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Ripple Effect

Editor's note: This story was originally featured in the March issue of DSNews, out now [1].

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:



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.