What Will Congress Do?

Congress gave taxpayers a great big turkey for Thanksgiving.

The turkey was the gift of the special 12-member deficit-cutting committee, which left town for the Thanksgiving recess without a deficit agreement or even a framework to address the nation's fiscal woes upon its return. Barring another economic meltdown, action on many important tax and spending issues is now unlikely until after next year's election. The tax issues include income and capital-gains tax rates, estate-tax exemptions and rates, and the alternative minimum tax.

Absent action, a number of current tax provisions will expire either next month or on January 1, 2013. They include home energy efficiency tax credits and the 2% Social Security payroll-tax cut, both of which expire at the end of this year (see separate article re the former, below). A number of others expire at the end of next year. Personal income tax rates would revert to 2001 and 2003 levels, resulting in a rate increase for all taxpayers. The long-term capital gains would increase to 20% from 15%, and it would apply to gains on the sale of a home (after the $250,000 exclusion for single taxpayers/$500,000 exclusion for married couples). The current 15% rate on dividends would lapse, and the current estate-tax exemption would revert to the previous $1 million level. Millions more taxpayers would be subject to the alternative minimum tax and up to 10 million low income taxpayers would be restored to the tax rolls. The tax deductions that are most likely to trigger the alternative minimum tax are high deductions for state and local taxes, miscellaneous deductions, and a large number of dependants. These changes would have the greatest impact on high earners (over $250,000 annually), but they would also be felt by most other taxpayers as well.

Previous legislation mandating across the board spending cuts will go into effect automatically if Congress does not act to reduce the deficit. Federal employees will be affected by these budget cuts as will many homeowners and other taxpayers, depending on their particular circumstances.

The import of these changes for homeowners can be significant. Those fortunate enough to have potential long term capital gains would be wise to take them before the current capital gains rate expires. On the other hand, losses from short term investments will be worth more for homeowners if their income tax rates increase. Other deductions will also be worth more as individual rates ratchet up. With mortgage rates at near record lows this is a good time to refinance. Interest is the greatest share of a mortgage payment in the early stages of a loan. Those bigger deductions, even if the new mortgage rate is lower and the mortgage balance remains unchanged, would likely result in larger deductions when taken against a higher future tax rate. Older homeowners who may have assets worth more that $1 million should consider gifting assets to children or grandchildren to reduce the possible effect of the estate tax reversion. In addition payments for tuition and qualified medical care are not subject to gift tax limitations when the donor pays the institution directly.

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More Home Sales, Cash Buyers, and Remodeling; Lower Prices and Mortgage Rates

The oxymorons abound.

It is very difficult to draw conclusions or make projections based on recent housing statistics.  Sales of existing homes rose 1.4% in October from September, yet home prices continue to decline. Median home prices in October were $162,500, down 4.7% from the previous October.

The drop in home values should also be attracting more first time buyers, as lower priced homes become affordable to more and more current renters. Yet the opposite is occurring. According to the 2011 National Association of Realtors® (NAR) Profile of Home Buyers and Sellers, a growing share of home buyers are repeat buyers, which has caused an upward shift in the typical home size. This also makes the drop in home values even harder to understand since repeat buyers are usually move up buyers who usually purchase larger and more expensive homes.

One possible explanation is the impact of the unusually large inventory of foreclosed homes. Mortgage-data firm CoreLogic estimated last month that there are 1.6 million single-family homes in some stage of default or foreclosure that will ultimately be taken back and resold by banks over the next 18 months. At current sales rates CoreLogic believes it could take until 2020 for markets to absorb this shadow inventory of potential bank-owned homes, and any significant improvement in home values is unlikely until that happens.

Also confusing is the increase in cash home buyers. According to the June, 2011 REALTOR® Confidence Index, there has been a high share of all-cash home purchases in the current market. At that time the monthly data shows 31 percent of purchases were all-cash. In 2010, 91 percent of recent home buyers financed their home compared to 92 percent in 2006.

