The Tax Man Cometh
Similar to other consumer goods such as meat and produce, real estate is a financial asset subject to economic fluctuations. After the economy recovered from the Great Recession from 2008-2010, San Diego housing and rental prices have only steadily increased. After seven years of increasing property values, it is entirely fitting to address the possibility that a market correction will occur in the near term.
As a professional broker and private investor, I have experienced four San Diego real estate recessions. The precipitating economic catalysts were, as the economists like to say, externalities; economic events occurring beyond the borders of San Diego wreaking havoc on local real estate assets. These storms seem to come out of nowhere, for example the 1973 oil embargo or the dot.com bust. Given the volatile state of national and world affairs, we are drifting in a sea of potential externalities with mostly negative outcomes for real estate values.
Welcome to the first article in a series on the invisible hand; economic forces outside San Diego largely shaping local real estate values. This column will examine how federal tax policies have supported, or even accelerated, extraordinary appreciation rates. Housing’s generous tax preferences are now on the endangered list, as the new Administration is seeking to reduce or eliminate housing’s preferred tax status.
Historically, legislators and presidents have all believed in the ideal of home ownership. For example, it is an act of political faith property ownership promotes economic and social mobility. Widespread land ownership is a central theme in the American myth, deriving from a common rejection of the European class system. The Jeffersonian Yeoman Myth, embodied by hardworking independent farmers and tradesmen, still resonates today and is part of our national self-image.
Since the end of the Second War, the ability to deduct state income taxes, property taxes, and mortgage costs have arguably been a factor in the meteoric rise of housing prices, and to some degree rents. Although these fiscal policies were enacted to encourage residential construction and ownership, it has created, in certain markets, a rate of appreciation that far outstrips income growth. Nowhere is this more evident than in coastal regions. Buyers in those areas have been able to bid up prices for real estate because they have more effective purchasing power, thanks to existing federal tax subsidies.
Today the central economic underpinnings of the San Diego pricing model could potentially pass into history. The Administration is seeking significant tax reform and tax cuts, or some combination of the two, that would negatively impact residential real estate. Republicans are ordinarily virulently opposed to borrowing money to make up for tax revenue losses. To cut personal and corporate taxes, the Administration and Congress will have two options: 1) increase the national debt, or 2) eliminate tax subsidies or loopholes. Once the third rail of domestic politics along with Social Security, the housing industry has always weathered past assaults on their favored status thanks to a well-financed army of lobbyists.
The Administration’s latest proposal has put many tax carve-outs on the chopping block--the mortgage interest deduction alone is worth $700 billion over the next ten years. Given the current state of affairs in Washington, housing may lose their preferred tax status this time around. The cause? As a result of and following the election, a new political dynamic of regional and class tribalism has blossomed. The negative impact of reducing or eliminating housing subsidies will fall hardest on blue states — those regions with higher state income and property taxes, and real estate prices.
It may be coincidental that real estate markets in the coastal belts are most at risk should the President get some of his tax proposals enacted. Losing the ability to deduct property and state income taxes and mortgage interest is a powerful externality that would sharply reduce coastal Californians’ real purchasing power for all goods and services. Effective demand, or the aggregate income available for purchasing housing and paying rents, will necessarily be diminished, leading to lower home prices, even considering the inadequate supply of living units. For most rural communities, these changes will have little impact. Those living in states with low or no state income taxes and inexpensive housing, such as Texas and other southern states, the effect of these proposed changes will be minimal.
The money men behind the GOP’s proposals contend the magic of trickle-down economics will generate new streams of income and wealth. Lower tax rates will spur an economic boom, the fruits of which will more than compensate for the loss of real estate subsidies. There are two problems with this argument. FIrst, most would agree the idea behind the Laffer Curve has been discredited; lower taxes do not necessarily create a binge of job-producing investments. Second, the economic pain from this shift will fall hardest on states like California. If these subsidies disappear, there is little question we will see a San Diego real estate recession.