In late January, Congress and the president enacted their new tax law.  The new law effects “the most drastic changes to [the] US tax code in 30 years,” according to The Guardian.   In previous posts, we discussed how these changes might affect the middle of the housing market in Texas and Colorado.  Today we discuss how the “pass through” provisions in the new law might reduce tax bills for small-to-medium sized flipping and rental companies.

“Pass through” defined

If you are running a small-medium-sized flipping or rental business, chances are it is a “pass-through” business.  A business is a “pass-through” if its income “passes through” to its owners for tax purposes.  The business pays no taxes on its own return.  Its return shows how much income (or loss) the business will add to (or subtract from) to the owner’s or owners’ returns.  Pass-through businesses can take a number of different forms prescribed primarily by state law.  These forms include sole proprietorship, limited liability company (LLC), professional service corporation, S corporation, partnership and limited partnership.

The change in law

The new law cuts tax rates for corporations to 21 percent.  Absent a corresponding change to pass-through taxes, the change in corporate rates would have given corporations a significant tax advantage over pass-through structures.  Seeking to level the playing field for non-corporate businesses, Congress also included pass-through provisions in the new law.

Very generally, the new law allows pass-through owners to deduct 20 percent of their pass-through profits from their income taxes.  These business deductions are available regardless of whether the taxpayer claims the standard deduction or itemizes.  But the new law also imposes a myriad of exceptions and qualifications limiting the new deduction.   The most significant limits restrict the types of revenue included in calculating the deduction, the application of the deduction to higher-income taxpayers, and the application of the deduction to certain service businesses.

Revenue types

The new rules entirely exclude certain types of investment gains and income from the calculation of the deduction amount.  Capital gains and dividends are excluded.  Interest is as well, unless it is “reasonably allocable to a qualified trade or business.”  The new law also excludes certain gains on trading in derivatives, commodities and other financial instruments.

Taxpayer income

The new law also includes a “wage limit” that reduces the deduction for pass-through companies that do not pay significant wages or own substantial physical property.  The wage limit kicks in only for taxpayers with over $157,500 in taxable income ($315,000 for joint filers).   The law refers to the income limits by a defined term: “threshold amounts.”

“Threshold amount(s)” reference the taxpayer’s total taxable income–as stated on the taxpayer’s tax return.  This contrasts them from the “qualified business income” amounts that provide the basis for the calculation of the 20% deduction.  (Compare 11th page under (3) with 12th page under (c).)  “Qualified business income” refers to the income from the the pass-through business or businesses.  “Qualified business income” will pass through to the taxpayer’s return and may well be less than the taxpayer’s total taxable income.

The law includes two separate phase-down provisions.  The first is a pure “wage limit” applicable to all companies except “specified service” businesses. Generally, taxpayers with income below $157,500 of taxable income ($315,000 for joint filers) get the full 20 percent deduction on their pass-through income.  For taxpayers above the threshold amounts, the pass-through tax cut phases down.  The phase down continues over the income levels from $157,500-207,500 ($315,000-415,000 for joint filers).  For taxpayers above $207,500 (415,000), the “wage limit” applies in full.  That means taxpayers over $207,500 (415,000) will benefit only if their pass-through business(es) pay wages or own physical property.

“Specified service” businesses

“Specified service” refers to businesses such as lawyers, accountants, investment advisers and other financial-service providers.  For “specified service” businesses, the new law sets the same “threshold amounts,” but applies a different phase down–or actually a phase out.  The deduction from a “specified service” business phases out between $157,500-207,500 (315,000-415,000).  It disappears completely if the taxpayer earns over $207,500 ($415,000 for joint filers).

Caveats and Disclaimers

You may have heard members of Congress and the administration describe this tax bill as a “simplification.”  If you believe that, try to decipher the pass-through portion of the new law, found on the 10th-19th pages here.  Or try reading over the conference report on the new pass-through rules.  (See 543rd through 563rd pages of this document).  Or try a more reader-friendly explanation of the new pass-through rules written by a journalist-tax lawyer.  No matter what source you consult, the new rules are anything but simple.  They are byzantine and confusing even if you are a tax accountant or lawyer.  And the IRS will need to issue further guidance over the next several years to flesh out the rules, define terms, and address issues that arise.  This guidance will make the pass-through rules even more complex.  Under these circumstances, any analysis of how these rules apply to any particular business is preliminary and subject to change.

