The 2017 Republican tax bill that just passed includes several provisions that will have a direct impact on California real estate. Most are not good, but there’s often some silver lining if you look hard enough.
Preface to say, I am not an accountant, so take this for what it is, it’s just what Tim thinks. The most obvious, most painful and most significant tax change affecting California, is the cap of $10,000 on state and local tax deductibility or SALT for short. If you are unfamiliar with this component, it’s a provision that caps how much local tax you can deduct. Because we in California are an income tax heavy state and pay as much as 10.5%, state income taxes, most coastal California home owners will exceed the cap of $10,000. To keep this real basic and simple, if you have a fire fighter and school teacher couple earning $150,000 per year, the 10.5% state income tax exceeds $10,000. If you are a scientist or engineer and your spouse an attorney and you make $350,000 a year, your state tax is over double the cap. This means that you will have to pay federal income tax on the tax you pay California. This is called double taxation, paying tax on tax paid. So if you had to pay Federal income tax on $25,000 California state tax you would have to pay an additional $8,000. ($25,000 x 32% tax rate). Why the 32% highest tax rate you ask? Because the addition of taxable income at this income level is added to the top line which is taxed at your highest rate. $315,000-400,000 income is now being taxed at 32%. This all by itself knocks nearly $700 a month off your monthly take home and therefore drops your ability to borrow/pay for a mortgage by over $100,000. In other words, you’ll be paying a lot more in taxes and therefore have less money to pay for that higher monthly mortgage. Do you think the nearly $1,000 a month take home might influence how much house you buy? Probably.
The second thing that hits Californians is that state income tax isn’t the only tax we pay. We also pay property tax. So, if I bought a median priced home in Los Angeles for $750,000, I’d be paying $9,375 in property tax. If you add $9,375 to your top line, you’ll have to pay the IRS and additional $3,469 or $289 a month. Added to the additional Federal tax you’ll pay on your state income tax, you now have $1,100 less a month. You will however save some money with the lowered tax rates. I mean that was the whole point of the legislation, right? But using our $350,000 income example, I calculate you’ll save about $7,500 a year or $625/mo. But you’ll pay $1,100 more. As you can see, the cost of losing the full deductibility of your SALT by capping it at $10,000 and the subsequent double tax you will be required to pay on the difference, marks a reduction in monthly income of about $500.
The third thing that affects many, albeit not all Californians, is the reduction of the mortgage interest deduction for loans above $750,000. Currently you can deduct $1.1M ($1M first trust deed and $100K 2nd.) This deduction cap drops to $750,000. This equates to an additional $5,180 in Federal income tax or another $431 a month less in the pocket ($350,000 x 4% divided by 12 months). Admittedly, many will not feel sorry for someone with a million dollar mortgage not getting the extra write off, but it is going to have an effect on high balance borrowers and that is going to trickle down. In other words, am I willing to pay $1.3M for that home now that I have $800 less income every month? The answer to that question gives us an indication on what is going to happen with values. By the way, that’s equal to a $200K loan payment. Yeah, the math is not good. There’s also the issue that second home interest is no longer deductible and that could lead some people to sell and/or not buy a second home.
About that silver lining I alluded to at the outset is my expectation of declining property values. Because I believe this tax revision will inevitably lead to some decline in California property values, theoretically more people will be able to afford them and we desperately need that. Of course, affordability is not just the price of a home, it also reflects the money we have to spend on a home. But more homes at a more affordable price isn’t a bad thing for many Califorinians.
Finally to the question of, “With this knowledge should I still consider buying and/or selling?” The answer is yes. You should buy but you should also crunch the numbers. It may not be the time to stretch to the breaking point. Be a little conservative. If you’re a seller, heck yeah, sell now. If you are considering moving in the next few years, now is probably the time because the effects on our net income won’t manifest until 2019 when we realize we will owe more than we did in 2018 (2017 tax year.)