The Tax Cuts and Jobs Act of 2017 (TCJA) was a congressional revenue act of the United States that amended the Internal Revenue Code of 1986. Pub. L. No. 115-97 (Dec. 22, 2017). Signed into law on December 22, 2017, by President Donald Trump, the TCJA (also known as GOP Tax Reform and the Trump Tax Cuts) featured major changes to corporate and individual tax policy, which will affect the real estate industry for years to come. This article explores the changes in the tax code that had meaningful implications for the real estate market.
To review the budgetary impacts of the law, estimates were used from the Tax Foundation (an independent nonprofit tax policy research organization that was established in 1937). The Tax Foundation issued a special report in December 2017 analyzing the implications of the TCJA. Tax Foundation Staff, Preliminary Details and Analysis of the Tax Cuts and Jobs Act, Tax Foundation, Special Report No. 241 (2017), https://bit.ly/3a6sXD3. They modeled the effects of the TCJA using two methods, a static baseline forecast and a dynamic scoring model. Their dynamic scoring model is called Tax and Growth (TAG) and can be considered a combination of tax simulation with a macroeconomic model. The total cost of TCJA was estimated at $1.47 trillion over 10 years on a static basis and $448 billion on a dynamic basis (which assumes revenue benefits from increased growth). Because dynamic scoring can be subjective, this article will focus on the ten-year static effects of the TCJA.
Effects on Homeownership
From a homeownership perspective, there were three major changes to the tax code.
Lowered Individual Tax Rate. The TCJA reduced most individual income tax rates, retaining the seven-bracket structure but modifying the bracket widths. At a cost of $1.87 trillion over 10 years (for government revenues), the individual tax change had the largest effect on the federal budget projections. These changes are temporary until December 31, 2025.
Elimination of Personal Exemption, Increase in Standard Deduction. The TCJA eliminated the personal exemption (revenue raise of $1.3 trillion) and increased the standard deduction (revenue cost of $774 billion) to $12,000 for single filers, $18,000 for heads of households, and $24,000 for joint filers (from $6,500, $9,500, and $13,000 respectively). Personal exemptions are deductions against taxable income and were $4,150 per person in 2018. They were intended to insulate from taxation the minimal amount of income someone would need to survive (enough income for shelter, food, and clothing). They were also independent of itemized deductions, meaning that for a married family of three, the loss of $12,450 (the total that can be claimed for all three dependents) from personal exemptions outweighs the increase in the standard deduction of $11,000 under the TCJA.
State and Local Tax Deduction Limit and Lowered Mortgage Interest Deduction. The TCJA limited the state and local tax (SALT) deduction to a combined $10,000 for income, sales, and property taxes. TCJA limits the mortgage interest deduction to the first $750,000 in principal value (from $1.1 million prior to TCJA). It also eliminates interest deduction for home equity debt. The SALT and mortgage interest deduction changes combined will raise $593 billion over 10 years for the federal budget.
The SALT $10,000 deduction cap affected the top 1 percent of income tax filers the most. In 2017 the top 1 percent had a benefit of 2.1 percent of income (when they itemized SALT and deducted against income). In 2018, this benefit was less than 0.3 percent under the new TCJA rules. Before the TCJA, six states had more than half of the aggregate benefits of the SALT deduction: California, New York, New Jersey, Illinois, Texas, and Pennsylvania. Nationwide, 4.1 million Americans pay more than $10,000 in property taxes. For instance, in Westchester County (New York) 73 percent of homeowners pay at least $10,000 in property tax.
Not surprisingly, two of the states most affected by the SALT were California and New York. Both have high state and local taxes as well as property taxes.
