Real Estate's Temporary Reprieve with Fiscal Cliff Legislation

The threat of falling off the fiscal cliff has been averted for 2013 -- Or at least, the consequences that could have triggered wide-spread recession. The real estate industry received a reprieve through extension of key components of the American Taxpayers Relief Act of 2012 signed on January 1st of this year.  A major concern was the Mortgage debt forgiveness rule that ensures that lender losses through short sales, foreclosures and principal reductions don’t end up as taxable capital gains for distressed homeowners was extended for yet another year, along with the private mortgage insurance (PMI) income tax deduction. On the flip side, expiration of Bush-era tax cuts and a 5% hike on top marginal tax rate for capital gains have many investors evaluating their options for 2013, along with weighing the consequences of a new 3.8% tax on investment income to subsidize health care reform.  In addition the state tax rate and new associated taxes have increased further creating a chilling effect on contemplated real estate investments. Opportunities do exist for both consumers and investors in this “post-cliff” cycle, but it requires a different perspective to make the most of them. I feel comfortable saying that the momentum will continue to be favorable due to the cliff avoidance unless further unknown developments take us down.

Allowing the Mortgage Debt Relief Act to expire would have signaled the beginning of the end for the housing’s recovery, and it was a prudent choice on the part of lawmakers to extend it. The impact of short sales on helping lenders and servicers cure their non-performing asset problem more than proved itself in 2012, and the extension serves to continue that momentum. Both distressed homeowners and lenders win. And, by allowing the deduction for PMI to continue through the end of 2013, first-time buyers without the traditional 20% for a down payment receive some relief from the additional premium MI adds to their mortgage. With 46% of first-time buyers utilizing FHA loans with mandatory MI in place during 2012, there are widespread effects of the deduction. In light of still-constrained underwriting standards for conventional loans, originators have found a way to offer mortgages to borrowers that don’t meet their minimum criteria through FHA-backed loans. In this case, first-time homeowners and lenders benefit.

Opportunities for investors in 2013 may seem a bit more elusive. Anticipating changes in the capital gains taxes this year, many investors that didn’t take a “wait and see” stance scurried to finalize transactions by the end of 2012. Those wishing to take advantage of opportunities in 2013 still have options at their disposal. Smart investors will embrace the benefits of the 1031 Exchange process that allows an investor to sell a property and to reinvest the proceeds in a new property as a way of deferring all capital gain taxes. The 3.8% Medicare tax from the investor perspective will have significant ramifications as the “investment income” qualification includes net gains from property held by investments.  While most homeowners will escape taxation on the sale of personal residences under the new law, investors that decided to wait for the fiscal cliff dust to settle may find the tax implications of real estate deals play a larger role in evaluating short and long term returns.  Deferring taxes should be part of the overall strategy and should be good news to the qualified 1031 intermediaries.

2013 may also bring new opportunities for investors in the bulk sales arena. The FHA, reeling from losses of vintage pre-2009 loan guarantees, has embraced distressed note sales as one of its strategies to remain solvent. Bank of America is shedding billions in mortgage servicing rights and through auctions of toxic assets acquired from its ill-fated Countrywide acquisition. Investors have found a new asset class in bulk purchases to fuel the newest REO-to-rentals market. While housing inventory at the consumer level is still constrained and driving up home values, bulk sales available to the investor class is developing as a new sector for 2013. This was being handled internally with a very limited number of qualified investment funds and not really open to a large class of smaller investors. Perhaps this year, they will open it up. 

While stopgap measures signed into law on January 1st extended consumer relief without a major disruption in investor activities, the jury is still out on the long-term consequences changes in taxation will have on the industry’s momentum achieved in 2012. The tougher decisions on debt ceiling and program cuts still lie ahead that now may have greater implications for the economy. Now that we’ve taken a few steps away from the edge of the cliff, the real estate industry can take a breather --- for now.

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.