New Tax Rules May Have Added to Housing Slowdown


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Two New York Federal Reserve Bank economists are asking whether the tax
reform act that went into effect at the beginning of 2018 is playing a role in
the decline of home sales.  Richard Peach
and Casey McQuillan, writing in Liberty
Street Economics
, say that the broad-based slowing in housing market
activity coincided with a roughly 70 basis point rise
, from 3.9 percent to 4.6
percent, in the thirty-year fixed-rate mortgage.  During the period in which rates were
increasing, from the fourth quarter of 2017 to the third quarter of 2018, new
home sales declined 7.6 percent and sales of existing homes dropped 4.6

The two point out, however, that those declines in sales were larger than
in the two previous periods of significant rate increases.  They theorize that provisions in the Tax Cuts
and Jobs Act of 2017 (TCJA) are contributing to the downturn.

The authors reference a post in Liberty
a year ago that took a detailed look at provisions of the TCJA that
might affect the cost of homeownership. That analysis concluded that homeowners
would experience significant increases in those costs, especially those living
in areas with high income and property taxes.
Deductions for state and local
taxes, referred to as SALT deductions are capped at $10,000.  Authors of the current article also took into
consideration the lower ceiling on a mortgage balance ($750,000) for which
interest can be deducted and how the lower marginal tax rates affect the value
of those deductions.

Peach and McQuillan compared the 7.6 percent dip in home sales in the
recent period of rising rates with those from Q2 2016 to Q1 2017 when rates
rose about 60 basis points and home sales grew 10.3 and those from Q1 2013
through Q4 2013 when the increase was 80 basis points and home sales fell 1.0

In the most recent episode, the largest declines in sales
tended to be in the highest price range, which is where homebuyers would be
most affected by the tax changes mentioned before. To the extent that sales
fell in previous periods, the declines were concentrated in the lower price
ranges while the sales in higher price ranges continued to increase. 

The authors say that the strength of the economy in 2018 and
the strong pace of job creation indicates that the housing market should be
able to shrug off the interest rate increases as they did in the two earlier
periods. The difference this time would seem to be attributable to the tax code

They developed a model which used the relationship between the costs of owning
and renting to compute the user cost of capital for owner occupants who itemize
deductions   It is widely accepted, they
say, that the user cost of capital strongly influences demand for owner occupied
housing. They then compared changes in the user costs of capital in the three

Their analysis took into account mortgage rates, median
property taxes in the U.S., and depreciation. The latter is offset by capital
gains from expected home price appreciation.  These calculations bring the final user cost
of capital for the quarter to essentially zero, or 0.1 percent.  As shown in the table below, the calculation
was replicated for each quarter with the appropriate housing costs variables.

The third quarter of 2018 was further analyzed with
information on the changes in the tax treatment of homeownership.  The top marginal income tax rate fell from
39.6 percent to 37 percent, meaning that the tax savings from itemized
deductions fell by 2.6 percentage points. 
Property taxes are assumed to be at the national median of
1.2 percent of property values so that, at the margin, property taxes are
no longer deductible although mortgage interest payments still are.  The effect is to raise the effective property
tax rate by 0.5 percentage point. From this they estimate that the user
cost of capital to owners increases from 0.1 percent to 2.1 percent, and that a
major part of this is due to a 1 percentage point decline in expected home
price appreciation. 



They also did an analysis for the
recent period focusing on high-priced homes in higher taxed areas. There they
assume property taxes at 2.5 percent of the home’s value, typical for such
areas, and that the owner has borrowed more than the $750,000 cap, meaning the
mortgage interest is no longer deductible at the margin, raising the effective
mortgage rate by 2.2 percentage points
. Under these assumptions, the cost of
capital appears to increase from around 1 percent to 5 percent for these

Of the three periods, the recent one experienced the greatest increase in user
cost of capital. From the second quarter of 2016 through the first quarter of
2017, the marginal user cost rose around 1.5 percentage points as the result of
higher mortgage rates, a slight increase in the median property tax rate, and
lower expectations for home price appreciation. In the first quarter of 2013
through the fourth quarter of 2013 episode, the marginal user cost rose by only
0.5 percentage points because of the increase of mortgage interest rates. Both
are less than in the 2017-2018 episode, particularly under the assumptions for
higher-priced homes in high-tax jurisdictions. 

The authors concede that their findings are not conclusive, but they are
consistent with the view that the TCJA has contributed to the slowing of
housing market activity that occurred over the course of 2018. Specifically,
this slowdown stems from a higher user cost of capital caused by lower marginal
tax rates, the $10,000 cap on the deductibility of state and local taxes, and
the lower limit for the amount of mortgage debt on which interest payments are

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