Texas’ tax-friendly nature and relatively affordable housing have attracted an influx of new residents, particularly from California and New York; I’m one of them. But will pending tax legislation lead to a slowdown in the Texas real estate market?
I hope not – and I have a personal stake in the matter. Although I recently wrote about why I didn’t think it was an ideal time to invest in Austin real estate, I will be doing just that soon. As I mentioned this summer, after all, buying a home is not only a financial decision, and my life has changed in the past couple of months.
But my thinking isn’t only blind optimism. I think I can make a good case that the potential tax changes Congress is considering might help Austin’s real estate market, even if they may hurt other regions.
The highest-profile changes to the tax code under discussion are the proposed reductions in corporate and personal income tax rates. Though the House bill and the Senate bill differ, both focus on cuts in these areas. Increasing the standard deduction and changing rules governing itemized deductions will affect people living in different parts of the country much differently.
By increasing the standard deduction to $12,000 for single people and to $24,000 for married couples – a feature of both chambers’ bills – Congress would reduce the number of people who benefit from itemizing their deductions. But for those who still itemize, the benefits of owning a home will likely change. The House bill limits the real estate tax deduction to $10,000 and limits the deductibility of mortgage interest to only interest on the first $500,000 of indebtedness, reduced from the current $1.1 million ceiling. (This change would only apply to new mortgages, not current homeowners.) The version of the Senate bill that cleared the Finance Committee this week eliminates property tax deductions altogether, though the mortgage interest deduction would remain for primary residences.
While we do not yet know for sure how the two chambers will reconcile their plans, or even that tax reform will certainly pass at all, it seems at least reasonable to consider what would happen if property tax and mortgage interest deductions suddenly became irrelevant to people who no longer itemize and less useful to those who still do.
When I first pondered these proposed tax changes and read commentary that they could negatively impact housing prices by around 10 percent, I was inclined to agree with at least the direction of the predicted change. However, after I thought about and discussed the Republican plan further, I realized that, like many personal finance topics, the real answer is more nuanced.
I analyzed my own situation under a variety of different scenarios. I currently rent and claim the standard deduction, but I considered how the proposals would affect me in different hypothetical futures: renting versus owning under both the current and proposed tax regimes. Whether I rent or own, I would be better off if the House’s tax changes were enacted. For me, the biggest difference would be the higher standard deduction, which would eat up the majority of the value of tax deductions related to owning a home. So if the House Republicans’ tax plan passed, I would have more disposable income, but the tax code would no longer incentivize me strongly to buy a house.
In certain circumstances, I could save about $3,700 per year by buying a house under current tax rules. Under the new rules, I would save about $500 per year. That’s about a $265 per month difference. With a 3.875 percent interest rate on a 30-year mortgage, that $265 savings would allow me to afford about $56,000 of house. You could argue that this is a decent proxy for the amount that the mortgage interest deduction has inflated housing prices.
Current tax rules incentivize buying a house over renting by making a portion of the cost of homeownership tax deductible. If the experience of owning a home and renting one were exactly the same, then fully rational individuals would theoretically compare the cost of owning to the cost of renting, including estimates of potential future changes and opportunity costs, and then pick the cheaper alternative.
People are not perfectly rational, however. The decision to buy a home is not always a financial decision, or at least not purely a financial one, and few people would base their choice entirely on running such calculations. Changing the tax code will not change human nature or the pride of homeownership.
Most people don’t look at the effective tax subsidy when they buy a home at all – not directly, anyway. They ask how much a particular property will cost every month. If you are not a tax professional, this question generally does not account for taxes, because most people wait to get their tax refund until after they file their return. It is not something they factor into their sense of a home’s monthly cost.
Nonetheless, the interaction between housing costs and taxes ultimately influences how much people can spend for housing, since they can only spend every dollar of income once. But I believe that, in the end, the key driver of housing spending is net disposable after-tax income. Most people are willing to pay more for housing when their incomes rise, even if their families don’t grow at the same time. They do pay less when other components of the monthly house payment, such as property taxes and mortgage rates, go up – but because they have less to spend, not because they particularly care about the division between deductible and nondeductible costs.
The bottom line is this: If the tax reform bill doesn’t reduce spendable income for most Texans, why would it reduce the amount they spend on housing?
While I will be personally better off if the tax cuts go through, whether or not I buy a home, some of my colleagues who earn a similar income but live on the East Coast will be hurt if the proposal becomes law. This is predominantly because they would lose the deduction for state and local income taxes, a feature of both the House and Senate plans. Although their marginal tax rates might decrease, my colleagues’ overall tax burdens would increase, leaving them with less to spend on housing. This decrease in spendable income could depress some housing markets in high-tax areas like California and metro New York City.
California and New York’s loss could potentially be Texas’ gain. Our comparative advantage would grow with these tax changes, which should in turn create a greater demand for housing, particularly in areas like Austin that already have drawn in outsiders. This increased demand could keep upward pressure on housing prices.
If Congress enacts the proposed tax rules, who wants to join me in the Lone Star State?
