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The Internal Revenue Code Made Me Do It


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2007 Feb 17, 12:18pm   27,218 views  218 comments

by astrid   ➕follow (0)   💰tip   ignore  

The Killer Rabbit
Home buyers frequently cite the mortgage deduction as one of the primary reasons for home ownership. Do you think this is a reasonable argument? Do you think additional considerations such as interest rate and pricing would affect the validity of the argument and if so, in what direction?

Secondly, many here have argued that Prop 13 and the $250,000 per person per home appreciation exemption played a much greater role in fueling the current housing bubble. Do you agree?

Your thoughts on the AMT? Was it created by the devil? Has it asked for your first born? Did the AMT invent granite countertops?

#housing

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1   ozajh   2007 Feb 17, 12:27pm  

All things being equal, the mortgage deduction would certainly be a factor in the rent/buy calculation.

But, as has been eloquently pointed out many times on this and other fora, all things are currently NOT equal.

I think the mortgage deduction for OO's in the US plays the same part as the building depreciation allowance for RE investors in Australia. It is a selling point for the Realtor (tm) to trot out.

2   Randy H   2007 Feb 17, 12:47pm  

For any newcomers, you can use this spreadsheet model I created with the help of lots of smart folks from this blog. It'll show you exactly what the tax-deduction is worth to you financially.

Bottom line is the tax deduction is powerful, and good, but it doesn't overcome dramatically overpriced houses.

3   Different Sean   2007 Feb 17, 12:52pm  

Investors in Oz get numerous tax breaks, and nothing much on owner-occupying, so the position is more or less reversed from the US one. However, we are seeing similar rates of investment purchasing, e.g. 40% of new mortgages have been for an investment property in both countries in recent times (altho that could be changing as the bubble bursts and ROI diminishes, which even the dummies who just attended a RE seminar can now see).

There's no Prop 13 in other bubble centres, both nationally and internationally, e.g. NYC and DC.

This might mean that other factors are equally to blame -- historically low interest rates, a shaky sharemarket post-Enron, WorldCom and dotcom, and much more liberal lending products from the banks, with a transformed 'acceptable risk' profile. (We are now beginning to see the fallout from the new acceptable risk products from the banks...)

Sharemarkets are recovering and confidence in stocks is increasing. Property ROI is mined out for another 10 years. The Juglar business cycle is turning another notch...

4   Peter P   2007 Feb 17, 1:20pm  

The psychological perception of tax benefit is just too powerful.

These two statements are the same. But they will be perceived very differently:

1. Not paying mortgage interest and not having to deduct tax.
1. Not paying mortgage interest and missing out on deducting tax.

5   B.A.C.A.H.   2007 Feb 17, 2:33pm  

House prices are higher in blue states than in red states.
So, the power of the mortgage deduction is higher in the blue states.
In a sense, where the mortgage deduction mitigates a blue stater's housing cost, it is a kind of a subsidy from the red state folks.

A cap on the mortgage deduction would be more fair to the red state people. But since the Republicans who pander to people in the red states are wealthy elites, they wouldn't dare stoke a fire of resentment in their home turf. So we in the blue states benefit in a trickle down effect.

6   Different Sean   2007 Feb 17, 4:05pm  

hmm, well, it's certainly an interesting picture... "Run away! Run away!"

7   surfer-x   2007 Feb 17, 4:10pm  

regarding the 250K (500K for a couple) discount, "how do you know if it's your primary residence"? Easy, it's the one you're selling.

8   e   2007 Feb 17, 5:09pm  

I don’t understand why so many people treat the tax deduction like it’s the best thing since sliced bread. After all, you can only deduct money that you spend. That’s money you don’t have for other things like an emergency fund, your kid’s braces, etc.

Well, it does cancel out the property tax that so many of us always bring up...

9   OO   2007 Feb 17, 5:20pm  

Oz OOs get a bigger tax break than the US when they sell, the gains from primary residence is NOT taxed at all. Of course, you get no deductions if you sell at a loss. How to determine primary residence? Any homes that you lived in for the last 6 years and rented out for less than 6 months (ajh and DS, correct me if I'm wrong). If you rent out for more than 2 years in the last 6 years, cap gains are calculated pro rata. So theoretically, I can move into one home every 6 years in Oz and reap all the gains tax free.

