The one sector of the economy that is creating the greatest controversy between bulls and bears is the housing market. Record housing starts, sales, and re-sales are confounding traditional market analysis that puts housing into a cyclical or demographic framework and then concludes that the boom can’t continue. On the one hand, the bulls point to record-low mortgage rates as the key reason for a booming market. Not only do low mortgage rates encourage new purchases because they increase the number of people that can qualify for a mortgage, but the refinancing of current mortgages also goes a long way toward providing the cash flow — and thus the down payment — for second and third homes. Low inflation and rising real incomes are also allowing more consumers to take advantage of these unusually favorable market conditions.
On the bear side is the belief that record rates of growth in the market for residential housing can’t be sustained because historic trends indicate that housing is a cyclical business. They warn that any upward move in interest rates will ratchet mortgage rates higher and cut off the credit flows that have bolstered this industry. The combination of very low down payments and high debt-to-equity ratios also threaten to burst the bubble since a rise in interest rates and a fall in housing prices will put a lot of house keys in the hands of banks when the buyer is upside down on his or her mortgage.
But one reason for this booming housing market that has not been discussed is changes in the tax law. For most homeowners, mortgage interest payments remain the last vestige of a viable way to reduce taxable income. However, as income-tax rates have been reduced and as interest rates have declined, this tax incentive is not as attractive for many homeowners. The secret in the housing market’s sustainable growth is the change in the tax law regarding capital-gains taxes on owner-occupied real estate.
In the old days, homeowners could sell a house without capital-gains tax liability, no matter what the capital gain, as long as they rolled that gain into a higher-priced house. This practice could occur as often as desired without any tax consequences. The problem was that the use of the proceeds was restricted and getting cash out of such transactions might have been difficult. If you traded down by buying a lower-priced house, you paid a capital-gains tax.
The 1996 changes in the tax laws allowed homeowners to sell their owner-occupied dwelling after two years with no capital-gains tax liability for up to $250,000 in capital gain and $500,000 per couple. The drawback to this tax change was that property held for long periods of time that had appreciated in excess of these limits would incur a capital-gains tax on the overage. The obvious option — if taxes are a consideration — is to sell a home when it approaches these limits.
On the other hand, this unusual exemption from the capital-gains tax created an entirely new business opportunity for individuals and couples. Instead of working and paying taxes in a traditional job, one or both homeowners could become competent at handiwork, purchase a run-down home, fix it up, sell it for a profit, and be rewarded by having earned money and not having had to pay either ordinary income or capital-gains taxes on these “earnings.”
This change in tax law created an enormous source of tax-free income for entrepreneurial couples — they could earn up to $250,000 a year tax-free! If one or both partners were realtors as well, some additional taxable income could be possible if they listed and sold their home.
Some observers may discount the importance of this tax change. However, I can attest to the viability of this strategy: I have done it twice since 1996.
As Arthur Laffer taught us many years ago, reducing tax rates creates incentives to work, save, and invest. Taking the tax rate to zero on capital gains derived from owner-occupied residences has encouraged activity in the housing market. Don’t underestimate the power of tax-based incentives to keep the housing market booming.
— Tom Nugent is Executive Vice President & Chief Investment Officer of PlanMember Advisors, Inc. and an investment consultant for Wealth Management Services of South Carolina.