California real estate relies heavily on tax subsidies. Is a subsidized housing market the best thing for California homeowners and real estate agents?
The necessity of social engineering
A recent article in The Economist asserts,
“Getting from 19th century misery to 20th century prosperity took a lot of social and governmental reform and investment. It is unreasonable to think that similarly grand shifts would not be necessary now. It is also unreasonable to expect that this transition should require qualitatively similar reforms to those which did the trick in the 20th century.”
The 19th century misery of which the author speaks can be characterized by one phrase: income inequality. Sticking specifically to the American economic landscape, one thinks of wealthy industrialists like Rockefeller and Ford wielding an iron fist over factory workers earning a lowly wage. It was this long-term wealth disparity between the underclass and the rentiers that created the conditions of possibility for the Great Depression.
The creation and subsequent grand expansion of the American middle class took, as the author remarks, some serious social engineering. While much of it began around the turn of the 20th century with the growing labor union movement, the middle class ultimately took shape as a result of the New Deal and the economic prosperity catalyzed by WWII.
Much of the past 80 years has been spent unwinding the progressive policies set in place in the early 20th century. While this mainly occurred via the deregulation of the financial services sector, fiscal housing policy also played an instrumental role in the battle over wealth distribution in the U.S.
Housing’s regressive tax regimes
Ever since the Baby Boomers exploded into suburbia, single-family residential (SFR) real estate has been the greatest store of wealth for the middle class. As such, real estate has proved a fertile battleground for the continued antipathy between tax-and-spend liberals and the so-called fiscal conservative tax hawks.
Fiscal issues surrounding housing policy, including the mortgage interest tax deduction (MID) and property tax reform, really defy political pigeonholing. On one hand, arguing to eliminate the MID comes across as liberal tax-and-spend ideology, since doing so effectively (if only nominally) raises many Americans’ tax bills. On the other, if the MID is seen for what it truly is, which is a social welfare program to subsidize homeownership, the charge to eliminate it falls in line with conservative ideology.
A similar contradiction exists in the property tax arena, especially in California where Prop. 13 controls. Depending on the weather, Prop. 13 might be viewed as a regressive tax regime benefiting the wealthy at the expense of middle-income taxpayers. Or it might be seen as a necessary tax cut to “keep our money out of Sacramento.”
Economic issues are best solved outside of the political arena. That’s why we prefer to take a more utilitarian approach — which policy provides the most benefit to the greatest number of people?
The California real estate market needs reform of both the MID and Prop. 13. We’ve entered a period of secular stagnation — long-term economic malaise — as middle-income earners have suffered wage erosion and the past several recessions have produced jobless recoveries. Fiscal reform and stimulus must step in to supplement the less than modest demand being generated by a sluggish jobs recovery. While this may occur on a number of strata, reforming these aspects of housing policy will keep the tax burden squarely on the shoulders of older, more established homeowners and give Gen Y a chance to enter the housing market.
first tuesday annals, think tanks and university studies have all shown the MID artificially inflates prices and does little to benefit the middle class. In fact, its main beneficiaries are wealthy who purchase high-tier properties and second homes.
Likewise, Prop. 13 offsets the tax burden from older, established (read: wealthy) residents on to younger, more modestly paid families responsible for new household formation.
This is not an argument for reform based on an abstract notion of political equality. It’s down to brass tacks (or tax). The middle class is the Atlas supporting the California real estate market: it does the bulk of the buying and selling — and incidentally, the employing of real estate professionals. But the middle class is shrinking. Who will ensure the livelihood of our dear readers, if the middle class continues to thin?
Creative destruction
A recent editorial published in the New York Times discusses the possibility of taxing imputed rents.
First, the definition of imputed rents. Every homeowner pays a dual role:
- a consumer of shelter, such as any tenant; and
- a real estate investor, such as any landlord.
As a consumer of shelter, when a homeowner makes a mortgage payment, they are paying rent (the imputed rent in the editorial’s scheme). Rent is an expense for the homeowner, as a consumer.
As an investor (owner of the property), the homeowner’s equity increases each time they make a mortgage payment. This is a form of income for the same homeowner, in their role as an investor.
The editorial proposes that all rents are taxed as income – meaning owner-occupants and landlord/investors all pay for the benefit of receiving rents, be they imputed or actual. Likewise, they each are eligible for write-offs like the MID and depreciation and maintenance deductions. This creates a “tax neutral” scenario where taxes paid on rental income — again, imputed or actual — are offset by deductions. Everyone is treated the same.
But if tax neutrality is the goal, why not simply eliminate the MID? The current MID offers homeowners (with mortgages) the tax write off without taxing imputed rents — the income derived from their investment. In other words, homeowners are treated as investors in terms of subsidies but not in terms of revenues.
Add Prop. 13 to this picture and one quickly sees how heavily tax-favored California housing truly is. Under the current regime, wealthy homeowners enjoy deductions for mortgage interest and property tax plus tax shelter from reassessments of their bloated high-tier property value. All this without paying income tax on imputed rent.
Rather than adding more confusion to an already convoluted tax code by taxing imputed rental income, how about destroying the subsidies altogether? The average middle-income homeowner benefits from these subsidies by name only — they are tantamount to a propaganda campaign to encourage homeownership while offering little real value. The wealthy, long-term owners of high-tier and second homes, benefit tremendously from the subsidies. Eliminate them to right the ship of fiscal housing policy while generating more revenue to boot.
Fiscal stimulus via tax reform
As alluded to in the beginning of this article, issues of housing policy and taxation are largely a matter of perspective. Rather than thinking of the elimination of the MID and Prop. 13 as raising taxes, we prefer to think of it as economist Timothy Taylor does:
“The goal over the medium terms should be to make the housing market less tax-favored. It would benefit the U.S. economy to focus less on housing and more on investments that generate future economic growth. Most of the tax benefits of housing go to those with well above-average incomes — since these are the people who are living in bigger houses and itemizing deductions.”
We couldn’t say it any better.
Phasing out the MID and Prop. 13 amounts to closing tax loopholes for the wealthy and leveling the playing field for the middle class. And that’s something we desperately need to do in order to keep the market alive.
It is counterintuitive to be sure, and many who would benefit from rolling back these programs vociferously defend them. What they don’t see is that they’re defending an ideology that maintains income inequality, that corrupts the fundamentals of real estate economics and that leads to continuous stagnation in the California real estate market. But this is how the most successful and insidious social policies work — by luring the masses with a basket of bread while their wealthy overlords plunder the fields.
Beat the drum on this one, readers. Without a change, your base clients will begin to dwindle – and there are only so many multi-million dollar property listings to go ’round.