Further, the new law’s application to any business will depend on the particular circumstances.   And we are not tax specialists.  Please consult your tax accountant or lawyer if you have any doubt about how these changes apply to you.  (And it’s hard to imagine how you wouldn’t.)

Application to flipping and rental companies

Disclaimers issued, it’s time to consider how the new pass-through rules might apply to flipping and rental businesses.  At this early stage, a few key factors appear particularly salient on the topic.

Deduction applies to income, not capital gains

Flippers seek to profit by buying and selling houses.  The tax code defines profit from buying and selling assets as capital gain–sometimes.  For those in the flipping business, however, the code applies differently.  “[T]he IRS classifies individuals who actively purchase and remodel real estate for profit on a continuing basis as dealers rather than investors,” writes Mike Slack of H&R Block.  “For these people, the real estate is treated as inventory, rather than capital assets, and the profits on the sale of those properties is treated as ordinary income, subject to the self-employment tax.”

The definitions of “qualified business income” under the new law excludes excludes capital gains.  (See the 13th page under (B), “Exceptions,” (i).)  So only a flipping business reporting its profits as income will be eligible.  Occasional flippers reporting their profits as capital gains on investments will receive no deduction from the pass-through law.

The deduction should apply to any rental income.  The new law does not exclude rent from “qualified business income.”

Phase downs will probably affect some high-income flipping and rental companies

The phase down provisions of the new pass-through deduction will apply to many pass-through owners having incomes over $157,500 ($315,000 for joint filers).  This includes high-income owners of flipping and rental companies.  But whether the phase downs apply in a particular case depends on the company’s particular situation and how it accounts for its income and assets.  The first phase down  in the law–the pure “wage limit”–is particularly likely to apply to high-income owners of flipping and rental companies.

The first phase down involves a series of calculations.  Four of those calculations are identified by letters in the new law:  (A), (B)(i), B(ii) and (B).  (See 10th and 11th pages.)

• (A) equals 20% of the “qualified business income” from the business.  “Qualified business income” is essentially the pass-through business’s income with exceptions and qualifications noted above.
• (B)(i) equals 50% of the business’s W-2 wages.
• B(ii) equals 25% of the business’s W-2 wages plus 2.5% of the value of the business’s “qualified property” at the end of the tax year.  The definition of “qualified property” includes most physical property used to produce income for the business.   (See 12th page.) For purposes of this calculation, the new law values “qualified property” at the time immediately after it was acquired, with no adjustments.
• (B) is the greater of (B)(i) or (B)(ii).

The formula for the phase-down provision compares (B) to (A).  If (B) is less than (A), the phase down applies.

On first look, it appears likely that a typical flipping business having income over the threshold amount would likely be subject to the phase down.  In our experience, flipping companies tend to be relatively lean in terms of wages.  In many cases, the company pays no wages at all or pays wages only to the owner(s).  A flipping company may have significant inventory around at the end of a tax year in the form of houses held for resale.  But part (B)(ii) of the formula multiplies inventory by a very small percentage–2.5%.  So it would take a very large year-end inventory to offset 20% of a high income.

For instance, take a hypothetical successful and busy flipping company with $200,000 of income and $600,000 in property, mainly houses under rehab.  (A) would by $40,000 ($200,000 x .2).  Without wages, (B) would be (B)(ii), $15,000 ($600,000 x .025).  So (B) would be less than (A), and the phase down will apply.

A rental business with a large portfolio may be in a better position to avoid the phase down under the formula.  Take for instance a rental business with a $2 million portfolio, returning nine percent per year.  Assume no wages.  Part B(ii) of the formula would equal $50,000 (2,000,000*.025).   Part A would equal $36,000 ((2,000,000*.09)*.2).  Because (B) would be greater than (A), the phase down would not apply.  These examples are admittedly oversimplified, but you get get the point.  For a company with a high income, it takes significant wages and/or physical assets to make (A) less than (B) in the formula.

An owner might try paying wages to herself to drive number (A) down and numbers (B)(i) and B(ii) up.   (The investor may need to have an S Corp. or elect to be treated as an S Corp. to do this.)  Of course, reducing (A) may also decrease the amount of the deduction. The new law specifies that the “qualified business income” from a pass-through business does not include “reasonable compensation” paid to the taxpayer (owner) for services to the business.  (13th page under (4).)  So when wages go to the owner, the basis for the 20% calculation decreases.  Still, paying oneself wages may increase a deduction under the new law in some instances, as shown in one of our hypotheticals below.  Further, the owner may have other reasons to pay herself wages.  For instance, it may help lower self-employment taxes.    That is a discussion for another day, but definitely worth raising with your tax adviser if you have one.

