Monday, September 27, 2010

The Bush Tax Cuts, Health Care, Housing, and You

It seems as if the biggest debate of the fall is whether the Bush tax cuts should be extended or allowed to expire, and if they should be extended, for whom.  As liberals and conservatives debate the impact on the economy, the focus of the media's coverage of the debate seems to focus mainly on the increases to the top income tax rate.  In the latest poll that I saw, Americans appear to be pretty evenly divided on whether the cuts should be extended only to the middle class or to everyone. 

I think that framing the Bush tax cuts debate only in terms of income tax increases really minimizes the full effect of allowing the tax cuts to expire.  Remember that the tax cuts did more than just lower the income tax rate; they also gave a hefty shot in the arm to the real estate market.

Under the Bush tax cuts, an individual could sell his or her primary residence and realize up to a $250,000 gain tax free.  A couple could sell their primary residence and realize up to a $500,000 gain tax free.  And this gain did not have to be reinvested in a new primary residence to reap the tax advantages; the sellers could choose just to put the money from the sale in an investment account and rent for the rest of their lives.  The capital gains tax holiday gave a powerful boost to the real estate market because it allowed Americans to purchase a home and benefit in a very direct way from their properties' appreciation.

If all of the tax cuts are allowed to expire, next year the sales of primary residences will again be subject to capital gains tax.  (Presumably the tax will revert back to the prior law before the tax cuts where no capital gains is owed if a new primary residence of equal or greater value is purchased within a set period of time.)  But what if the tax cuts are extended to the middle class and only allowed to expire for taxpayers with incomes of $250,000 a year or more?  What effect will that have on the housing market?

Remember that Fannie Mae and Freddie Mac's average borrower today has a credit score of 751 and a down payment of more than 30%.  That means essentially that these two agencies, both of which have received about $148 billion combined in tax dollar bailouts, are basically making loans to upper middle class borrowers--the ones who typically have higher incomes.  A capital gains' tax on primary residences, combined with higher income taxes and a looming threat to discontinue the tax deduction for mortgage interest, may discourage these borrowers from investing in real estate.  At the very minimum, it is going to discourage them from buying higher priced homes.  Discouraging the very borrowers who are in the best position financially to purchase homes and pay the mortgages on them can only result in a further slowdown of the real estate market, and potentially greater declines in housing prices.  Many of the taxpayers in the $250,000 bracket are actually small business owners.  With increasing economic problems, and dropping market values, how comfortable are they going to feel going through the pain of purchasing a home knowing upon sale the gain will be subject to taxes because they earn over $250,000 a year.

I know that it can be argued that for many years primary residences were subject to capital gains tax upon sale, and that the tax did not stop people from buying or selling property.  But I would counter that there is a strange phenomenon that comes into play when people are used to getting something (in this case a capital gains' tax holiday on their primary residence) and then see it taken away.  We saw this with the home buyer tax credit.  Buyers had bought and sold houses without an $8,000 tax credit since the beginning of civilization, but in the short time that it was implemented, buyers came to believe that they should expect a tax credit.  Consequently, when the tax credit expired, buyers largely stopped putting in contracts on houses.  The credit should not have provided all that much incentive--after all, the primary reward for purchasing a home is having a place to live--but once the inducement was offered and then removed, borrowers did not seem to see the point of buying a home for which they would not receive a tax credit.

There are so many differing opinions on the tax cuts--one blog I read today recommended extending the tax cuts for two years for everyone--including those making over $250,000--and then ending them for everyone in 2013.  But this plan poses an additional set of challenges.  The new health care law signed in March also contains a tax on real estate.  The 3.8% tax on the sale of residential real estate applies to individuals with incomes higher than $200,000 and couples with combined incomes over $250,000.  On a sale of a $300,000 home, the tax would be $11,400.00.  This would be in additional to the capital gains tax.  And since the health care tax is on the sales price and not on the gain, it would apply to any borrower in the income bracket being taxed.  In other words, if you sell your house for enough to cover what you owe the bank plus the agent's commission and your costs as seller, you could still owe Uncle Sam a check.

We like to think that "rich" people, whom we have defined as a society as people with incomes over $200,000 or $250,000, have so much money that they don't feel these taxes at all and that any complaining that they do is only a result of greedy whining.  But at what point do the more affluent people in our society decide that real estate is too heavily taxed and that they are better off renting rather buying?  At what point do current homeowners who do have extra cash decide to offer their homes for rent rather than for sale because they are rebelling against a plethora of taxes which gobble up their equity?  And what are the consequences of this shift in thinking for an already lethargic housing market?

All of the numbers coming out of the housing sector--mortgage applications, existing home sales and new home sales--have been depressingly low for the past couple of months.  And as the housing market remains in a slump, those who make their living primarily through real estate will continue to lose their jobs, which will continue to feed growing unemployment. Maybe what the Treasury needs to do is a study of the net income to the U.S. government from the increased taxes versus the losses incurred by the society as a whole from increased unemployment, foreclosure and bankruptcy as a result of the steady decline of the housing industry.  A U.S. News and World Report article posted Friday April 23, 2010 used final quarter 2009 figures from 10 U.S cities to show the real cost of the housing market crash.  For example, in Las Vegas, Nevada, where construction was the primary job provider until the market crash, unemployment was 13% in the fourth quarter of 2009.  In Merced California, where a large portion of the population worked in real estate or real estate related industries--"home building, home financing, or home sales"--by the fourth quarter of 2009 the unemployment rate was 19% in a city of 77,000 residents.  Other cities where unemployment was between 14 and 30% by the fourth quarter of 2009 due to the loss of real estate related jobs include Fort Myers, Florida, Rockford, Illinois,  and El Centro, California.  Those job losses led in turn to higher real estate defaults in these areas as homeowners could not pay their mortgages.

Raising taxes--even for the top income brackets--may generate a lot of money for the U.S. Treasury in the short term,  but in the long term it will lead to increased unemployment which will lead to increased mortgage defaults and delinquencies at a cost to lenders, Fannie Mae, Freddie Mac, and ultimately the American taxpayers.  Taxing the life out of what is left of the housing industry is really just cooking and eating the goose that laid the golden egg.



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