In the US, if you live for 2 years out of the last 5, you can claim that home as one of your main residences (up to two), and get that $250K pp, $500K per couple tax deduction. So theoretically, you can move every 2 years and pocket your gains $500K tax free.

Oz encourages property speculation far more than the US. Prop 13 is unusual and confined to California, Oz land tax is a joke. You know how much it is for a million-AUD property in QLD, for example? Around $2500 AUD a year, that's it. I don't know how they assess it, but the tax % of the property is so low that the hike in value won't lead to a big jump in annual holding cost of property tax. Then, the council rate is about $1200-1500, so the total holding cost is south of $5K even for high end properties.

Therefore, although Australia taxes heavily on income, and investment gains, holding property in Oz for long-term gains is very cheap. Those in the highest bracket of 48.5% typically buy negative gearing (slightly negative cash flow) properties to lower their income tax while waiting for appreciation.

This whole negative gearing thingy has just as much of a psychological impact as the mortgage interest deduction. You really have to run the numbers to understand if it works for your scenario. With the exception of those who have most of their income locked in the 48.5% tax bracket and confident of property appreciation, the tax benefit is offset by the negative cashflow one has to sustain throughout the lifetime of the property. If your cashflow is positive, then no negative gearing tax benefit can be reaped.

AMT is a complicated bitch. You CAN deduct mortgage interest but NOT property tax. Property tax for a typical million-dollar home in CA is $10K, while the annual interest on a typical loan for that million-dollar home is around $50K, so you see AMT doesn't dilute the tax benefits so much.

10   e   2007 Feb 17, 5:27pm  

If you folks want to see something curious, check out this realtor's site:

http://www.erinna.com/mylisting.php?q=1

I like how some of the properties call out that they were "sold over asking".

11   OO   2007 Feb 17, 5:29pm  

The IRS code should have worked the other way around, discouraging property speculation in the US.

Prior to the 97 tax law change, one had to roll all the gains up into a more expensive home within a year of selling his old home, or the gain on his home would be taxed as capital gains. The 97 change made it possible for people to bubble sit, such as Herr Randy, because he got to keep all his $500K gain tax free while waiting on the side line. Plus, lots of flippers are flipping their properties within 1 year, so they are not even taking advantage of the 2-year residency that is mandatory for the $500K cap per couple, nor are they taking advantage of the capital gains tax treatment which requires them to hold their property for at least 12 months.

Therefore, I think the IRS codes have less to blame than the historical low rates and the extremely loose lending policy. If everyone had to borrow money the way that I borrowed back in 94, Bay Area property value would have to crash at least 30% if not more.

12   e   2007 Feb 17, 5:57pm  

NY City expert requested

http://www.mlslirealtor.com/unidetails.cfm?mlnum=1873210&PFormat=1&typeprop=1

This is a house in Little Neck, Queens for $775k. Why is the property tax only $1,444 a year? In fact, property tax for most properties in Queens are really low.

Across the border in Nassau, it's easily $10k a year.

13   Different Sean   2007 Feb 17, 6:07pm  

As my father once told me, “You don’t get rich spending a dollar to save 30 cents.”

It's just like buying google shares at $200, and the whole P/E disaster of the dotcom era -- you buy a stock for its perceived capital gain value, not for its dividend. In the case of Oz, investors can write off any losses on investment property against personal income, and thus could get up to a 50% refund from the govt at tax time. A refund for speculating at a loss. They also halved the capital gains tax on the sale of investment property. These things prompted RE gurus/spruikers to encourage people to buy loss-making properties in the belief that the inevitable "conservative" 10% growth a year would put them into positive cash flow territory in, ooh, say 10 or 20 years. Meanwhile, the govt will be equal partners in your loss! The taxman is paying for your property! Isn't life great? So these guys were making a loss to get ahead, in their estimation. It *can* work in that the dollar will inevitably be devalued over 20 years, so a large mortgage now may look like a small mortgage in 20 years time.