From a policy perspective, the arguments for repealing the SALT deduction were threefold. First, the federal government should not subsidize high tax states. In essence, a SALT deduction allows individuals to deduct costs that go to local services and goods they benefit from. Second, SALT deductions rewarded states with more wealthy taxpayers (as deductions were worth 39.6 cents per dollar at the top income tax bracket and less than 10 cents at the bottom). California and New York accounted for a third of all SALT deductions despite representing only 18 percent of the population. Finally, SALT deductions were a target since they were the largest itemized deduction for federal income tax. The New York Times analyzed the effects of the SALT deduction cap and found the biggest losers to be high income, Democratic states. Alicia Parlapiano & K. K. Rebecca Lai, Among the Tax Bill’s Biggest Losers: High-Income, Blue State Taxpayers, N.Y. Times (Dec. 5, 2017).
How much the TCJA affects the decision to purchase a home is unknown and depends on an individual’s personal situation. What is clear is that the new provisions do not incentivize homeownership as much as the previous tax law, particularly in states with high income taxes, property taxes, and home values. Any homeowner who uses the standard deduction (in lieu of itemized) will forgo the tax benefits of home ownership (deduction of mortgage interest and property taxes). In 2019 the percentage of all taxpayers itemizing returns fell to 13.7 percent from 31.1 percent pre-TCJA Law.
Real estate conditions are generally driven by local conditions—population and job growth, demand and supply of available housing, federal and local tax policy, and local public goods (education, police, transportation, and parks). Historically, home ownership has been an attractive investment to increase net worth. After World War II, America grew at a reasonably steady pace alongside increases in population and household formations, which increased demand for housing.
When making the decision to own or rent, there are many factors involved:
- Are the two housing units similar in quality?
- What is the opportunity cost of capital for the equity (down payment) in a purchase?
- What is the cost of capital to fund the purchase with a loan (mortgage rate)?
- What are the other costs to purchase a home: closing costs, maintenance costs, homeowner’s insurance costs, brokerage costs, property taxes?
- What are your assumptions for home appreciation?
- What are the tax shields for property tax and mortgage interest?
A useful tool in this analysis is a rent-to-own calculator. See, e.g., Financial Mentor, Rent vs. Buy Calculator, https://bit.ly/2RC6IhB. The result is highly dependent on the assumptions for home appreciation (especially in high loan-to-value mortgages), mortgage rate, and opportunity cost of equity (down payment).
The ability to leverage equity while owning the implied put optionality of a mortgage loan has benefitted homeowners over the long run. The implied put in a mortgage contract is the borrower’s ability to default (turn over the keys to lender) when the house value is less than the remaining mortgage loan value. There are costs of exercising this option for the homeowner (lower creditworthiness), but, during a financial crisis or hardship, there are few alternatives. In certain states, strategic default can also lead to a deficiency judgment (the balance to make up for the collateral liquidated versus the higher loan amount) during the foreclosure process. In some states like California, there is no recourse for deficiency judgments. In some states like Florida, deficiency judgments are allowed. For a complete list, see Noko, Key Aspects of State Foreclosure Law: 50-State Chart (2020), https://bit.ly/37Q73lH.
The homeowner (borrower) also has an option to refinance the mortgage loan (prepay the original loan) when she can lower her borrowing costs (lower the interest rate). Thus, institutions that lend against housing collateral are short both interest rate convexity and credit default convexity.
Lower long-term interest and housing price appreciation have been long-term trends. After peaking at 19 percent in 1981, 30-year fixed mortgage rates are below 4 percent and have supported real estate asset price levels through affordability (lower payments given fixed purchase price) and refinancing. From an investment perspective, US households have accumulated more than $18 trillion of wealth by owning real estate, doubling since 2012.
Looking at homeownership rates and household formation data, after a long decline following the financial crisis of 2008, homeownership has been trending up since 2016. Renters dominated household formation from 2007 through 2016 even though housing was more affordable than pre-financial crisis level (according to the National Association of Realtors index).
The TCJA did affect certain high income and high SALT states such as New York, where homeownership levels have not recovered. Given the contradicting evidence for the effects of the TCJA on homeownership nationally, it is worth exploring other aspects of the law that affected business and investment that could explain both the rise in national homeownership levels since 2016 and the continued appreciation of real estate assets.
