A View from the Cliff

The looming danger of the "Fiscal Cliff", the terms of the Budget Control Act of 2011 that will enact drastic spending cuts and end tax cuts affecting middle and upper income tax brackets, has apparently superseded the gains in the economy in 2012. Consumers and investors alike are focused on the negotiations out of Washington to address the federal deficit, and what the impact will be on their pocketbooks and investments. The real estate industry finds itself with much to gain, and quite frankly, with the most to lose depending on what steps are taken to prevent across-the-board cuts and tax increases from kicking in.

We’re all aware that what’s at stake in this debate: generating more revenue to pay down the debt through a combination of program cuts and tax increases. The possible expiration of Bush-era tax cuts on capital gains taxes at the end of 2012, for example,  has sparked a flurry of real estate transactions during the third and fourth quarters to take advantage of a more favorable capital gains environment than could be encountered on January 2nd. As a result, the metrics could paint a lopsided picture of strong activity in 2012 with comparatively little activity in 2013 as investors consider future tax liabilities.

What presents the most significant threat to our industry during these negotiations is the future of the mortgage interest deduction representing over $83 billion in savings for homeowners annually. This same savings also represents a potential source of lost revenue. Despite a fierce lobby from the MBA, NAR, NAHB and other related industry organizations, this most significant tax break for homeowners finds itself under the microscope.  The deduction, no longer just a partisan talking point during an election year, has recently been acknowledged by the President as being a possible casualty as a result of  the Fiscal Cliff discussion.   While the possible scenarios involving modification of mortgage deduction attempts to direct most of the burden to upper income households with a gross adjusted income of over $250,000, there will still be enough collateral damage to middle income household to make a significant difference and a change in the attitude of buyers in general.

Case in point: the proposal of a blanket $35,000 flat deduction to replace the standard itemized deductions inclusive of the mortgage interest and property taxes could actually move many middle-income homeowners  currently “on the edge” into higher taxes brackets. Another popular proposal to reduce the current mortgage interest deduction allowed from $1 million on the initial principal balance to $500,000 also seeks to shift more tax liability to affluent households. Remember that “affluent” is a relative, regional descriptor.  In primary coastal markets such as New York, San Francisco, and selected California communities, median home values are approaching and exceeding the $500,000 potentially bearing the brunt of the cap. Five California markets, Santa Barbara, San Francisco, San Jose, Salinas and Los Angeles, will see a significant amount of homeowners paying higher taxes, and homeowners will strongly evaluate if there is a cost savings in continuing to make a higher priced mortgage payment. Based on forecasts that home values will continue to appreciate over the next two years, more single-family real estate transactions in other markets will hit the cap.

Tampering with the mortgage interest deduction would have serious ramifications not only for the real estate sector, but for the economy as well. The NAR estimated that complete elimination of the deduction could reduce property values as much as 15%, wiping out all the gains of 2012. Rising equity this year gave homeowners hope, and combined with the benefits of the mortgage interest deduction, made homeownership attractive again. For the first time, the rebound in real estate played a contributing factor to nation’s growing GDP as a result of sales generated and jobs created.

It is clear that the rebound in values in most markets was heavily influenced by the investors moving in to acquire properties that can be rented while they wait for appreciation. However, there is the need of an exit down the road a bit and at some point there needs to be an influx of true homebuyers looking for a beneficial investment, and more importantly, a place to live. The elimination of deductions related to homeownership will make this day further off than most investors will wait. The risk then becomes that a new wave of selling hits the market further depressing the values and starting a new collapse in values.

We’re hopeful that lawmakers will soon get past the usual brinkmanship that accompanies the start of making difficult budget decisions. Then, when considering what’s best for the country and the economy, they can entertain the idea that the current mortgage interest deduction is not a sacred cow, but a path leading them away from the Cliff.