However, the price of properties may well collapse, since it's travelling at 200% of historical norm, and since they pushed up the income tax threshholds, most people will now most likely only get 33% back at most. These things have served to cool the market a little. Finally, the Treasurer has relented from his bubble-pumping habits of the past and has done a couple of tweaks to encourage more investment in shares and less in property as boomers approach retirement...

14   ozajh   2007 Feb 17, 8:20pm  

OO,

It's actually more generous than you describe, or at least it used to be.

After you establish a primary residence by 6 month's occupation, you can then have as many under-2-year rental periods as you like as long as you move back in (for at least 6 months, I think) between each rental period.

However, you can only have one primary residence at any one time, so you can't cycle between 3 or 4 houses and progressively claim them all as 'primary' when selling. (Mind you, people try this all the time, according to a Tax Office employee of my acquaintance. The other common 'mistake' is to ignore building depreciation when calculating CGT on sale.)

As you say, the Australian system grossly favours RE over other investments for people paying high marginal tax rates, as long as you see some level of price increase, and also favours investors over Owner-Occupiers. The politicians won't change things, because the last time someone tried (in 1986) there was more or less a landlord's strike in Sydney, and the private rental situation deteriorated so rapidly that the pollies backpedalled. In fact, backpedalled to the point where investers were MORE favoured than previously.

* Not Investment Advice - the rules may have changed since I was last a landlord in 1991 *

15   astrid   2007 Feb 17, 11:20pm  

Peter P,

That's a perfect illustration of the bubble mentality. Most FB I meet are indeed driven by the fear of missing out.

Or as my mom says "it can't be bad if everybody is doing it - at least you won't look like an idiot that way."

16   gavinln   2007 Feb 18, 1:10am  

The mortgage interest deduction cannot be responsible for the recent increase in home prices either in San Francisco or nationwide. It has been around for decades and prices have risen and fallen (in real terms) over that time. Why didn’t earlier homebuyers bid up prices? Is it different this time and today’s buyers are more intelligent, realize that the tax deduction has a benefit and have bid up prices?

You could use the same reasoning to show that neither prop 13 nor the $250,000 per person exemption was responsible for the rapid rise in home prices recently.

So what explain the rise in home prices in the Bay Area since 1996? The run-up in prices in the last 1990s was caused by the dot-com boom and justified. In the early part of this decade price stagnated or fell slightly because of the crash but the surprising fact is that prices started rising again in 2003 even while jobs were being lost in the Bay Area.

In my opinion the most recent price rise is due to a combination of speculation (purchasers not just buying for a place to live but in expectation of future gains in prices) and loose credit. The easy availability of interest only, negative amortization, low down payment and sub-prime loans allowed more home buyers to compete for housing even with the number of job holders and even population in the Bay Area falling slightly.

Evidence that the last two explanations are valid is the curious phenomenon of falling sales even with a good economy. In January 2007 sales were at the slowest since January 1996. This means that sales in today’s relatively good economy are even slower than during the recession in 2001. The drop in employment in San Jose during the last recession was the worst (as a percent of population) of any city since the great depression. Employment also fell substantially in San Francisco and the east Bay.

What would encourage people to buy during steep job losses but stop buying when there have been job gains? Speculation and easy credit.

17   astrid   2007 Feb 18, 1:46am  

I'm certainly not denying the role of easy credit and speculation, but I think that Prop 13 in CA and $250K exemption has played its part in changing the psychology of ownership from consumption to "investment."

Since Prop 13, CA's median prices have been rising faster than the national. You can argue that this is due to CA's other tangible and intangible factors, but none the less, I often hear fixing tax rate as a major reason for holding houses.

$250K exemption has spurred a lot of speculation on the margins, not by the hardcore speculators but lots of younger buyers and baby boomers are buying more house than they need (or buying when they would otherwise be renting) in the hopes of cashing in on the exemption.

18   astrid   2007 Feb 18, 4:01am  

justme,

I apologize for my obtuse remark on the previous page. I was listening to Erlend Oye's DJ Kicks compilation and reading a book about pizza at the time -- I can't think of another connection.