In any event, some high-income owners of flipping and rental companies are likely to be subject to the phase downs under the new law.  As such, it makes sense to consider how those phase downs operate.

Application of the phase down

The new pass-through rules include two separate phase down provisions.  One is generally applicable to companies not in “specified service” businesses.  A “specified service” business means legal,  account, medical, financial services, actuarial sciences, performing arts, consulting, athletics.  It can also mean any other business where “the principal asset . . . is the reputation or skill of one or more of its employees.”  (See 553rd-554th page here.)  The IRS is probably unlikely to characterize a typical flipper or rental-property owner as a “specified service” provider.

To recap, the phase downs apply to people with income levels between $157,500-207,500 ($315,000-415,000 for joint filers).  They operate with reference back to calculations (A), (B)(i), B(ii) and (B) described above.  For ease of reference, here they are again.

• (A) equals 20% of the “qualified business income” from the business.
• (B)(i) equals 50% of the business’s W-2 wages.
• (B)(ii) equals 25% of the business’s W-2 wages plus 2.5% of the value of the business’s “qualified property” at the end of the tax year.
• (B) is the greater of (B)(i) or (B)(ii).

 

Businesses not in professional services, financial services, or other “specified service(s)”

For non-“specified service” businesses, the phase down applies only if (B) is less than (A).  The calculation breaks down into five not-so-simple steps.  And that doesn’t even include the arithmetic necessary to come up with (A) and (B) in the bullet list above.  Anyway, it works like this:

1. Take the taxpayer’s total income and subtract $157,500 ($315,000 for joint filers).
2. Take the result from step 1 and divide it by 50,000 ($100,000 for joint filers).
3. Referring back to the bullet list above, subtract (B) from (A) ((A)-(B)).
4. Multiply the result from step 2 by the result from step 3.
5. Take the result from step 4.  Subtract it from (A).  The resulting difference is your deduction.

For instance, let’s revisit our hypothetical successful and busy flipping company referenced previously.   The company has $200,000 of income and $600,000 in property–no wages.  To fill in the picture, the owner is a joint filer who together with his spouse has $350,000 of total income.  The calculation works as follows:

(A)  40,000 (200,000*.2)

(B) 15,000 [B(i)=0(0*.5); B(ii)=15,000(0+600,000*.025)]

1. 350,000-315,000=35,000
2. 35,000/100,000=.35
3. (A) 40,000-(B) 15,000=25,000
4. .35*25,000=8,750
5. 40,000-8750=31,250 (taxpayer’s deduction from the flipping business).

At taxpayer income levels above $207,500 ($415,000 for joint filers), the “wage limit” applies in full.  Actually, this makes the calculation much simpler.  The deduction from the pass-through business is the lesser of (A) or (B).

For example, return to our hypothetical above of a rental business with a $2 million portfolio, returning nine percent per year.  To flesh out the example, assume that the taxpayer has $500,000 in total income, well over the threshold amount.  Again, (A) would equal $36,000 ((2,000,000*.09)*.2).  B(i) would be 0 (no wages).  B(ii) would be $50,000 (2,000,000*.025).   (B), the greater of (B)(i) or (B)(ii), would also be $50,000.  The phase down would not apply because (B) would be greater than (A), and because the taxpayer would be well over $415,000 in total income.  The pass-through deduction would be $36,000–the lesser of (A) or (B).

 

Businesses in professional services, financial services, or other “specified service(s)”

It appears unlikely that the definition of “specified service” businesses under the new law will ensnare many flipping or rental companies.  Like we said, however, the law’s application is complicated and uncertain.  So just in case, we’ll briefly run through the phase down for “specified service(s)” businesses.

The phase down for “specified services” businesses involves the same general concepts as the broader phase down.  The “threshold amounts” are the same:  the phase down applies to taxpayers with income over $157,500 (315,000 for joint filers).  Also, like the general phase down, the “specified service(s)” phase down takes effect over the income levels between $157,500-207,500 (315,000-415,000).

The formula for “specified service” businesses operates differently, however.  And the deduction phases out completely for “specified service(s)” businesses at $315,000 (415,000) of taxpayer income, regardless of wages or other factors.  So the “specified service(s)” formula is not just a “phase down”; it’s a “phase out.”

