The Moderate Income Homeowner Tax
There are some folks in Congress who apparently think that the best thing that government can do for low and moderate income families is to impose a special 18 percentage point tax on their income. Of course they don’t call it an income tax, they call it being a homeowner in a home on which families have no equity.
Yep, you guessed it -- this is yet another twist on those wild and crazy bailout schemes that the bankers’ buddies are devising to use government money to buy up their mortgage debt. Prior posts have focused on the money going from ordinary taxpayers to incredibly wealthy investment bankers. This one focuses on how badly these plans screw the moderate income families they are supposed to help.
It’s a simple story. The key fact to remember is the current ratio of sales price to annual rent: 20 to 1.
This ratio is important because it makes it really easy to show how badly moderate income homeowners get nailed in these bailout schemes.
Let’s assume that our homeowners get a mortgage at 6 percent interest. Many will do much worse, paying 7 percent or 8 percent, but let’s be generous and assume 6 percent. Then add in 1 percent of the sales price for annual property tax payments. Throw in another 1 percent for maintenance, insurance and other ownership related expenses and we get up to 8 percent of the sales prices for annual housing costs.
Now we compare this to cost of renting, which we know is just 5 percent of the sales price from the 20 to 1 sales price to rent ratio. If homeowners have to pay 8 percent of the sales price in annual housing costs, then they are paying excess costs that add 60 percent to the cost of renting (8 percent equals 160 percent of 5 percent). Rent/ownership costs average 30 percent of income, which means that the excess costs associated with homeownership come to about 18 percent of income. We can think of these excess ownerships costs as being equivalent to an 18 percentage point surtax that Congress has opted to impose on the moderate income homeowners it is “rescuing.”
We can put this in dollar and cents terms. Suppose the home in question sells for $200,000. That means it would rent for $10,000 a year or roughly $830 per month. By contrast, the homeowner would pay total costs of $16,000 a year, an extra $6,000 or $500 per month.
This makes for a great contrast. While some in Congress are trying to extend health care coverage, which costs around $3,000 per kid, or child care, which costs around $6,000 per kid, at the same time other members of Congress want to put a $6,000 a year tax on these same families by getting them to spend much more to live in their house than necessary.
The obvious problem in this picture is that sales prices are hugely out of line with rents. Before the housing bubble, the ratio of sales prices to annual rent was in the neighborhood of 14 to 1. In this environment, it might have been a good idea for moderate income families to buy a home. However, when sales priced soared to 20 times annual rent, and in some cases much higher, homeownership no longer made sense. Homeowners pay far more each year to say in their house, and their prospect of accumulating equity in a plunging housing market is essentially zero.
Those of us who can do arithmetic knew this and tried to get the message out. Unfortunately, those in policy positions continued to push ownership in a housing bubble and still do. Millions of low and moderate income families will pay a big price for following this bad advice.
I'm confused. Let's say all your math is correct, and it's more expensive to own a house than to rent one. How is this Congress' fault?
Also, a couple problems with your math. First of all, there's the mortgage interest tax deduction, which makes -- by your estimates, I think -- about 30% of the homeowners' income tax deductible. (In your example, the entire mortgage payment is on interest).
But you also neglect inflation, which reduces the costs of ownership year after year since the mortgage is fixed in nominal terms. In terms of your example here, I think the right way to handle it is to calculate interest rate net of inflation, which brings it down from ~6% to ~3%. (Loosely speaking, this is equivalent to assuming that your house price stays flat in real terms. If house prices appreciate at all, you need to factor that in as well). Inflation doesn't affect rental costs, since these increase every year with inflation.
March 3, 2008 12:23 AM | Reply | Permalink
I should add that I don't mean to be making a snide attack here. Obviously you know much more about these issues than I do. I'd just appreciate some clarification about your numbers, and -- more importantly -- about what Congress is doing that you think is so wrong.
The first two paragraphs of your article suggest that Congress is imposing some new cost of 18% of income on homeowners. The rest of the article seems to establish that homeowners pay about 18% of income more than do renters -- what's the connection?
March 3, 2008 3:02 AM | Reply | Permalink
Anonymous,
Congress of course doesn't force people to be homeowners, they -- along with teams of financial counselors -- just strongly encourage moderate income families to be homeowners, even when this means buying homes at bubble inflated prices. It is my hope that these families stop taking such disastrous advice.
In terms of the arithmetic, the bulk of these moderate income families will face little or no income tax liability. In the cases where they do, odds are that they take the standard deduction. Even if they do take mortgage interest deduction, the value is only the gap between the value of their deductions with the mortgage interest deduction and the standard deduction, which is likely to be very small. (Their marginal tax rate will also be no more than 15 percent and is quite likely 10 percent.)
As far as adjusting for inflation -- this would show up in the value of the home. House prices are currently falling at double digit rates in nominal terms. Under some of these proposals, like the Office of Thrift Saving's plan, homeowners start out hugely underwater. Since the typical period of homeownership for moderate income families is just 4 years, it is very unlikely that these folks will ever accumulate any equity in their homes.
In fact, the situation is likely worse than I have described here since the mortgage will likely accumulate some payment toward equity, which the homeowner will not be able to recover when they sell their home.