I am Chinese. My handle came by the way of a defunct Scottish pop outfit named after the German girlfriend of the fifth Beatle -- it was also short, in all lower case, and I have a thing for A names.

19   astrid   2007 Feb 18, 4:45am  

justme,

I'm certain someone could track me down if they made an effort - I've narrowed myself down very small population sets, and I have a very unusual knowledge set. Odds are, the best I can aim for is semi-anonymous and not disclose opinions that could get me fired.

20   Randy H   2007 Feb 18, 5:19am  

* I agree with Peter P, Eliza and others that the psychology of the mortgage tax deduction is the foremost factor for most home purchasers. Keep in mind that most people either can't or just don't do the math. And a big tax deduction makes people feel smart and shrewd.

* For many people (although not people in the Bay Area so much due to inflated incomes) the home mortgage deduction is the first thing that causes them to "outgrow" the EZ filings. Finally, they have some tax shelter that outweighs their standard deduction. This makes them mentally think they're ahead of the game.

* The financial math of the qualifying mortgage interest deduction is more powerful than a lot of skeptics want to recognize. That is our weakness in this forum. The mortgage interest deduction is a leverage upon the leverage, and the calculation of its benefit to the buyer is iterative. That means a buyer really does get a big financial kick all else being equal. If you knew that your home would not lose any real-dollar value, then using borrowed money that is government subsidized against interest payments is very smart. Of course, no one knows that your home won't lose any real-dollar value.

* Once you draw all the graphs from the math, you come out with the mortgage deduction offsetting a good chunk of potential real-dollar losses for most buyers. But the effect is limited, and diminishing over time.

* So the worst case scenario is you borrow huge amounts of money to buy a vastly overpriced home. It slowly loses real value (let's say it's nominal value stays flat for 15-20 years as compromise "soft landing" case), all the while you pay off 2/3 of your fixed-interest 30 year mortgage. Your early deductions offset your real losses. But every year your losses mount and your tax benefits diminish, making your losses mount even more.

But...

None of that will mean boo to 95% of buyers. They'll just go on about their happy way patting themselves on the back for being shrewd and smart.

21   surfer-x   2007 Feb 18, 6:12am  

Government set to ‘cradle’ girl child

makes sense for an economic and intellectual powerhouse to resort to infanticide.

22   astrid   2007 Feb 18, 6:38am  

Ha Ha,

It's no laughing matter. A highly imbalanced gender ratio is historically linked to radicalized young male population. It is very much in American's interest that these boys grow up to marry girls.

23   astrid   2007 Feb 18, 6:43am  

Randy,

Yeah, it's the buying IPO factor times fifty or a hundred.

24   astrid   2007 Feb 18, 7:10am  

I think PRC's problem will be less severe than that of India. In China, while filial piety traditionally calls for sons, practical reality is stacked in favor of daughters. Chinese marriages usually calls for the groom's family to bear the entire burden of marriage including housing. Women also have an easier time finding work and are less likely to get into trouble.

Amongst my family's Shanghai connections, most elderly widow/widowers live with their daughter's family or lives alone. I can't think of a single current case of a widow/widower living with a son's family.

25   OO   2007 Feb 18, 8:14am  

People don't like to pay taxes.

I know of a couple who DIVORCED on paper so that each of them can carry 2 houses on their individual mortgage deduction, instead of 2 per couple. Well on top of this, they sort of hated the marriage tax penalty. They still lived together with kids after the divorce.

The Superhome series also feature some Californian couples who camp out in Vegas 6 months out of a year to evade the CA state income tax. I mean, they actually change their living behavior to cater to the tax codes. I also know of an ex-colleague who moved to Seattle for half a year before he cashed out his options, so that he didn't have to pay CA state tax, running the risk that the stock price might go a lot lower in the meantime. There were plenty of people during the dotcom time who borrowed money to pay AMT for exercising their options and hold for another 18 months to qualify for cap gains tax treatment (a swap of 40%+ bracket for 20%), without regards to the risk of plummeting stock price in the meantime.

