Impacts of Proposed Tax Reforms on Real Estate

The current versions of both the house and senate tax reform proposals include changes that will impact the real estate market.  The biggest impacts will come from changes to 1) the mortgage interest deduction; 2) capital gains exemptions; and 3) local property tax deductions.

Under the proposals, allowable mortgage interest deductions will be reduced from interest on $1M of mortgage down to $500,000 of mortgage.  However, this change would only affect new mortgages (those taken out after the new tax law were to go into affect).  While theoretically only impacting the higher end market, the effects could ripple out to the rest of the market.  Because existing mortgages would be grandfathered in (which means they could continue to deduct the same amount of  interest on their mortgage), there would be more incentive for those homeowners to stay put, which could impact the amount of available inventory in the upper end, which could then impact pricing and affordability in that sector.  If it becomes more expensive to move-up into a higher-end home because of lack of available inventory, diminished tax deductions, and the need/desire to put more money down (because of the diminished deductions), then the lower-end homeowners are more likely to stay put as well, which could in turn affect inventory and affordability in that sector as well.

Proposed changes to the capital gains exemptions would require a homeowner to have lived in his or her home for 5 out of the last 8 years, as opposed to the current 2 out of 5 years requirement, in order to claim an exemption on their capital gains from the sale.  Again, this change would incentivize more people to stay put for longer periods of time in order to reduce their tax liability upon selling.   In a market that has appreciated significantly over the course of the last five years, many people will want to ensure they take advantage of that tax savings by staying in their homes for at least 5 years.  More people staying in their homes, means less inventory, which could in turn mean higher prices.

The elimination of the deduction of state and local taxes, which includes property taxes, would likely impact the higher end market more than the lower end.  More homeowners in the higher end market itemize their deductions to begin with and the higher the property value, the higher the property taxes and thus the greater the impact of eliminated deductions.

If more people choose to stay in their homes in order to reduce their tax liabilities moving forward, one might conclude that in addition to there being fewer homes for sale, there would also be fewer buyers.  This could turn out to be true and we may, in fact, see a reduced pace of sales as a result, which could dampen appreciation.  We are already seeing a slow-down in the pace of appreciation – not depreciating prices, just a slow down of appreciation. This, I think, is just a natural course correction as the previous rate of appreciation could not be expected to continue in a healthy manner.  However, despite the fact that fewer people may elect to move if these tax reform proposals go into effect, the quality of life here and our relative affordability compared to our west coast neighbors (San Francisco, San Jose, San Diego and Seattle) I think will continue to be a powerful draw that will motivate people from out-of-state to move here.  Oh, and then there is the flood of millennials that is expected to start entering the market and buying their first homes.  I think the pressure on demand will continue to exceed supply….at least for the short term.