Most people who can afford to pay cash could easily qualify for a mortgage even under today's tighter lending standards. Today’s mortgage rates are at record lows and they are unlikely to go much lower. Thirty-year fixed-rate mortgages averaged 3.98 percent with an average 0.7 point for the week ending November 23, 2011. At this time last year, the 30-year FRM averaged 4.40 percent. It would seem to make sense for today’s home buyers to lock in today’s low mortgage rates for the next 30 years and save the cash for more productive future investment purposes.  

Despite the anemic home sales market, remodeling is doing well. The September Residential BuildFax Remodeling Index showed 34 percent rate increases year-over-year. September was up 2 percent over August of this year. One possible explanation may be that many homeowners are taking lemons and making lemonade. Even though they aren’t able to sell their homes because of the current slow market, many can still refinance them, often at much lower rates. Since they aren’t going anywhere, they may be paying for the remodeling with the proceeds from cash out refinancing, or else redirecting their monthly mortgage payment savings into remodeling projects. 

The most popular remodeling projects were:

In terms of where the residential real estate market is headed it is hard to make much sense from the current data. However, until there are some dramatic changes in US policy it is difficult to imagine when we will see a robust housing recovery.  

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Time to Fix Home Ownership Incentives

Nibbling at the problem isn’t working.

We have to give the Administration credit for recognizing the seriousness of the housing crisis, and for its persistence in trying to help distressed homeowners through an ongoing succession of efforts. Congress has also tried to help as well, most recently increasing the size of mortgages insured by the Federal Housing Administration from $625,000 to $729,750 in the most expensive regions of the U.S. for the next two years. Many believe that the government’s bailout of the financial sector prevented a severe recession from turning into a full scale recession, and they may well be correct. The efforts in housing policy over the last five years may also have helped prevent an even more serious rout of housing values, but we still face a serious housing crisis today.

There are currently more than six million homes in distress, a third of those in foreclosure and another third 90 days or more delinquent. Not included are another 4 million homes with mortgages that are that are 30+ days past due, but not in foreclosure. There are an additional 2 million current negative equity loans that are more than 50% or $150,000 "upside down." While each of the previous efforts has helped, even in their aggregate they haven’t begun to turn things around. Millions more solvent homeowners are stranded. They would like to sell their home and buy a nicer home, but there aren’t any buyers. Until new buyers come into the market they are stuck.

Policymakers and housing advocates have fallen into a pattern of nibbling at a problem of huge and growing proportions. The recent increase in the size of FHA loan guarantees is a perfect example. The number of mortgages that fall in that range is not that great, and it isn’t clear that most of the homeowners who will get those FHA mortgages would otherwise be unable to obtain or afford a conventional mortgage. Does anyone really think more bite sized nibbles at the huge housing challenges like this can have a significant impact on the housing crisis?

It is time to stop nibbling and find a game changing solution.  The major challenge facing unsold foreclosed homes, the shadow inventory, and solvent homeowners who are unable to sell their homes for lack of buyers is the same. We need a large number of new buyers and we need them soon. A first time buyer typically facilitates the sale of two or three upstream homes. With the decline in home values there is a rapidly growing inventory of homes that have become affordable to the huge number of potential first time home buyers. According to the Urban-Brookings Tax Policy Center 33% of U.S. workers earn between $16,359 and $57,212. Perhaps half that number might make between $30,000 and $45,000, or enough to qualify for a mortgage of $100,000 - $150,000 if they have good credit. However, the number of first time buyers is declining when it should be growing.  According to the 2011 National Association of Realtors® (NAR) Profile of Home Buyers and Sellers a higher share of today’s buyers are repeat buyers.

An important reason that there are so few first time buyers is that most don’t benefit or benefit very little from the current federal home ownership tax incentives. The current code is very regressive, conferring the greatest benefit on those with the highest tax bracket and largest mortgages. At the other end lie the huge number of current renters/potential first time buyers. For many young couples starting their careers the current system offers no incentive whatsoever to buy a home.