Let's face it, people HATE taxes. They do all sorts of crazy things to avoid paying tax.

26   OO   2007 Feb 18, 8:20am  

The biggest social engineering tool of human history is always TAX.

In the 1800s, Chinese population went through an explosive growth, not that there was effective contraceptive measures before then, but people were f***ing like rabbits to make more babies. Why? There was an important tax code change. Prior to that, Chinese were taxed by their emperor on a per head basis, so more kids you have, more tax you pay. The new tax code had it that a household was only taxed on the plot of land they held, not on the number of heads within the household. So naturally people bred like mad so that they would have more helping hands in the field. It was a disastrous, nevertheless effective tax code that achieved results way beyond expectation.

27   astrid   2007 Feb 18, 8:20am  

Ha Ha,

Wishful thinking or not, I've at least attempted an economic/demographic argument for comparatively less gender imbalance in China relative to India. What have you got to buttress your criticism?

Ditto your mind reading prowess. If you followed my previous arguments regarding China, you might have recalled that I'm deeply pessimistic about many aspects of the PRC and has never attempted to cover up its failings.

(Besides, most contemporary Chinese don't really resort to female infanticide. A combination of selective abortions and selective enforcement of the one child policy can achieve gender imbalance just fine).

28   astrid   2007 Feb 18, 8:29am  

OO,

That's quite interesting, I've never came across that particular policy. Was that before or after the Taiping Rebellion?

I would considered the agricultural innovations to be the primary factor spurring Qing population explosion. Double cropping rice and introduction of new world crops allowed the preexisting land to support much higher population density than before. I've looked at some anthropology studies from the early 1900s and the main population control appears to be land productivity - people would have many births, but only one or two children would survive to adulthood.

29   OO   2007 Feb 18, 8:54am  

astrid,

that was the tax policy of yongzheng era, it is called tan1 ding1 ru4 mu3, so-called distributing heads into field. You can look up the details on more chinese history website. Sorry that I got the year wrong, it should be around 1730.

It was meant for the simplification of tax codes which would have made tax collection more efficient. It worked for a while, until his people were too financially motivated that the population growth spurred out of control. Many historians point to this tax code as one of the major causes for overpopulation in China, a plight that even modern China has to struggle with.

30   Paul189   2007 Feb 18, 9:03am  

CB,

Since Canada has no mortgage interest deduction can we do any comparisons with the US bubble markets and what contribution the decution plays into the bubble levels? Does/did Canada have major bubble markets? My guess is Vancouver and maybe Toronto but that is just a guess.

Paul

31   OO   2007 Feb 18, 9:13am  

Vancouver is a essentially a spill-over receptor for west coast America, Hong Kong, Taiwan and China.

I really feel sorry for people who have to make a living in Vancouver and buy a house there. Because Canada has no restrictions on foreigners buying property, and the banks lend almost as generously to non-Canadians, it becomes a parking place for money from relatively well-off Americans and Chinese expats. On top of this, Canada has a weird tax code that favors foreign investment, I know this because I at one point intended to buy a place in Vancouver.

Canadians get no interest deduction on mortgage and pays full income tax to Canadian IRS. As a non-resident foreigner, I will only get taxed on a flat 20% for rental income, while a resident Canadian will get taxed PST + Canadian tax rate for the same income. Therefore, one will be much better off holding Canadian property as a foreigner. This is the same situation in UK. My Hong Kong friends who bought properties in UK are entirely exempted from capital gains, while UK residents / citizens are not. Therefore, London is increasingly owned by foreign money.

32   lunarpark   2007 Feb 18, 9:21am  

http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2007/02/18/REGL7O6FH81.DTL

"So overall, Bay Area housing has always been expensive and over the years it has become even more so. However, there are a variety of financing options available today that are allowing individuals to break into the market. Just realize that you may need to live farther away and more than one person in your household may need to be pulling in an income. The good news is that your property taxes will rise at only modest levels and your homeowners insurance premiums may even decrease.

