This week’s post considers the impact the House tax bill could have on the flipping/rehab business for middle-market houses in Texas and Colorado. This is a preliminary assessment, subject to change as more information becomes available. No doubt eyelids are getting heavy after that intro. Remember though, this could affect the business. As explained below, we believe that if the current proposal were to pass, it would likely have a negative impact. But the effect would more likely be small than large.
Background
House Republicans introduced their tax bill on Thursday November 2. Several home-builder organizations immediately declared their opposition due largely to issues discussed in this post. The bill is likely to undergo changes before the House votes on it. The process of reconciling the House bill with whatever bill the Senate proposes will involve further changes. Anyone wanting a refresher on that process can revisit this good old “Schoolhouse Rock” video. Or you could watch one of the many satirical versions that might more realistically represent the current process.
Three provisions in the Bill have become the focus of popular commentary for their likely impact on the housing market: a lowering of the cap on the mortgage amount eligible for the mortgage-interest deduction; a cap on the deductibility of state and local property taxes; and an increase in the standard-deduction amounts. While the first two categories have generally received more attention, the third is by far the most likely to affect the flipping business in the middle market.
Lowering cap on mortgage amount eligible for mortgage-interest deduction
Current tax law allows homeowners to deduct interest paid on mortgages for amounts up to $1 million. The proposed bill would reduce that amount to $500,000. So the change would allow homeowners with mortgages over $500,000 to deduct only interest on $500,000 of principal. This would impact the broader market in areas where housing is very expensive, mainly on the east and west coasts. In states like Texas and Colorado, however, this change should not significantly affect sales in the middle of the market.
Cap on deductibility of property taxes
The bill would also cap the amount of deductible property taxes at $10,000. So taxpayers who pay over that amount in state and local property taxes could only deduct $10,000.
Similar to the change in the mortgage-interest deduction, the cap on property-tax deductibility would primarily affect the top of the market. Even in areas like Dallas-Ft. Worth with relatively high property taxes, the maximum rates generally fall around 2.5-3%. (Colorado has much lower property taxes; the change is unlikely to affect the middle market in Colorado at all.) At a full 3% tax rate, a homeowner would hit the $10,000 ceiling only on a property with an assessed value of $330,000 or more.
Further, while flippers themselves are commercial borrowers not eligible for the homestead exemption, buyers for rehabbed houses generally will qualify for the exemption. The exemption will generally reduce the buyer’s taxes by roughly 20%. Considering the 20% homestead exemption, the limit would apply only to properties with assessed values well over $400,000.
And even if the tax on a property exceeds $10,000, the first $10,000 would still be deductible. So the change would not bite that hard on homeowners with property tax bills only slightly over $10,000.
As such, the proposed change in property-tax deductibility will likely have little affect on the middle market in Texas and Colorado. But stay tuned for the next change, which would largely eliminate the incentive for many taxpayers to deduct their property taxes (and mortgage interest) at all.
Increase in standard deductions
The proposed bill would double standard-deduction amounts–from $6,350 to $12,000 for singles and from $12,700 to $24,000 for joint filers. As many will already know, standard and itemized deductions are either-or: you take the higher of the two. Higher standard-deduction amounts would cause more taxpayers to opt for the standard deduction. Those taxpayers switching to the standard deduction would no longer take itemized deductions, which include the mortgage-interest deduction and the property-tax deduction.
The head of the congressional Joint Committee on Taxation estimated Monday that the percentage of taxpayers itemizing would likely shrink from 29 percent now to six percent if the proposed bill becomes law. It follows that the percentage of taxpayers taking the mortgage-interest deduction will also fall. That percentage would decrease from 21 percent to four, according to a well-known tax think tank. The percentage of taxpayers deducting property taxes would likely fall by a similar ratio.
Unlike other changes in the bill, the standard-deduction increase would likely affect the middle of the market more than the top. The lower a taxpayer’s mortgage-interest and property-tax payments, the more likely the doubled standard-deduction amounts will exceed the taxpayer’s itemized deductions. So it stands to reason that few people shopping for homes in the middle market would be deducting mortgage interest or property taxes under the House proposal. This article includes a chart showing the income distribution of taxpayers taking itemized deductions under current law. If the percentage of taxpayers itemizing falls into single digits, very few taxpayers with incomes under $200,000 will likely be deducting mortgage interest.
The mortgage-interest and property-tax deductions provide tax incentives to buy houses rather than rent. The proposed tax bill would likely cause the deduction incentive to disappear from the middle market. So potential buyers would no longer have the same tax incentive to buy homes.
How much does it matter?
Opinions differ on how much tax incentives really affect the middle of the housing market. Some argue that the home-mortgage interest deduction already benefits primarily high-end purchasers with large incomes and mortgages. They add that shortages in inventory (see our main page) are keeping prices up and will more than offset any loss in demand due to the tax change. Others argue that any decrease in demand is likely to reduce prices. If the change in tax laws makes even a fraction of buyers in the market less willing to pay current prices, it will likely reduce market prices somewhat.
Both sides of the argument have valid points. Fundamentally, the change is likely to decrease the amount some buyers in the market are willing to pay. This will create downward pressure on prices. So if the change passes, it will likely keep prices lower than they would have been if current law had remained in effect. On the other hand, taxes are likely a rather small factor in the decision to buy a home for most middle-market buyers. The supply of houses in the market is likely a much larger factor than taxes. Given the large number of factors in the market and the secondary importance of taxes, the tax change would likely have a small effect on prices rather than a large one.