Here is the phase-out formula for “specified service(s)” businesses:

1. Take the taxpayer’s total income and subtract $157,500 ($315,000 for joint filers).
2. Take the result from step 1 and divide it by 50,000 ($100,000 for joint filers).
3. Take 1 (or 100%) and subtract the result from step 2.
4. Take the lesser of (A) or (B).
5. Multiply the result from step 3 by the result from step 4.  The resulting total is your deduction.

Take the flipping company from the hypothetical above:  joint filers, $350,000 total income, $200,000 from a flipping company.  Now assume that $120,000 of the joint income comes from a CPA firm owned by the wife of the flipping- company owner.  The CPA firm is a pass-through professional service corporation.  For starters, assume that the CPA provides the services herself and pays no wages.  Assume further that the company has negligible physical property.  The calculation for the CPA firm would work like this:

(A)  $120,000*.2=24,000

(B) 0

1. 350,000-315,000=35,000
2. 35,000/100,000=.35
3. 1.00-.35=.65
4. (B) is the lesser (0)
5. .65*0=0 (taxpayer’s deduction from the CPA business).

So in the CPA business would generate no deduction.  Since our wife is a CPA who has studied the new rules, however, assume a slightly different hypothetical.  Take the $120,000 in income from the CPA firm and divide it into $80,000 of income and $40,000 of wages.  Now the calculation changes:

(A)  $80,000*.2=16,000

(B) 20,000 [(B(i)=20,000 (.5*40,000); (B)(ii)=10,000 ((.25*40,000)+(.025*0))]

1. 350,000-315,000=35,000
2. 35,000/100,000=.35
3. 1.00-.35=.65
4. (A) is the lesser ($16,000)
5. .65*16,000=10,400 (taxpayer’s deduction from the CPA business).

So splitting the income between profits and wages allows the taxpayer to claim a $10,400 deduction that would be unavailable otherwise.  We have found nothing in the text of the law or the Committee report that would prevent the CPA from achieving this result by paying the wage to herself.  This illustrates how it could make sense to ask your tax adviser about ways to structure your businesses and your income that could help maximize the new pass-through deductions.

Note also that in the final hypothetical, the joint filers could claim deductions from both the flipping business ($31,250) and the CPA business ($10,400).  The text of the new law does not prohibit a taxpayer from claiming deductions from more than one pass-through business.  And the examples in the conference committee report clearly indicate that Congress intended to allow more than one pass-through deduction.  (See 559th page here.)

In summary, the new law will provide deductions for many flipping and rental companies

As discussed above, the new pass-through rules operate in a complex and arcane manner.  But much of the complexity may not matter for the typical flipping or rental company.  If you have a flipping company that reports its profits as income from a business rather than capital gains, you are likely eligible for a tax deduction based on the income from that business.  And if your total taxable income is less than $157,500–or $315,000 if you are a joint filer–then the deduction will likely be 20 percent of your income from the business.  The same applies to a rental business owned by a taxpayer whose income level falls below the threshold amounts.  If your income level is over the threshold amounts, you are probably still eligible for some deduction based on the income from the business, but you will want to work through the amount with your tax adviser.

This post updates our prior offerings on the effect of the new tax law on mid-market housing prices.  In particular, we continue to focus on mid-market investors in Texas and Colorado.  Both houses of Congress passed the final tax bill just before the holidays, and Trump signed it into law.  The new law modifies two of the provisions we discussed in our previous posts.  Despite the modifications, our conclusion remains the same:  the new tax law will likely have a minor negative effect on mid-market housing prices in Texas and Colorado.

Lowering cap on mortgage amount eligible for mortgage-interest deduction

The two sides met in the middle and arrived at a $750,000 cap on the mortgage-interest deduction.  As detailed in previous posts, the original House bill included a $500,000 cap.  The original Senate bill retained the $1,000,000 cap in current law.  We previously concluded that the proposed caps were unlikely to significantly affect the middle of the housing market.  That same conclusion also applies to the compromise cap in the final law.

State-and-local tax deduction

The final law as passed allows taxpayers to deduct up to $10,000 in state-and-local tax payments.  These payments may include property taxes, income taxes, and sales taxes in states (like Texas) that impose no state income tax.  As detailed in previous posts, the original House bill allowed a deduction for up to $10,000 of state property tax, but no deduction for other state taxes.  The original Senate bill allowed no deduction at all for state and local taxes.  So the final bill is more generous to state taxpayers than either of the original bills.

