How Will Home Builders Fare Without the Mortgage Interest Deduction
The Tax Cut and Jobs Act, America’s most significant tax reform legislation since 1986, has been passed by Congress and will take effect for 2018. The changes in this legislation are landmark; major changes have been made with the goal of making America more competitive internationally, stimulating economic growth, creating more jobs, and raising wages.
Corporate rates are not merely lowered, they are slashed from 35% to 21%; full expensing of property, plant and equipment for the next five years on new and used equipment; a deduction of 20% of S-Corp and partnership income passed through to individual returns. In these and other ways, this bill doesn’t just change tax rates, but changes the way Americans are taxed.
Prominent among these fundamental changes to the tax code are provisions that are of special interest to the home building industry. The deduction for state and local taxes, including real estate taxes will be limited to $10,000; the home mortgage interest deduction (MID) will be limited to mortgages up to $750,000, and the standard deduction for families will be increased to $24,000. As a result of these changes, it is estimated that the number of taxpayers that deduct mortgage interest will drop dramatically, to less than 15% of filers. The question is, how will these changes impact home builders?
Historically, the deduction has not incented people to buy homes or builders to build them. People don’t buy homes so they can get a tax deduction. People buy homes because buying is better than renting, and the benefits of homeownership will not be diminished if the MID goes away.
For 2013, the year of most recent IRS statistics, the homeownership rate was approximately 64%, but only 30% of filers itemized. Half of all homeowners didn’t take the deduction. In Canada, where there is no MID, the home ownership rate is slightly higher than ours. This being the case, builders should not be worried that new limitations to the deduction will decrease the demand for homes.
Nationally, the median price of a house is about $260,000. (This figure includes California, where for various political and zoning reasons, housing costs are radically higher than the national average.) Taking into account a 20% down payment, homes costing more than three times this amount can be acquired with a mortgage under the $750,000 limit. That is little comfort if you live in California, the New York City area, or other areas where housing costs are well above the national average. What affect will the new standard deduction and the new limits on interest and taxes have in these areas?
A 30-year mortgage of $1,000,000, the current limit for the interest deduction, starting January 1, 2018, at the current rate of 4.125% will cost $305,000 of interest over the eight years of this provision. (This provision expires on December 31, 2025.) With 20% down, that’s a $1.25 million home. A $750,000 mortgage, to buy a $937,500 home, will cost $229,000 in interest over the same period.
At the highest tax rate of 37% (earning over $600,000) the nondeductible portion of interest ($76,000) will produce an additional tax liability of $28,000, or $3,500 a year. Will the additional tax convince our home buyer to purchase a $900,000 house instead of a $1.25 million house? Would it dissuade them from buying at all? Especially in California, where the shortage of housing is so severe, builders will find a strong market for whatever they build.
The deductions for mortgage interest and real estate taxes are like rebates: a portion of what the taxpayer pays are returned as a reduction of their federal tax liability. Ostensibly, losing the deduction will add to the cost of owning a home, but two things must be kept in mind. First, the cost of home ownership would increase only to the extent that the lost deductions exceed the new standard deduction. Secondly, homebuyers will want to recover the lost ‘rebates’ in the form of lower home prices. And they will. Stephen Melman, Director of Economic Services for the National Association of Home Builders, expects that without the deduction, prices will fall about 5%, while other published studies estimate a 2% drop. What should also be kept in mind is that if the tax reform produces the 3-4% economic growth Congress is hoping for, home values and demand, will increase!
Bill Amster has served as the controller at BidClerk for the past 10 years. Prior to that he worked in the public accounting field. Bill lives in Chicago with his wife and children.