March 3, 2008 4:55 AM | Reply | Permalink
Dean, don't you need to account for the value of the asset the homeowner is purchasing? After 30 years of renting, the renter has no asset and must continue to pay full rent. After 30 years of paying a mortgage (assuming the homeowner took a 30-year loan as most used to do), the finance cost goes away and the homeowner is left with a valuable (and generally, over the long-term at least, appreciating) asset.
This is not to say that renting is always a bad choice--before I purchased my own home I did the math and was surprised to discover how good renting looked. It's one reason I ended up buying a relatively inexpensive home. I think a large part of the problem is that so many home buyers have been willing to overspend on homes (and over borrow). This has driven up the prices for homes, made them more expensive (and therefore less attractive) investments, and left many people in very tenuous financial positions. Purchasing an affordable home, though, doesn't seem like a bad decision.
March 3, 2008 6:47 AM | Reply | Permalink
One would have to enumerate what is done to encourage ownership and what is done to encourage renting.
Encouraging ownership: (1) interest deduction, (2) deduction of real estate taxes, (3) lax regulation or lending, to wit, excessive ease of taking mortgages with less than 20% down.
Discouraging renting: implicit payment of real estate tax, with no deduction.
There are also question of tax treatment of investing in rental properties versus investing in own home, with strong preferences for the latter.
Many zoning regulations can discourage renting (limits on unrelated persons renting one property) and building specifically for renting (limits on multifamily construction and other density limits, often quite excessive toward low density).
Finally, there was a lot of propaganda for "ownership society", to the point that owning a home was viewed as more moral then renting. Not to mention often repeated advise that money spent on rent are lost, while payments for a home are "building equity and capital gains".
I do not know what happened to regulations that strongly discouraged purchases with very little down payments. Somehow, high risk mortgages were allowed to be packaged as low risk commercial paper. Now I think the markets took care of that
That said, this 5% for yearly rent is false in many markets. Location, location, location.
Dean, what practical steps do you propose? Could one make it more attractive to convert owner occupied properties to rentals? Currently there is actually a penalty in some cases, I think that if you rent your home for one year you loose exemption from capital gains.
March 3, 2008 6:25 AM | Reply | Permalink
The rent vs ownership debate is one thing and an important one, however, I'm interested in the potential remedies for addressing the irresponsible lending that has occured in the past 5-10 years.
From what I have read it appears the banks used deceptive enticements to lure in customers for mortgages that were likely just more than many could afford in the long haul particularly when distracted by the prospect of eternally low interest rates at the level seen 3-5 years ago which made ARM's literally too good to be true. How many consumers--even those who understood what they were agreeing to--really thought that interest rates would move as high as they did as fast as they did? Not many I imagine.
So, the banks and mortgage brokers were, in essence, making what they knew to be irresponsible loans if interest rates rose much at all (as they did over the past couple of years). Now, with the cold, hard reality of people being hard pressed and increasingly unable to meet their mortgage obligations, the banks are facing a crisis of their own making and one which sober bankers could easily have foreseen. While caveat emptor always applies for consumers of all products including mortgages, many of those hwo find themselves in dire straights now or in the coming months did not comprehend the level of risk they were taking when they signed on the dotted line, yet the potential remedies that are being discussed seem tilted toward easing the pain as much as possible for the lenders and speculators and providing only minimal relief to those who got suckered into mortgages they could only afford with teaser rates and very, very low interest rates.
Is there anyone out there who is actually proposing a solution to the "crisis" that is focused on relieving the homeowners and letting the banks swallow the heftiest part of the bad deals they themselves made knowing full well it could all backfire as it has? I haven't heard much about relief for homeowners. It all seems to be relief for lenders.
One question I have is, why isn't anyone trying to help homeowners first? Another question I have is why wouldn't it be feasible to simply require that the initial rates of loans be extended for say 5 years and that all these extensions also have provisions limiting the extent to which the interest rate can rise above prime to a reasonable number that most, if not all, consumers could afford? Why, for example, can lenders not be required to limit the interest rate that is charged to no higher than 6% or some other figure that is reasonable to the homeowner in order to ensure that people can weather the crisis we face currently and so that the threat to the overall economy is reduced? I would think that saving all those families from being foreclosed is really the best thing we could do for the economy in the short term since all the gloom and doom and financial melt down seems to be fueled by worries regarding vast numbers of foreclosures on the horizon.
Please excuse the questions if they're not particularly brilliant, but I'd really like to know what homeowner focused remedies could/should be offered instead of simply fixing things for the bankers who knew better and really are most responsible for this terrible mess.
March 3, 2008 9:01 PM | Reply | Permalink
Mr. Baker:
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This is really poor quality writing. It is extremely difficult to understand and reads more like a rant than a serious political and economic discussion.
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You should consider having someone read & edit your stuff before posting.
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Nelson
March 3, 2008 10:32 PM | Reply | Permalink
i stopped reading when i got to the key fact to 'remember': the 20:1 sale price to rent ratio.
you're asking your readers to 'remember' something without showing them where they might be reminded of it. i have no idea what this number is or where it comes from. i imagine i am not alone.
please explain and cite.
March 4, 2008 1:42 PM | Reply | Permalink