. The largest impact stems from losing the state and income deductions, since this group of filers generally does not pay real estate taxes of more than the $10,000 cap. Unfortunately, the revised Senate version of the bill still recommends removing the state and local income deductions which is one the major reason a third of California tax filers itemize their taxes.
In terms of the mortgage interest deduction, since the proposed cap would apply to newly originated mortgages going forward, current borrowers would not be affected. However, homebuyers with gross adjusted incomes of less than $75,000 could choose to purchase properties priced below $625,000 to maximize on their mortgage interest deduction, although they may not be able to qualify unless they have a substantial down payment.
However, the proposed tax changes could be more disadvantageous for those with incomes over $75,000, who comprise two-thirds of itemized filers and one-third of California returns. Also, home prices in Los Angeles metro area are rapidly approaching $625,000. In September, median price for Los Angeles County stood at $606,110, which is over 10 percent increase from a year ago, with the forecast of strong future increases. This means that the mortgage interest deduction cap (assuming a home price of $625,000 with 20 percent down would mean a mortgage of $500,000) would be a serious concern for some of the buyers.
Figure 1, row f shows the average of total itemized deductions, which average between about $23,000 and $53,000 for adjusted gross incomes between $75,000 and $500,000. Simply eliminating state and income taxes may be most arduous for filers earning between $100,000 and $200,000 and $200,000 and $500,000. As row g suggests, 28 percent to 42 percent of their total deductions come from state and local income taxes. Among all returns, the value of state and local deductions comprises 43 percent of the total value of itemized deductions. If those are removed for the $200,000-to-$500,000 adjusted gross income group, the remaining deductions come close to standard deduction (assuming joint returns, which most of them are, according to row b). For the $100,000-to-$200,000 bracket, a quarter of Los Angeles households, losing the state and local income tax deductions removes the need to itemize deductions, since the remaining deductions fall below the standard $24,000 limit. All in all, removing the ability to deduct state and local income taxes markedly increases bills for many California residents.
Further, while the mortgage interest deduction averages $12,283, and 24 percent of all returns deduct the mortgage, the proposed changes are more impactful on the future homebuyers and the housing market in general since the proposed changes would apply to newly originated mortgages.
Over the last year, about 50 percent of Los Angeles metro homes sold were priced above $625,000, and 15 percent were priced higher than $1.2 million. Those two price benchmarks represent mortgages between $500,000 and $1,000,000, with an assumed 20 percent down payment. Thus, half of home sales are at a potential loss from changes to the mortgage interest deduction.
Nevertheless, the lower cap on the mortgage interest deduction would be particularly detrimental to buyers in Los Angeles communities where median prices exceed $1million. For example, a buyer of a $1.2 million home with a $1 million mortgage would pay almost $40,000 in amortized interest in the first year. However, at the $500,000 mortgage interest deduction cap, the buyer would be able to deduct only half of that interest, thus losing about $20,000 in deductions. Again, if this is a first-time buyer and falls in the income range of between $100,000 and $200,000, the loss of a $20,000 mortgage interest deduction would make a notable difference, not only in the resulting tax bill but also on the decision to purchase a home. Also, note that while the proposed tax plan reduces the number of brackets, not everyone’s tax rate will decrease, and these deductions will play a big role in where a household falls along the income spectrum.
Furthermore, a $10,000 cap on real estate property taxes would also impact those buying a home priced above $1 million, since California property taxes generally average about 1 percent. Again, in Los Angeles metro, 20 percent of home sales year to date were priced higher than $1 million. For example, a buyer of a $3 million home would lose $20,000 in property-tax deductions.
Moreover, with proposed changes impacting future homebuyers, current homeowners are less incentivized to sell, which would further intensify the severe inventory shortage in Los Angeles metro — especially for more affordable homes.
In addition, the proposed change that limits the capital-gains exemption used by homeowners when they sell would be another major blow for supply conditions. Under the new proposal, homeowners must have owned and lived in the home for at least five of the last eight years to qualify for the exemption. Currently, the rule is two of the last five years. The exclusion would also be limited to one sale every five years rather than one every two years. In addition, households with incomes over $500,000 if married or $250,000 if single lose the exclusion. With the current capital-gains exemption limit at $500,000, it already poses a constraint on many current owners whose homes have appreciated significantly since they purchased them and who consequently choose not to sell. Further limiting the use of the capital-gains exemption will slow housing turnover even more. At the end of the day, while severely undersupplied inventory may help push prices higher, the proposed changes would lead to fewer home sales and an even more difficult environment for first-time buyers.
Taken together, the proposed tax reform is a serious concern for Los Angeles homebuyers and the future of the housing market. Again, the proposal is still under revision and Senate’s version has made some concessions for California homeowners. Still, this is still a long way of being in interest of California’s and America’s families.
Ultimately, we may or may not see some form of tax reform pass. Admittedly, the changes discussed here are somewhat simplified, and not all proposed changes have been evaluated. Also, this analysis does not include the potential impacts on corporate taxes, charitable deductions, or pass-through organizations. Overall, we would urge caution with moving forward with the proposal as it currently stands.