Effects on Business and Investment
The TCJA fundamentally changed the tax structure of corporate America. Three new features affected real estate the most.
Reduced Corporate Taxes, Expanded Bonus Depreciation
The TCJA reduced corporate taxes to a flat 21 percent tax rate from a graduated structure with a top rate of 35 percent. The corporate tax cut is permanent and is estimated to cost the government $1.420 trillion over ten years on a static basis. Tax Foundation Report, supra. The TCJA also significantly expanded bonus depreciation.
Bonus depreciation is a tax break available for qualified new business assets such as vehicles, machinery, equipment, new computer systems, and property improvements. It allows a business to deduct immediately a large percentage of the purchase price rather than write it off over the useful life of that asset. The new law increased bonus depreciation deduction to 100 percent in the first year (from 50 percent), which will fully phase out in 2027. It also extended the bonus to cover used property in addition to new property. In theory these tax breaks trickle down to the American workers in the form of more jobs and higher wages.
The 21percent corporate tax rate and accelerated bonus depreciation were put into law to encourage investment by business to stimulate the economy as well as make American corporations globally competitive. Average top corporate tax rates have been trending lower for the last three decades. Post-TCJA, the United States’ statutory corporate tax rate is closer to the worldwide average.
After the TCJA was put into law, capital spending rose 20 percent in the first half of 2018 for companies in the S&P 500, the fastest rate of increase since 2011. Since then capital goods spending has slowed, partly because of the ongoing global trade war between the United States and China.
Looking at US GDP components aided by the TCJA, consumption (blue bars in Charts 12 and 13) remains strong and is 69 percent of total GDP. Business investment (red bars in Charts 12 and 13), which is 18 percent of GDP, has stalled and is slightly negative in 2019. Yearly GDP growth has slowed from 3 percent to 2 percent, which is below the post financial crisis average of 2.1 percent.
The corporate tax cut had an immediate effect on any company that had deferred tax credits. A company with a deferred tax asset (deducted against taxable income) had to write down value of the asset because that tax rate was lowered to 21 percent. By contrast, a company with a deferred tax liability would see a benefit from lower future taxes due. Citibank had to write down the $43 billion of deferred tax assets it accumulated during the financial crisis (negative earnings) by $17 billion. As a whole, however, Forbes estimated that the S&P 100 companies had a benefit of $120 billion resulting from the TCJA corporate tax law change. Peter J. Reilly, Earnings Havoc Unleashed By Tax Act, Forbes (Dec. 31, 2017).
The TCJA enacted a deemed repatriation tax for foreign corporate profits (US domestic corporations with profits overseas). Before the TCJA, corporate profits were not taxed until monies were repatriated (cash sent back to the United States), so most companies kept their profits abroad. In 2017, an estimated $2.8 trillion of foreign corporate profits had been accumulated and kept overseas. Anne Marie Knott, Why the Tax Cuts and Jobs Act (TCJA) Led to Buybacks Rather Than Investment, Forbes (Feb. 21, 2019). The TCJA changed the law to tax foreign profits when earned and offered a tax “holiday” on pre-2018 foreign profits at a reduced rate of 15.5 percent on liquid assets and 8 percent on other assets. The deemed repatriation tax was estimated to raise $339 billion over ten years for government revenues on a static basis. Tax Foundation Report, supra.
Allowing corporations to bring back profits at a reduced rate was meant to spur investment, jobs, and wage gains. The results so far point less to investment and job growth and more towards equity buybacks. JPMorgan Chase analysts estimated that in the first half of 2018, $270 billion in corporate profits were repatriated back to the United States after the change in the tax law, $124 billion of which was spent on stock buybacks. Jim Tankersley & Matt Phillips, Trump’s Tax Cut Was Supposed to Change Corporate Behavior. Here’s What Happened, N.Y. Times (Nov. 12, 2018).
