$$$: What’s the impact of the Tax Cut & Jobs Act on house prices?

Answer: For sure, the TCJA put downward pressure on home values … how much depends on a home’s value before deduction caps were put in place.

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In a prior post, we started thinking about this question (since nobody else seems to have landed on the issue) … and took a stab at estimating the isolated impact of the TCJA’s cap on the mortgage interest deduction.

A couple of readers asked (1) What about the impact of the SALT deductions cap?, and (2) Can you work through a example from start to finish … as simply as possible?

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Always aiming to please my loyal readers, here’s a try at answering both inquiries with a simple(?) example….

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Base Case

Assume that a home (we’ll call it “Ken’s home”) had a fair market value (FMV) of $1.5 million before the Trump Tax Cut & Jobs act (TCJA) went into effect.

If a person had bought Ken’s house pre-TCJA for its FMV ($1.5 million), put 20% down ($300,000) and financed the balance ($1.2 million) with a 30-year mortgage at a 4% interest rate, then …

The principle & interest (P&I) portion of the buyer’s monthly mortgage payment would have been $5,729.

In Excel, you can use the PMT financial function: PMT(rate, number of periods, starting balance).

For this example, the function’s values are PMT(0.04/12,360,1200000).

Since we’re trying to find the monthly payment the number of periods is 360 (30 years times 12 months per year) and the monthly interest rate is approximately 4% divided by 12 months.

Let’s assume that the $5,729 is the absolute maximum that the buyer is willing & able to pay each month.

Keep the number ($5,729) in mind. We’ll be referring back to it often.

OK, now let’s see what happens post-TCJA.

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TCJA Changes Impacting Homeowners

The TCJA made a couple of significant changes to cap deductions that homeowners can take when filing their income taxes.

The most publicized (and controversial) change was capping the allowable deduction for State and Local Taxes (SALT) at $10,000.

The second, less publicized change, was to limit the allowable deduction for home mortgage interest to interest paid on mortgages totaling $750,000 … a cut from $1 million.

Technical note: There are complicators like grandfathering of existing loans, mortgage interest on 2nd homes and home equity loans that we’ll ignore to keep things relatively simple.

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The Cap on SALT Deductions

Let’s deal with the SALT cap first.

Let’s assume that real estate taxes on Ken’s home are $15,000 … about 1% of the house’s FMV (which is pretty typical).

Pre-TCJA, the full amount ($15,000) was an allowable deduction for tax filers itemizing deductions.

Post-TCJA, there are 2 range-determining scenarios to consider: one is bad and the other is worse.

SALT Scenario #1

In the best case (i.e. the least bad one), a taxpayer loses $5,000 of SALT deduction – the difference between $15,000 and $10,000

Assuming that the taxpayer is in the 25% marginal tax bracket, that translates to an additional $1,250 in income taxes each year ($5,000 times 25%) … or restated, $104 per month.

How does the $104 monthly hit impact a home’s price?

Above, we assumed that Ken sold his home for $1.5 million pre-TCJA … and that the buyer financed the purchase with a 20% ($300,000) downpayment and a 30-year, 4% mortgage.

The buyer’s monthly P&I payment was $5,729 … and that was the maximum that the buyer was willing & able to pay each month.

So post-TCJA, with $104 going towards additional income taxes, the buyer would only be willing & able to make a $5,625 monthly P&I payment.

Again, the question is: how does that translate to a home’s price?

A $5,625 monthly P&I payment “amortizes” a $1,178,220 mortgage over 30 years at a 4% interest rate.

In Excel, you can use the PV financial function: PV(rate, number of periods, payment).

For this example, the values are PV(0.04/12,360,5625).

Since we’re trying to solved based on a monthly payment, the number of periods is 360 (30 years times 12 months per year) and the monthly interest rate is approximately 4% divided by 12 months.

Assuming that the buyer still makes a $300,000 downpayment, he should be willing & able to pay $1,478,220 for Ken’s house.

So, Ken’s house has lost almost $22,000 in FMV due to the SALT cap.

And, that’s the best case!

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SALT Scenario #1

Everybody pays state & local taxes besides real estate taxes – think state & local income taxes, sales taxes

In many (most?) cases, these other state & local taxes use up the entire post-TCJA SALT cap ($10,000).

The implication: A post-TCJA buyer probably loses the entire $15,000 real estate tax deduction.

Still assuming a 25% marginal tax rate, that works out to $3,750 per year ($312.50 per month) in additional income taxes.

What does that do to the value of Ken’s home?

Applying the same logic as above, post-TCJA, with $312.50 going towards additional income taxes, the buyer would only be willing & able to make a $5,416.50 monthly P&I payment ($5,729 minus $312.50 equals $5,416.50)

The $5,416.50 monthly P&I payment amortizes a $1,134,547 mortgage over 30 years at a 4% interest rate.

Assuming that the buyer still makes a $300,000 downpayment, he should be willing & able to pay $1,434,547 for Ken’s house.

So, in this worse (but probably most common SALT cap scenario), Ken’s house has lost over $65,000 in FMV due to the $10,000 SALT cap (the difference between $1.5 million and $1,434,547).

OUCH!

And, the $65,000 hit is not the end of the story.

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The mortgage interest deduction cap

Now, let’s consider the second, less publicized change: limiting the allowable deduction for home mortgage interest to interest paid on mortgages totaling $750,000 … a cut from $1 million.

Under all of the scenarios above, the buyer was taking on a mortgage greater than $1 million.

So, the buyer would lose a mortgage interest deduction on the $250,000 difference between the pre-TCJA cap ($1 million) and the post TCJA cap ($750,000).

Since we are assuming that the buyer gets a 4% loan, the lost annual mortgage interest income tax deduction is about $10,000 ($250,000 times 4%).

That’s $2,500 in additional income taxes each year … or, $208 each month.

Using the same calculation logic as above, the impact on the FMV of Ken’s home is about $45,000.

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Let’s pull the pieces together …

Losing the full $15,000 real estate deduction because of the SALT cap increased income taxes by $312.50 per month.

Limiting the allowable deduction for home mortgage interest to interest paid on mortgages totaling $750,000 increased income taxes by $208 each month.

So, applying the same logic as above, post-TCJA, with $520.50 going towards additional income taxes, the buyer is only willing & able to make a $5,208.50 monthly P&I payment ($5,739 minus $520.50)

The $5,208.50 monthly P&I payment amortizes a $1,090,979 mortgage over 30 years at a 4% interest rate.

Assuming that the buyer still makes a $300,000 downpayment, he should be willing & able to pay $1,390,978 for Ken’s house.

So, under the above assumptions. Ken’s house has lost almost $110,000 (about 7%) in FMV due to the TCJA’s SALT and mortgage interest deduction caps.

Double OUCH!

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WARNING re: Behavioral Economics

Buying a house is an emotional experience, buyers and sellers are heavily influenced by the sale price of comparable properties … so, very few buyers are likely to go through these calculations.

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Technical note: This example illustrates the impact of the TCJA impacts under very specific assumptions, e.g. pre-TCJA house value, mortgage balances, interest rates, marginal tax rates, non-real estate SALT taxes. The calculation logic holds for alternative assumptions, but the results vary.

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