Posted by Benjamin C. Sullivan, CFP®, CVA, EA
Texas’ tax-friendly nature and relatively affordable housing have attracted an influx of new residents, particularly from California and New York; I’m one of them. But will pending tax legislation lead to a slowdown in the Texas real estate market?
I hope not – and I have a personal stake in the matter. Although I recently wrote about why I didn’t think it was an ideal time to invest in Austin real estate, I will be doing just that soon. As I mentioned this summer, after all, buying a home is not only a financial decision, and my life has changed in the past couple of months.
But my thinking isn’t only blind optimism. I think I can make a good case that the potential tax changes Congress is considering might help Austin’s real estate market, even if they may hurt other regions.
The highest-profile changes to the tax code under discussion are the proposed reductions in corporate and personal income tax rates. Though the House bill and the Senate bill differ, both focus on cuts in these areas. Increasing the standard deduction and changing rules governing itemized deductions will affect people living in different parts of the country much differently.
By increasing the standard deduction to $12,000 for single people and to $24,000 for married couples – a feature of both chambers’ bills – Congress would reduce the number of people who benefit from itemizing their deductions. But for those who still itemize, the benefits of owning a home will likely change. The House bill limits the real estate tax deduction to $10,000 and limits the deductibility of mortgage interest to only interest on the first $500,000 of indebtedness, reduced from the current $1.1 million ceiling. (This change would only apply to new mortgages, not current homeowners.) The version of the Senate bill that cleared the Finance Committee this week eliminates property tax deductions altogether, though the mortgage interest deduction would remain for primary residences.
While we do not yet know for sure how the two chambers will reconcile their plans, or even that tax reform will certainly pass at all, it seems at least reasonable to consider what would happen if property tax and mortgage interest deductions suddenly became irrelevant to people who no longer itemize and less useful to those who still do.
When I first pondered these proposed tax changes and read commentary that they could negatively impact housing prices by around 10 percent, I was inclined to agree with at least the direction of the predicted change. However, after I thought about and discussed the Republican plan further, I realized that, like many personal finance topics, the real answer is more nuanced.
I analyzed my own situation under a variety of different scenarios. I currently rent and claim the standard deduction, but I considered how the proposals would affect me in different hypothetical futures: renting versus owning under both the current and proposed tax regimes. Whether I rent or own, I would be better off if the House’s tax changes were enacted. For me, the biggest difference would be the higher standard deduction, which would eat up the majority of the value of tax deductions related to owning a home. So if the House Republicans’ tax plan passed, I would have more disposable income, but the tax code would no longer incentivize me strongly to buy a house.
In certain circumstances, I could save about $3,700 per year by buying a house under current tax rules. Under the new rules, I would save about $500 per year. That’s about a $265 per month difference. With a 3.875 percent interest rate on a 30-year mortgage, that $265 savings would allow me to afford about $56,000 of house. You could argue that this is a decent proxy for the amount that the mortgage interest deduction has inflated housing prices.
Current tax rules incentivize buying a house over renting by making a portion of the cost of homeownership tax deductible. If the experience of owning a home and renting one were exactly the same, then fully rational individuals would theoretically compare the cost of owning to the cost of renting, including estimates of potential future changes and opportunity costs, and then pick the cheaper alternative.
People are not perfectly rational, however. The decision to buy a home is not always a financial decision, or at least not purely a financial one, and few people would base their choice entirely on running such calculations. Changing the tax code will not change human nature or the pride of homeownership.
Most people don’t look at the effective tax subsidy when they buy a home at all – not directly, anyway. They ask how much a particular property will cost every month. If you are not a tax professional, this question generally does not account for taxes, because most people wait to get their tax refund until after they file their return. It is not something they factor into their sense of a home’s monthly cost.
Nonetheless, the interaction between housing costs and taxes ultimately influences how much people can spend for housing, since they can only spend every dollar of income once. But I believe that, in the end, the key driver of housing spending is net disposable after-tax income. Most people are willing to pay more for housing when their incomes rise, even if their families don’t grow at the same time. They do pay less when other components of the monthly house payment, such as property taxes and mortgage rates, go up – but because they have less to spend, not because they particularly care about the division between deductible and nondeductible costs.
The bottom line is this: If the tax reform bill doesn’t reduce spendable income for most Texans, why would it reduce the amount they spend on housing?
While I will be personally better off if the tax cuts go through, whether or not I buy a home, some of my colleagues who earn a similar income but live on the East Coast will be hurt if the proposal becomes law. This is predominantly because they would lose the deduction for state and local income taxes, a feature of both the House and Senate plans. Although their marginal tax rates might decrease, my colleagues’ overall tax burdens would increase, leaving them with less to spend on housing. This decrease in spendable income could depress some housing markets in high-tax areas like California and metro New York City.
California and New York’s loss could potentially be Texas’ gain. Our comparative advantage would grow with these tax changes, which should in turn create a greater demand for housing, particularly in areas like Austin that already have drawn in outsiders. This increased demand could keep upward pressure on housing prices.
If Congress enacts the proposed tax rules, who wants to join me in the Lone Star State?
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