In Texas, homeowners who itemize will be allowed to deduct a total of $10,000 in property and sales taxes.  The addition of sales taxes to the mix reduces the value of the property-tax exemption slightly, but probably not much.  The maximum income tax rate in Texas is 8.25 percent.  The tax exempts certain items, mainly food, prescription drugs, and over-the-counter drugs.  As such,  a typical middle-market buyer is unlikely to have more than a few thousand dollars in sales taxes to write off.  Most buyers should have plenty of room within the $10,000 deduction limit to include most or all of their property taxes.

In Colorado, home buyers will be able to allocate the $10,000 deduction between income and property taxes.   Colorado has a 4.63 percent flat income tax.   This likely generates more tax liability for the typical middle-market buyer than does the Texas sales tax.  As noted in our previous post on the House bill, however, Colorado has low property taxes.  So this rather modest difference in property-tax deductibility is unlikely to be a major factor for middle-market home buyers.

Increase in the standard deduction

The final law as passed maintains the increase in the standard deduction from the initial proposals.  So the analysis in our first post covering the House bill holds on the standard deduction.  As discussed in the previous post, the change in the standard deduction is likely the most significant change in the new law for buyers and sellers in the middle of the housing market.  A policy advisor at Zillow estimates that under current law, 44 percent of homes are worth enough that it makes sense for the taxpayer to itemize.  The same advisor projects that only about 14 percent of homes will be worth enough to merit itemizing under the new law.

Same conclusion with supporting sources

With the increase in the standard deduction remaining unchanged from the previous bills, our conclusion also remains the same.  The new law will likely have a relatively small negative effect on the middle of the housing market.  A couple recent articles support this conclusion.  This article from Curbed discusses a Moody’s Analytics research report.   The report concludes that the new tax law will reduce nationwide housing prices by about four percent relative to what prices would have been had the tax law remained the same.

Largest impacts driven by top of market

The linked article includes a heat map showing Moody’s projections for markets throughout the US.  The projections show an effect of four percent or less in much of Texas and Colorado.  Each state has a few areas where the new law is projected to affect prices by four-to-six percent.  And Colorado has a couple regions where the effect is projected to be more than six percent.

Looking closely, the areas projected to be the hardest hit appear to be those with the most expensive real estate.  In Texas, the map indicates that the  Austin is one of the markets where a four-to-six percent drop is projected.  In Colorado, the map indicates that some areas around Denver and Boulder and some ski areas in the Rockies will see impacts larger than four percent.  Overall, it appears that the top of the market likely drives most of the larger projected impacts shown on the map.  This would explain Austin, Denver, Boulder and the Rockies.  It would also explain the heavy impact shown upon swaths on the east and west coasts.   The map appears to support a projection that the new law’s effect on the middle market will likely be four percent or less.

It makes sense that the bill would affect prices at the top of the market more than the middle given the provisions discussed previously.  The law caps the mortgage-interest deduction at $750,000 and the state-and-local tax deduction at $10,000.  Both of these changes bite more for higher-cost properties.

This article from Realtor.com reaches the same basic conclusion.   It explains how the new law could hit more expensive housing markets.  But its interview subjects opine that the change will likely affect the housing market throughout most of the country only slightly.  

Next up:  Pass throughs

Many of you are likely running your investing business as “pass through” entities.  These are companies that pass their tax gains or losses through to their owners’ tax returns.  LLCs and sole proprietorships are two examples.  The new law has lengthy and complex provisions seeking to benefit pass-through entities.  In our next post, we’ll attempt to wade through these byzantine provisions and describe in general how they might save investors on their taxes.  As you read all these posts, keep in mind that we are not professional tax advisers and you should rely on your pros for definitive tax advice.

 

 

Part II–The Senate bill

Since our first post on the potential impact of proposed tax bills on real estate investors working the middle of the housing market in Texas and Colorado, Congress has taken further action.  Most importantly, the Senate republicans have proposed their own bill.  The House Ways and Means Committee also passed a revised version of the House bill, meaning it now goes for consideration by the full House.  The provisions in the House bill analyzed in our post earlier this week have not changed.  Accordingly, this post focuses on the Senate bill.