Most don’t have many significant tax deductions to itemize, so the majority of renters just take the standard income tax deduction instead, which was $11,400 for a married couple last year. Coincidently that is also about the same deduction they would have received for their annual mortgage interest payments on a $150,000 mortgage. However, to take the mortgage interest deduction the couple would have to give up their standard deduction, because they aren’t allowed both. The net result is that the couple pays the same tax whether they rent or own - they effectively have no tax incentive to buy a home. With a shaky housing market that at best won’t recover for many years in the opinion of most economists, it is no wonder that millions of renters who can afford homes at today’s prices are sitting on the sidelines. Even if the mortgage payments are the same as the rent, they don’t run a risk of losing money through further declines in housing values, and they have the mobility that so many current homeowners lack.

The solution is to restructure the current tax incentives for home ownership so that they become meaningful to the large number of potential first time buyers. If the total lifetime home ownership tax incentives received by a typical couple were restructured so that the total amount was unchanged, but they could begin benefiting fully from tax incentives even as first time buyers, the home ownership cost for most first time buyers would drop dramatically, well below the cost of renting in many hard it areas today. These are the buyers that are needed both to eliminate the supply of foreclosed homes and facilitate upstream sales of new and existing homes. Our organization believes that if the cost of owning were to drop to hundreds less than their current monthly rent, a huge surge in first time buyers would result.

One way to do that has already been identified by the Simpson-Bowles Deficit Commission, which was appointed by President Obama.  It was the predecessor to the recently deceased deficit supercommittee. A core concept of the Simpson-Bowles proposal was to replace the current regressive home ownership mortgage interest tax deduction with a flat mortgage interest tax credit that would be a percentage of the mortgage interest paid. Since tax credits are taken against a taxpayer’s net tax liabilities after they have taken the standard or other tax deductions, it would not prevent first time home buyers from also taking the standard deduction, and why should it? 

Set at a rate that would be neutral with respect to federal revenues, a flat mortgage interest tax credit would create for the first time a huge tax incentive for millions of young folks to become first time buyers. It would actually make owning a home substantially cheaper than renting for a huge number of potential first time buyers. More young couples would buy homes earlier in their careers because many would have a real home ownership tax incentive for the first time. This flat tax credit approach would also mean the incentives wouldn’t be worth as much to them later in their career when they earned more money and were contemplating the purchase of a more expensive home. By then they would have accumulated home equity and other savings however, and would have many more options in terms of buying a move up home. For this reason a mortgage interest tax credit approach would have little or no negative impact on home buyers at the higher end of the market. Those home buyers wouldn’t be receiving any more or any fewer home ownership tax incentives over their lifetime anyway; they would have simply received more of the benefits earlier in their careers.

Getting more people to buy homes earlier in their careers also means more savings in the form of accumulated home equity over their lifetimes. People with more savings are less likely to require needs-based federal subsidies later in life (Medicaid, etc.) so a flat home interest tax credit would also help reduce that area of burgeoning federal deficit costs. This solution wouldn’t cost taxpayers anything or require government involvement in bureaucratic, and potentially risky, programs.

This solution to the current housing crisis will require both policymakers and home ownership advocates to think out of the box. Many organizations in the housing sector as well as many policymakers adamantly oppose any changes to the current mortgage interest deduction. Their intentions are good, but they haven’t yet recognized how much this restructuring could help homeowners and help the housing market recover in the near future. That’s a lot better than muddling along for the balance of this decade as most housing economists predict. It’s time for new thinking and new solutions to the housing crisis. This is one that would not affect federal revenues and which deserves receive serious consideration in future federal tax policy deliberations. 

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Home Energy Efficiency Tax Credits Set to Expire; New Legislation Introduced

Act this month if you want to take advantage of the incentives.

A federal tax credit for energy- and money-saving home upgrades will expire on Dec. 31. But you can beat the deadline by making energy-efficient upgrades now. To be eligible for the credits (see chart below), the products must be installed by December 31. That means you’ll have to get a contractor and complete the job (or do it yourself) by then.

Five basic energy efficiency upgrades are among the six items that are eligible for the tax credit:

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