Ripple Effect

Editor's note: This story was originally featured in the March issue of DSNews, out now.

When the Tax Cuts and Jobs Act went into effect, many in the industry began to speculate what impact this would have on home prices, sales, and business confidence. While the industry is already feeling the change, the tax code isn’t the complete game changer some have claimed it is.

National home prices are still expected to grow–just at a slower rate. The impact varies substantially by region and sub-market, with low-cost markets getting a minor boost and upper-middle class and high-tax markets being hit on multiple fronts. The changes, particularly the limits on deductions, make renting relatively more attractive for high-income households. So it follows that the future homeownership rate will be slightly lower relative to what it would have been under the old rules.

Home-price growth is likely to continue because of strong underlying housing-market fundamentals and a strengthening world economy that is finally firing on all cylinders. Fundamental factors such as strong job growth, low interest rates, and a shortage of homes for sale outweigh the weaker incentives for homeownership in the new tax code in the vast majority of areas.

While many economists think a strong economy is a wrong point in the business cycle for a tax cut, the timing works well for the housing market. Since rapid national home-price growth over the past five years (5 to 7 percent a year) has far outpaced the 2 to 3 percent annual income growth, some cooling of the housing market isn’t as bad as it sounds. It might even help prevent housing markets from overheating.

A Closer Look at the Pros and Cons

The most  important impacts of the new tax law on housing include the following:

PROS

• Increased business confidence (which also was helped by a push for regulatory relief). Higher confidence supports continued strong hiring and increased capital spending, which has been relatively weak over the past decade. However, the incremental economic growth attributable to the tax bill will be modest. Estimates of the total increase in Gross Domestic Product over the next 10 years are typically under 1 percent.
• Lower taxes for most people could stimulate demand, at least in lower-cost markets where fewer people itemize their taxes. Also helped is the tiny segment at the other extreme: The ultra-high-end luxury housing segment may benefit due to lower taxes for those who can structure their income into pass-through companies.

CONS

• Interest rates will be higher, all else being equal. That is because the U.S. Treasury will increase borrowing by $1.5 trillion over 10 years. Borrowing will be even greater if individual tax cuts are made permanent or if there’s a recession. Recently, we’ve seen rates increase about a quarter of a percentage point.
• Limitations on the deductibility of state, local and property taxes (they went from being unlimited to maxing out at $10,000) mean higher taxes for many in the upper middle class. The result will be a permanent dampening effect in high-cost areas relative to the previous tax rules.
• Fewer people will itemize, tipping the buy vs. rent calculation in favor of renting for some potential homebuyers. That is because there is no value in the mortgage interest deduction for people who don’t itemize (recall that taxpayers can either take the standard deduction, which is now higher, or itemize, but not both). The drop in the number of people who itemize their taxes is dramatic—one estimate is a decline from around 30 percent of tax filers to approximately 10 percent.
• Higher-income households are more likely to itemize their taxes and thus are more likely to be hurt by the changes. More than 50 percent of tax returns for households with adjusted gross income between $75,000 and $100,000 include itemized deductions. This statistic varies substantially by state, with Maryland having the highest share at 76 percent, followed by Oregon, Utah, Connecticut, and New York.
• Mortgage interest deductions are now capped at $750,000 on new loans, down from $1 million. However, the impact is minor compared to the impact of the limits on state and local taxes, since fewer loans are affected and because any loan amount is still deductible up to the new limit. Loans for homes purchased before December 15, 2017, were grandfathered in at the higher limit.
• Home equity loans are no longer tax-deductible unless they are used to purchase or renovate a home. Previously, borrowers could deduct the interest on home equity loans up to $100,000, depending on their filing status. The home equity deduction was eliminated for both new and existing borrowers, so all home equity loans not used for a purchase or renovation became relatively more expensive on January 1, 2018.
• More individuals will choose to pay down their mortgages or buy with cash—if they can. This is because the effective after-tax mortgage interest rate will be substantially higher for those who switch from itemizing to using the standard deduction, making borrowing more expensive.
• Construction of new affordable housing units is likely to drop. It is primarily funded by federal corporate tax offsets, which are now far less valuable because corporate tax rates have decreased from 35 to 21 percent.

Because the rules on capital gains (allowing up to $500,000 in tax-free capital gains on a primary residence) did not change, the tax code still favors homeownership, just not as strongly as before.

The Regional Hit

High-tax areas in particular face a new, permanent drag on their housing markets that will slow price growth or perhaps even lead to minor declines in a few areas. Most affected are New York, New Jersey, Connecticut, California, and Maryland. Most at risk of falling home prices are Connecticut and New Jersey, where home-price and population growth are already weak and taxes on the upper middle class are substantial.

Several different studies estimate that home prices in a few years will be slightly lower compared to what they would have been without the tax changes. Researchers at JPMorgan Chase & Co. put the national impact on home prices at around 1 percent lower than they would have been, and up to 3 percent in some states. Moody’s Analytics estimates national home prices will be around 3 percent lower relative to where they would have been in two years’ time, and up to 10 percent lower around New York City and some parts of Chicago. On the more pessimistic side, the National Association of Realtors (NAR) estimated U.S home prices will only grow 1.9 percent this year (down from 2017’s 5.8 percent median home price growth) because of the tax changes. NAR estimated that high-cost, higher-tax areas will see price declines as a result of the legislation’s new restrictions on mortgage interest and state and local taxes, led by New Jersey (-6.2 percent), the District of Columbia (-4.8 percent), and New York (-4.8 percent). While such declines are possible, we believe the strength of the current housing market will prevent that large of an outright price decline.

In addition, the rent vs. buy calculation changes according to income. For example, a family earning $50,000 a year pays less in taxes and probably doesn’t itemize their taxes, so buying is slightly more favorable. However, for a family earning $150,000 a year, the rent level that would tip them in favor of buying is now 25 percent higher.

The bottom line is that the benefits of homeownership in comparison to renting are now less favorable for housing, at least for many upper-middle-class households. The changes in the tax law are particularly bad for higher-cost areas because of the larger loss of allowable deductions. It would not be surprising to see increased demand for smaller, cheaper housing and lower demand for larger, more expensive housing. This is likely to result in a lower homeownership rate over time relative to what it would have been.

Nearly every housing market is still likely to experience positive home price growth over the next two years, but some high-tax areas, such as Connecticut, New Jersey, New York City, and Chicago may see minor price declines because of the tax changes. We believe strong economic and housing market conditions, such as extremely low unemployment rates and low-interest rates, more than offset the negative tax changes.

Ralph DeFranco is Global Chief Economist of the Mortgage Group Arch Capital Services Inc., White Plains, New York. He leads the company's efforts to forecast regional home prices and develop predictive economic models. He is also the author of "The Housing and Mortgage Market Review," a quarterly report on the state of the nation's housing sector based on the findings of the Arch MI Risk Index.