Across America, the scars still show. Nearly a decade after the mortgage crisis, homeowners are treading lightly, painfully aware of the razor’s edge between living the American dream or some nightmarish version of it. And for those homeowners who came back above water on their mortgages over the last decade, the new tax law is throwing the idea of homeownership back into question.
A microcosm of today’s housing dilemma
Imagine you are a manager at a tech company in flourishing Silicon Valley. You are professionally successful, yet still live paycheck-to-paycheck in an expensive housing market that just got even more expensive thanks to the Tax Cuts and Jobs Act. This new tax law now limits several key tax benefits of homeownership, the “pros” on your list weighing the merits of owning versus renting.
How the Tax Cuts and Jobs Act impacts housing
Why are families re-analyzing their current or future housing situation? While lower individual tax brackets and a major reduction in corporate taxes took most of the headlines, several itemized deductions were wiped away or significantly altered to “simplify” the tax code.
The law caps state and local tax (SALT) deductions at $10,000 on federal income tax returns. Previously, the deduction was just limited by the alternative minimum tax (AMT), which is still around with higher minimum thresholds.1 These deductions historically allowed taxpayers to reap the benefits of itemized deductions, especially if they lived in high-tax states like New York, California, and New Jersey.
Instead, the new tax law doubled the standard deduction to $24,000 for married couples, lowered most individual tax brackets, and doubled the child tax credit. While applauded by some, these cuts will not offset the savings many homeowners received through SALT deductions.1 In fact, these reforms have put renters on a level tax playing field with homeowners in many markets.
Homeowners who justified tenuous mortgages may start looking to escape, but where will they find takers? Just like current homeowners, window-shoppers ready to make the move to a white picket fence are looking at the same situation, especially in high-tax states where it may become more difficult to get a new mortgage. The tax bill will add $1.5 trillion to the federal deficit over the next decade, putting further pressure on already-rising mortgage rates.3 And many looking at larger homes priced at $750,000 and up also lost the mortgage interest deduction in the new law. New homebuyers factor these real estate tax deductions into pricing and affordability.
Potential homeowners at the low-cost end may also have trouble finding affordable housing. The Tax Reform Act of 1986 encouraged private equity investment into affordable, lower-to-low-middle class housing. However, the drop in the corporate tax rate from 35 to 21 percent has lowered the value of the credits utilized to finance development. Instead, many of these corporations are using the savings for shareholder dividend increases and share buybacks.4 As a result, families scouring Zillow and Trulia late in 2017 may start renewing the leases on their apartments.
Affordability is still the pressing issue
Tax reform may have put a few more dollars in people’s pockets up front, but at what cost? Homeownership now looks less appealing across many demographic groups, especially in high-tax states. For Millennials just starting to gain their financial footing, more expensive mortgages and less tax benefits may give them the incentive to continue renting in or just outside business and lifestyle hubs. Working families that were already living paycheck-to-paycheck may look to downsize or find jobs in a low-tax state such as Texas or elsewhere in the south. And Baby Boomers hitting retirement at roughly 10,000 per day are already staring at fixed budgets with the uncertainty of Social Security. Migrating to more tax-friendly states and removing the upkeep of homeownership may make sense, especially with the tax benefits now gone. This increased rental demand may further stress today’s multifamily affordability crisis. Apartment supply is either aging or upscale, with little inventory for renters desiring affordable, updated apartments.
What this means for investors
This supply-demand disconnect may benefit multifamily investors, who have been experiencing low vacancy rates and rent growth in many markets. Investment vehicles such as traded REITs, real estate mutual funds, non-traded REITs, and 1031 Exchanges all may offer investors access to multifamily real estate.
Apartment industry leaders were afraid that tax reform would wipe away 1031 Exchanges, but the popular real estate tax deferral strategy was saved. Accredited investors can still exchange into a high-quality “like-kind” apartment asset through vehicles like Tenant-in-Common (TIC) interests and Delaware Statutory Trusts (DSTs) to defer capital gains tax on a commercial real estate sale, if they meet certain criteria and follow specific guidelines. Tax reform did, however, limit the definition of “like-kind” real estate to strictly real estate, removing art work, auto fleets, and heavy equipment for the options.5