Differences from the House bill

The Senate bill differs from the House bill in two respects relating to our analysis.  First, the Senate Bill would not lower the $1 million cap on mortgage-interest deductibility.  To review, the House bill lowers that cap to $500,000.  As discussed in the original post, the House provision would not likely affect the middle of the market.  It follows that the Senate bill would not affect the middle market by keeping the limit where it is.

The second relevant difference in the Senate bill is another matter.  The Senate would completely end the deductibility of property taxes, as well as all other state and local taxes.  As discussed in the original post, the House would preserve the deductibility of up to $10,000 in property taxes.

Likely Impact

The Senate approach to the property-tax deduction would further reduce tax incentives for middle-market home buyers.  As noted in our post on the House bill, the doubled standard-deduction amounts present in both bills would reduce itemization among middle-income home buyers.  The Senate approach would intensify the reduction in itemization.  With no more deduction for property taxes, even fewer middle-income home buyers would have itemized deductions exceeding the newly doubled standard-deduction amounts.

As discussed in our prior post, even the House approach would likely leave very few middle-income homeowners who would itemize.  Educated estimates put the percentage in the single digits.  The Senate approach would likely reduce that percentage even further.  And for any remaining middle-income home owners who would still have incentive to itemize, the Senate bill would cut the value of their deductions.

The factors discussed in the previous post under “How much does it matter?” apply to the Senate bill and the elimination of the property-tax deduction just as they did to the changes in the House bill.  Despite those factors, however, we concluded that the House bill would put some downward pressure on market prices if it passed as proposed.  Applying the same reasoning, we conclude that the Senate bill would put more downward pressure on the middle market than the House bill.  Accordingly, the Senate bill is as written has relatively more potential to negatively impact real estate investors than the House bill.

A word about broader economic effects

Anyone following the debate over these bills will hear claims and counterclaims about broader economic effects the bills may have.  Supporters of the bills will claim that they will lift the general economy.  The positive overall economic impacts will offset the loss of any particular benefit or deduction, supporters claim.  Opponents of the bills will argue that they will not have the positive economic effects supporters claim.  Some opponents also believe the bills will have negative economic effects that will offset any positive effects.  For instance, the bills would very likely increase national deficit and debt levels, which could crowd credit markets and raise interest rates.

Predicting future trends, causes and effects in the broader economy is notoriously fraught with peril.  It is  also beyond the scope of this post.  So we are not attempting to resolve conflicting predictions about the broader economic consequences of the bills.  That’s why we have focused only on the proposed changes to provisions that directly affect incentives in the middle of the housing market.

 

 

 

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.

 

 

 

Introduction and observation

Welcome to the website for FlipFunds Southwest, a hard money lender to real estate investors undertaking flip/rehab projects.  We make loans to investors on properties throughout Texas and we are looking to expand to the Colorado market.  The pages of this site include a description of our flip-loan business, contact information, general descriptions of some of our recent loans, and some key considerations for evaluating a hard-money loan.  If you are looking for a commercial loan on a rehab property in Texas, we hope you will contact us to see if we can help.

We also want this site to be informative for visitors interested in information relating to the rehab business–either specifically or broadly.  In this vein, our links page connects to a number of recent articles about the rehab business in Texas, the housing market and the wider economic context.

Which brings us to today’s topic.  A few days ago, the venerable New York Times published an article on the nationwide flipping business.   The piece generally provides a good high-level summary of the risks and benefits in the business.  It hits many of the same areas discussed in several of the articles listed on our links page.

The Big Fish

Our present discussion will focus on one trend noted in the article:  the entry of larger finance companies into the market.  A number of large private-equity and asset-management companies are becoming increasingly active in the market.  And as the Times reports, Goldman Sachs recently bought flip-financier Genesis Capital.

It makes sense that Wall Street financial behemoths would find their way into any profitable financial endeavor.  And it is not surprising to find in the middle of the fray Goldman, which Rolling Stone’s Matt Taibbi famously described as a “great Vampire Squid wrapped around the face of humanity, relentlessly plunging its blood funnel into anything that smells like money.”  Hyperbole aside, scale arguably has its benefits.  Some investors  may see advantages in dealing with these giant companies given their large organizations and deep access to funds.

We just ask you to shop around and ask yourself a few questions.  Can these large companies really close as fast as a small lender working with independent local brokers?  Will they be as flexible on terms?  Will they respond as quickly to your draw requests, payoff requests, and other periodic needs?  Consider all of your options and compare them on all factors that are important to you and your project.  And we hope to be one of the options you consider.  Give us a chance and we think you’ll like us.