The return of cash to sharehlders via buybacks and dividends was $1.4 trillion in 2018, a new record. Net issuance of equities factoring in buybacks was negative $600 billion in 2019, which has aided the performance of US equities, with most indexes near all time highs. Adding a buyback yield of 3.26 percent along with a dividend yield of 1.93 percent, the S&P 500 has a total yield of 5.19 percent, which is attractive compared to ten year government bond rates of 1.75 percent.
To put the equity buybacks in perspective, the ten-year cumulative total of $4.7 trillion is larger than the Federal Reserve quantitative easing program, which increased the Fed’s balance sheet from $900 billion to $4.5 trillion from 2009 to 2015. Peter Brennan, S&P 500 share buybacks could reach $1 trillion in 2019 on swollen cash piles, S&P Global Market Intelligence (March 26, 2019).
Despite the buybacks, corporations seem to be in a good leverage position with the strong US economy. Corporate debt to equity ratios are currently 33 percent, which is historically low. Households have also deleveraged since the financial crisis, moving from 100 percent of GDP to 77 percent. The US government has used the most leverage, raising debt levels to 104 percent of GDP from 62 percent in 2008.
The TCJA created a 20 percent deduction for pass-through business income. Pass-through entities are special business structures formed as partnerships, sole proprietorships, limited liability corporations, and S corporations. Pass-through entities do not pay corporate income tax. Instead, they “pass through” the profits and losses of the business to the owners, who then report that income on their individual tax returns.
Real Estate Investment Trusts (REITs) also qualify for the 20 percent deduction, which essentially lowers the individual tax rate to 29.6 percent from 37 percent on pass-through income. There are restrictions on specified service income (a business in which the principal asset is considered to be a skill or reputation such as a lawyer or athlete) above $157,500 for single and $315,000 for joint filers. The 20 percent deduction for pass-through income is estimated to cost $289 billion for government revenues over ten years on a static basis.
The REIT market does benefit from the 20 percent deductibility of dividend income, but overall the Wilshire US REIT Index has underperformed the broader stock market since 2017, partly due to lower corporate tax rates, which REITs do not pay.
The Tax Cuts and Jobs Act of 2017 was the most sweeping update to the United States tax code in more than 30 years. The reforms lowered taxes on businesses and individuals yet repealed personal exemptions and capped deductions for state and local taxes.
The media have targeted certain aspects of the TCJA as being against the real estate industry, such as the 20 percent pass-through income deduction. The corporate income tax reduction, however, is a much larger tax break ($1.4 trillion over ten years) than the pass-through deduction ($289 billion). Also, REITs, which are pass-through entities, do not pay corporate income tax and had no direct benefit from the corporate rate reduction.
The main direct effect on the real estate market from the TCJA seems to be a negative effect for high SALT states where individual income tax deductions are capped at $10,000. Interstate migration patterns had already favored low income tax states before the TCJA. Florida and Texas had the largest in-migration in 2017 according to the US Census Bureau. California and New York were among the states with the highest out-migration. It will be important to analyze the post-TCJA data to see if these patterns accelerate and people vote with their feet. As these demographic forces shift, it will also be important to monitor the political consequences. For instance, in Texas the Republicans have largely been in control for the last 20 years, but Texas is predicted to become a battleground state in 2020 because more Democratic voters have relocated to cities such as Houston and Dallas. Tom Dart, Texas: Republican Powerhouse Could Shift to Democrats as Demographics Change, The Guardian (Aug. 12, 2019).
Finally, the main indirect effect on the real estate market from the TCJA has been a continued recovery in housing prices as the combination of lower taxes, job growth, and accommodative global monetary policy have led household wealth in real estate to top $18 trillion. The cost, however, is $1.5 trillion in additional future deficits, which leaves little scope for fiscal policy to counteract the business cycle when it eventually turns.