Here are my views of how federal tax policy makes houses much more expensive for American families. I’m not a tax expert at all but this is is how the tax code overly benefits landlords and hurts American families. -John

Congress last week proposed a lot of changes to the tax code.

The National Association of Realtors (NAR) will no doubt say the changes are the end of the world as we know it because the standard deduction (the amount that is NOT taxed) would be doubled and that, in turn, would mean that people would pay less in taxes and that in turn would mean the mortgage interest deduction would save fewer people money and save those people less money.

And, apparently, it would hurt NAR’s feelings if people paid less in taxes and it wasn’t due to people buying the product they sell.

A lot of these proposed changes wouldn’t apply to your current home but would only apply to homes you buy in the future.

But there’s one large group that can keep the Mortgage Interest Deduction 100% – investors in single family homes and condos.

My understanding is mortgage interest payments are business expenses for real estate investors and are fully tax deductible. (Please leave a comment if that’s inaccurate.)

So if you want to deduct 100% of your mortgage interest, maybe you should rent your house back to yourself. (Just kidding… I think.)

The federal tax code gives huge tax breaks to investors of single-family homes and condos.

Those tax breaks let investors bid more on houses and that drives up home prices.

Tax breaks for investors make homes MUCH LESS AFFORDABLE for American families.

Tax Breaks for Investors of Single-Family Homes

  • Mortgage Interest Deductible
  • State & Local Taxes & Property Taxes Deductible
  • (Pretend) Depreciation Deductible
  • 1031 Exchanges to Avoid Depreciation Recapture
  • Low Long-Term Capital Gains Tax Rate
  • Cash-Out Refis are “Tax-Free”
  • Investment Losses Reduce Taxes on Wage Income
  • No FICA Tax on Income (May Change)
  • End of Alternative Minimum Tax (Maybe)

Mortage Interest Deduction

Even if this tax bill passes as is, investors will still be able to deduct their mortgage interest payments from their federal taxes as business expenses. Investors will still be able to afford to pay a higher price for homes than non-investors, AKA “families.”

For investors, the breakeven price they can pay for a home is higher when they can deduct their mortgage payments from their taxes.

State/Local Taxes & Property Taxes Deductions

Like mortgage interest, state and local taxes, including property taxes, will remain business expenses and will remain 100% deductible for investors in single-family homes and condos.

The proposed tax bill eliminates the deduction for state and local taxes for individuals and couples and reduces the maximum amount of property taxes that can be deducted.

Depreciation Deduction

Homes don’t wear out like factory equipment. After a number of years a machine becomes worthless, it’s completely worn out. That doesn’t happen to homes.

Homes are completely different. 

The tax code lets investors depreciate homes for 27.5 years. Has there ever been a time in American history where home values weren’t phenomenally higher priced 27.5 years after purchase? Homes do NOT wear out like factory equipment.

Homes appreciate. Homes don’t depreciate.

So why do we give real estate investors a tax break for pretend depreciation?

Let’s say an investor pays $200,000 for a house and the land value is $30,000. The investor can pretend depreciate $170,000 for tax purposes. Let’s say the investor nets $500 per month. The investor keeps the $500 per month as income but the investor does NOT have to pay any tax on that $6,000/year income because the annual pretend depreciation for tax purposes on that house is more than $6,000. ($170,000/27.5 years = $6,181 pretend depreciation a year)

Homes are different. If the tax code was based on the reality that homes don’t wear out like factory equipment – that homes appreciate, they don’t depreciate – and the tax code removed the depreciation deduction for single-family homes and condos, the breakeven price most investors could pay for a house would be less and homes would be more affordable for American families.

One reason homes are so unaffordable is we have a tax code that encourages over-investment, and really, over-speculation, in single-family homes and condos.

Yes, there is a thing called “Depreciation Recapture.” When that investor above sells that house they paid $200,000 for, they’ll have to pay a tax (~25%) on the amount they depreciated.

Deferring the tax with the depreciation deduction means the government essentially LENDS money to people to speculate in single-family homes and condos.

If investors had to pay taxes on that $6,000 net rental income every year, that changes the breakeven price they can pay upfront for the house, especially for investors banking on the house appreciating in value. That is, the depreciation deduction encourages speculation in single family homes and condos.

Of course, if investors didn’t have a depreciation deduction for single-family homes, that would also mean investors would NOT have to pay the depreciation recapture tax later when they sold the house. The investor would pay a LOT less tax when they sell the house which would encourage investors to sell and increase the supply of homes for sale.

Everyone is complaining today about the tight housing supply. The tax code is one reason.

If we removed the depreciation deduction on single-family homes and condos, that would tend to increase the number of homes that come up for sale. And sometimes those investors would sell their investment properties to American families.

The current system encourages people to speculate in single-family homes and condos by letting them put off paying their taxes and then the system discourages those people from selling their homes by making them pay a large depreciation recapture tax when they sell.

The tax code’s pretend depreciation encourages investing and speculating, and then it discourages selling. Both increase home prices for American families.