Also, keep in mind that home appreciation is on hiatus. With interest rates still near record lows and a healthy inventory, that certainly makes for a buyer's market. Of course, if history is any indication, prices will start to climb again before you know it. "

33   astrid   2007 Feb 18, 9:52am  

Thanks. I've read a little bit about it, though in rather glowingly positive terms (in PRC publications).

I think contemporary Chinese overpopulation is more the combined outcome of enlightened and ignorant Maoist policies. There were only 400 million Chinese in 1949. My parents were born at the start of a huge post-1945 baby boom. Many of their friends and neighbors had 9 or 10 kids, whom, thanks to improved access to medical facilities and food rations, all survived to adulthood...all living in 10 or 15 square meters of space together.

The ignorance part is that the Maoists didn't realize they created a huge demographic time bomb until the 1960s. They actually believed in "ren do hao ban shi" and thought the bigger the population the better. They wanted more good soldiers available to die gloriously fighting Nationalist/Imperialists.

The people's commune system also perversely encouraged more births - firstly through improved access to food and health care, but also by encouraging individual families to have more kids to lock up their share of the commune's resource and consolidate their family's power within the village power structure. I think people behave quite rationally on an individual basis, it's the collective where the truly irrational patterns arise.

34   Doug H   2007 Feb 18, 10:45am  

Astrid said: (Besides, most contemporary Chinese don’t really resort to female infanticide. A combination of selective abortions and selective enforcement of the one child policy can achieve gender imbalance just fine).

I guess that accounts for the 1/2 million unaccounted for females in the PRC. Your heart has to go out to all the female babies, in orphanages, whose only hope for a good life is to be adopted by foreigners. My son flew home, through The Netherlands, from Jinan this month and his flight was packed with female babies coming home with their new parents.

Whatever the cause, it's tragic, and an embarrassment to the Party.

35   gavinln   2007 Feb 18, 10:47am  

Here is my letter to Mr Venezia who wrote the article in the SF Chronicle

http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2007/02/18/REGL7O6FH81.DTL
-----------------------------------------------

Mr Venezia,

Your story in the San Francisco Chronicle on February 18, 2007 is incomplete and potentially misleading. You imply that housing has become consistently less affordable in the Bay Area since 1979. The graph with the article also appears to show this.

But if you use a combination of interest rates, housing prices and income to measure affordability you clearly see three years where affordability was at its minimum, around 1982, 1989 and 2006. In between those years affordability was much better.

By leaving out a key variable, interest rates, you are doing a disservice to your readers.

Gavin

36   lunarpark   2007 Feb 18, 11:13am  

justme -

How funny, I noticed the article you linked right after I read the first one. I had the same exact thought.

I think Mr. Venezia's bio says it all:

Craig Venezia is the author of "Buying a Second Home: Income, Getaway or Retirement."

37   astrid   2007 Feb 18, 11:29am  

zidane2,

I doubt there will be many foreign mail order brides in China in the near future (if any, they're likely to come from poorer countries like Cambodia, Burma, and the former Soviet -stans). What happens in this situation is that most men on average end up with "lower"quality female companionship than would otherwise be the case. Only the poorest of the poor will end up with no spouses at all -- they're trouble.

Ha Ha can continue to insist otherwise, but based on what I've seen first hand, I'd say daughters are quite popular in major Chinese metropolises such as Shanghai and Guangzhou. In cities where "quality"dwell, there are a lot more complaints of impending spinsterhood for accomplished young women than complaints of young men unable to find a decent wife.

38   Doug H   2007 Feb 18, 11:46am  

Back on track,

Here's an EXCELLENT article on pricing:

http://www.nytimes.com/2007/02/18/realestate/18cov.html?pagewanted=1&_r=3

39   Randy H   2007 Feb 18, 12:38pm  

lscharen,

Agreed 100%. I haven't seen you around here before this thread, so let me extend my welcome.

40   lex   2007 Feb 18, 1:34pm  

This year there was one thing the pissed me off when I was doing my taxes.
I realized that the amount of my California state tax was almost equal to the amount of the standard deduction. So as a renter in the state of California I can't count on the standard deduction giving me any advantage.
It sucks. I think the state tax shouldn't be a part of "Schedule A" deductions. Any ideas?

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