To begin, we basically have three tax advantages to home ownership.
1) The mortgage tax deduction. This became more important after the Tax Reform Act of 1986. Before that, all personal interest expenses were deductible above a minimum level. After that, mortgages carried a tax advantage to other forms of debt. The effect on the housing market is limited, however, because the marginal tax savings only kick in for a household once itemized tax deductions exceed the standard deduction. Thus, most of the potential tax savings is unused. The Reason.org study mentioned above references work that puts the effect on home prices of 3%-6%. In my models here, I am using 3.5%. That looks about right to me. This amounts to an annual transfer from renters to owner-occupiers of about 0.5% of GDP. I won't get into this here, but if we broke out households more finely, we would find that within the homeowner group, most of that transfer would be going to upper-middle class households who have mortgages large enough to capture the benefit. So, an unfortunate redistribution of income, but not a significant distortion in the housing market.
2) The capital gains tax exemption. This was significantly strengthened in the Taxpayer Relief Act of 1997, which made the availability of exemptions on real estate capital gains much more universal. I should have concentrated on this more in my previous posts. I am surprised this isn't more of a focus in general. Here is a comparison of home prices and homeownership rates in the US. Note that while homeownership rates seem to have reacted to the 1994 passage of the Community Reinvestment Act, price appreciation kicks into gear in 1997 along with the capital gains tax exemption.
I have been defending home prices in the 2000s as being a reasonable reflection of the effect of low real interest rates. I might have to walk a little of that back. (I don't know. This is going to be really complicated before I'm done.) But, in general, this does still point to my general intuition that while home prices do react to changing demand from more universal access, most of the change in home prices is a reflection of the changing intrinsic value.
In terms of its effect on the housing market, if we assume a 20% capital gains tax rate and 75% utilization of the exemption, the value of a home increases by about 10% at today's interest rates. Since owner-occupier rent represents about 14% of GDP, this amounts to an annual transfer of about 1.4% of GDP from renters to owners.
Keep in mind, in aggregate, the capital gains taxes on real estate are largely a tax on inflation effects. My preference is to avoid this distortion by eliminating all capital gains taxes. The effect here is to create a dislocation between owners and renters. And the effect is very sensitive to inflation. So, even though this effect may have been very strong, the low inflation environment we have been in has greatly diminished this distortion. The 10% effect on home values is based on 2% inflation expectations. In a 4% inflation environment, the capital gains exemption would create a 20% price distortion.
3) The tax exemption of the rent income itself. As far as I know, this has always been the policy. This is surely a reason why homeownership rates were nearly 50% even before the mortgage deduction, capital gains exemption, and low income homeownership programs were in place. In effect, this is the opposite issue that two-earner families face. If a second parent joins the labor force, there is a tax penalty that arises from the fact that much of the household value that had been provided by a full time homemaker is now filtered through additional household cash income, which is taxable, to payments for child and home care services, which are frequently not tax deductible. Homeownership is sort of the capital version of labor's household production. Owning a house allows a household to consume its own production in a way that doesn't trigger a public transaction.
This is a case where it is important to separate forms of ownership (debt and equity) from the returns to the asset itself. We need to start here with a comparison between a landlord who owns an unleveraged house and an owner-occupier that owns an unleveraged house. When we keep focused in this way, this is a very simple concept. Let's assume an income tax rate of 25%. If a landlord has, say, a $300,000 house that has a market rental rate of $1,000, then his post-tax monthly return is $750 on that property. Since an owner-occupier doesn't pay that tax, she would be willing to pay 25% more for the same property. At those different prices, both home owners - the landlord and the owner-occupier - would be earning the same after-tax return on investment.
Now, I know, there are costs to owning the home that need to be deducted from the rent, etc. I will make these adjustments as I work through this issue. But, I think the value of this factor is pretty clear. And, unlike the mortgage and capital gains tax factors, utilization does not mitigate this factor. For most households, if imputed rental income was taxable, their taxes would rise with the first marginal extra dollar of income. This factor is nearly 100% utilized.
If we assume that all homes are fully owned with no leverage, a model of home values that accounts for costs of ownership, with a 25% income tax rate, ascribes a 20% increase in the home value due to this factor. That amounts to an annual transfer from renters to owners of about 2.9% of GDP.
The relationship between the income exemption and the mortgage tax deduction
This is where the mortgage tax deduction comes into play, and before I have thought through it this way, but I hadn't fully appreciated the value of the income tax exemption separate from the mortgage deduction. A cash homeowner receives the full advantage of the income exemption. But, if we assume that a homeowner is fully leveraged 100% on a home, with a perpetual interest only loan in a zero inflation environment, we can imagine that they might have $1,000 in monthly income that is untaxed, but also $1,000 in monthly interest expense that is not deductible. They would have no net benefit from homeownership. (Differences between rent expense and interest expense for actual homeowners are effectively a product of inflation and duration exposures they are taking due to the different characteristics of the mortgage and the home.)
So, in an economy where household real estate is leveraged to roughly 50% in the aggregate, this means that owner-occupiers claim roughly 50% of the income exemption benefit - which would account for a 10% increase in intrinsic home values and a 1.4% of GDP annual transfer from renters to owner-occupiers. The mortgage tax deduction is, effectively, a way for leveraged home owners to also capture this benefit. But, since the utilization of the mortgage deduction is so low, leveraged home owners only capture about 1/3 of the benefit. (As stated above, the mortgage deduction might increase home values by 3.5%, compared to my estimate of an additional 10% increase that homeowners would see if they had 100% equity instead of 50%.)
Here is a summary of the effects. (Keep in mind that these are broad estimates, which interact with one another and also change slightly in scale as interest rates and other assumptions change):
|The capital gain exemption is proportional to expected inflation.|
(assumed to be 2% here)
<**Edit: Vivian Darkbloom has talked me down a bit in the comments. After considering her input, I would revise these numbers to: 3% + 5% + 7% = 15% of home values and 0.4% + 0.7% + 1.0% = 2.2% of GDP. The Cap Gains numbers may still be high, but for a number of reasons having to do with the relationships of the factors in the model, the effect on the modeled price is higher than the effect we might estimate simply by accounting for this year's expected real estate gains. This factor may turn out to be lower in many contexts.>
<Edit #2: These estimates are bound to change some more as I continue to review data and concepts. I am purposefully kind of thinking aloud. So please check on follow-up posts in the series if you are interested in these estimates.>
Over the next few posts, I expect to show that the actual increase in home values may be much less than 23.5%. But I expect to demonstrate that this transfer to owner-occupiers exists regardless of the total effect on nominal home prices. The conclusions I have reached so far have been pretty shocking to me, and I may continue to be shocked as I work through the models to complete the remaining posts, so my conclusions may differ from what I currently expect. (I am proceeding as I work this out, so you might see my errors as I proceed. And, this will get complex enough that I might end up reaching the limits of my analytical tools.) At the point where I am in my analysis now, I believe that if these factors are not manifest in higher nominal market prices for homes, then the potential increase in home values coming out of these policies is a sort of risk-adjusted deadweight loss on our economy.