1031 Exchange

With this nifty tax provision, investors and speculators can sell their single-family homes and condos and NOT pay the depreciation recapture tax. They just have to buy another investment property.

Joe Homeowner can’t indefinitely defer paying many thousands of dollars of taxes when they sell a home by simply buying another single-family home. Investors can.

The 1031 Exchange encourages investors to buy a home at the same time they sell a home. Without the 1031 Exchange provision, investors would buy fewer homes when they sell homes and the supply of homes for sale would increase a bit.

An easy way to increase the supply of single-family homes for sale a bit would be to remove 1031 Exchanges for single-family homes and condos.

Leave 1031 Exchanges for apartment buildings, office buildings, warehouses and so on. All those players are investors and they’re all playing by the same rules.

But with single-family homes and condos, you have two sets of players. Investors are playing by a completely different set of rules than families but both are competing against each other to buy for the same homes.

If people want to invest in real estate, let them invest in apartment complexes, office buildings, warehouses or real estate investment trusts.

But single-family homes and condos are different. You have two very different set of players. I think family homeowners are more important than the investors. The tax code hurts families when it gives tax breaks to investors it doesn’t give to families.

Long-Term Capital Gains

This is a bigger issue than just housing but I’m not seeing why you should pay a higher tax rate on your salary than what an investor would pay when selling the rental house next door. Why do salaries get taxed at a higher rate than investment income? Doesn’t seem fair.

In this case, the lower rate for long-term capital gains encourages over-investment and over-speculation in single-family homes and condos which prices out some families from homeownership.

Cash-Out Refis are “Tax-Free”

Let’s say that investment house you paid $200,000 for appreciates a lot so you do a cash-out refi and get $40,000 in cash. It’s tax-free cash, at least for now. You’ll have to pay taxes on it someday, but not today, and maybe not for many years.

And with 1031 Exchanges, you can even sell the house you did that cash-out refinancing on years ago and still not pay the taxes on the $40,000, at least not yet.

Investment Losses Can Lower Taxes on Wages

Passive losses on your real estate investments can be used to lower your taxable wage income by up to $25,000. So, up to $25,000 of your wage income would not be taxed because of your real estate investment losses.

Again, the tax code rewards over-investment and over-speculation in single-family homes and condos.

It’s a bummer that you over-paid for that investment property and it doesn’t cash-flow but at least the investment is reducing the taxes you pay on your wage income and the house is appreciating every year. You’ll likely make money in a few years when you sell it. In the meantime, the tax code reduces your cost of owning the investment home.

No FICA Taxes (May Change)

Currently, the real estate investor next door doesn’t pay any Social Security/Self-Employment taxes on their (tax-advantaged) rental income each month or their (tax-advantaged) capital gains income when they sell.

However, that may change with the new tax bill. As currently drafted, some types of income would have to start to pay the self-employment tax.

End of Alternative Minimum Tax (Maybe)

And finally, the proposed tax bill gets rid of the alternative minimum tax. This would benefit some investors.

Real estate investors who in previous years had to pay the alternative minimum tax will likely pay less in taxes in the future if that provision is in the final tax bill. I don’t know how many real estate investors currently pay the alternative minimum tax.

Takeaway

Single-family homes and condos are different.

Tax breaks given to investors and speculators in single-family homes and condos drive up home prices and monthly mortgage payments for families.

Those higher mortgage payments take money away from the rest of the economy. Single-family mortgage companies, investors, and speculators benefit but the overall economy suffers.

Investors and speculators in single-family homes and condos add a lot of instability to home prices and households. When home prices are rising fast, investors and speculators buy more homes which can quickly cause big increases in home prices for families. When prices are falling, investors and speculators bail out a lot more quickly which only makes things worse for the family homeowners who are trapped with high mortgages and high mortgage payments.

Family ownership is a lot more stable than investor ownership. Given the incredibly inelastic supply of homes, small changes in (investor) demand create huge changes in prices.

When it comes to affordable housing for the middle 90% of Americans, government policy should be, “first, do no harm.”

That means first correcting tax policies that lead to higher home prices for families.

And there’s no need to “punish” current investors and speculators in order to create new tax policies that lead to more stable home prices, household wealth and a stronger economy in the future.

Just give current investors some new temporary tax breaks during the transition.  Maybe reduce the depreciation recapture tax on current investment properties. The goal isn’t to punish current investors. The goal is leveling the playing field to create wealthier families in the future.

The goal is “Homes for Homeowners.”  

(FYI, A reduction in the depreciation recapture tax would also encourage the selling of investment properties which would help with the tight supply of single-family homes for sale and housing affordability.)

What Do YOU Think? Leave a comment.

P.S. I’m not a tax expert, at all. I’m an economist. This is intended as a discussion paper of the economic impact of current tax policies on American families.

Here’s a GREAT summary of the tax advantage of investing in real estate. Brandon may never talk to me again if he reads this post of mine but his post is still REALLY good.

And here’s a great summary on the new tax bill from an accounting firm.