By Anthony Michael
Project Manager, Economic Impact & Research
Earlier this month, AE began its tax reform mini-series by analyzing how tax rates would change under President Trump’s tax reform proposal. You can find that blog here. Today, we will explore two provisions, and how they collectively impact an economic activity that is currently incentivized in our tax system: home buying.
When filling out your taxes, you are given the choice to either itemize your deduction, or take the standard deduction – an amount that the IRS pre-determines across each filing type (single, married, and head of household). Regardless of your choice, the deduction amount is subtracted from your adjusted gross income to determine the amount of your income that is subject to taxes.
If you opt to itemize your deductions, you may subtract the following expenses from your adjusted gross income:
- Home mortgage interest
- State and local income or sales taxes
- Property taxes
- Medical and dental expenses
- Charitable donations
- Other miscellaneous deductions
Under the Trump Administration’s proposal, all itemized deductions would be repealed except for charitable deductions and home mortgage interest.
As for the standard deduction, the Trump Administration’s proposal seeks to double it for each filing type. Today, single filers are given $6,350 and married filers are given $12,700. Under the proposal, these amounts would become $12,600 for single and $24,000 for married filers.
Now, what does this have to do with home buying?
Most home owners can likely deduct more from their taxes via itemized deductions than they can with the standard deduction, since they are able to subtract both mortgage interest and local property taxes from their federal return. Essentially, if a home’s value is above a certain threshold, then these two deductions will save the homeowner on their taxes.
To illustrate how this works, let’s consider two imaginary Texans: Bob & John.
Bob & John are nearly identical from a tax perspective:
- Both are single
- Both have adjusted gross incomes of $70,000
The only difference is Bob rent’s a home, while John owns a home worth $250,000.
Since Bob rent’s and does not have any eligible deductions, he chooses to take the standard deduction on his taxes.
John on the other hand owns his home, so he elects to itemize his deduction.
Now, let’s dive into their individual tax bills to see who has the heavier tax burden.
Bob’s Tax Bill | ||
Adjusted Gross Income: |
| $70,000 |
Standard Deduction | -$6,350 |
|
Personal Exemption | -$4,050 |
|
Taxable Income |
| $59,600 |
Taxes Owed |
| $10,639 |
Since Bob elects to take the standard deduction, his tax bill is calculated fairly quickly. From his adjusted gross income, the standard deduction and personal exemption amounts are removed and he is taxed at a rate of 25% – which means that he owes $10,639 on his taxes.
John on the other hand, is able to deduct the amount he pays in interest on his mortgage and his state and local property taxes. In Texas, the average mortgage interest rate is 3.8%, while the average property tax rate is 1.94%. Both are subtracted from his adjusted gross income and he is still taxed at the same 25% rate as Bob. Below is John’s tax bill:
John’s Tax Bill | ||
Adjusted Gross Income: |
| $70,000 |
Itemized Deduction |
|
|
Mortgage Interest (@ 3.8%) | -$9,500 |
|
State & Local Property Tax (1.94%) | -$4,850 |
|
Personal Exemption | -$4,050 |
|
Taxable Income |
| $51,600 |
Taxes Owed |
| $8,639 |
As we can see, John’s home saves him roughly $2,000 annually on his taxes.
So how does the Trump Administration’s proposal impact home buying decisions?
By doubling the standard deduction and removing most itemized deductions, the Trump Administration will effectively raise the home price needed to take advantage of this tax incentive. Let’s consider another hypothetical scenario to see this in action:
Let’s say you are considering whether to purchase a home or continue renting. You have the following characteristics from a tax perspective:
- Filing Status: Single
- Adjusted Gross Income: $70,000
Before purchasing your home, you want to see what the minimum price of home needs to be for you to save on your taxes. This is called the “break-even” home price.
Historically, you’ve taken the standard deduction – so $6,350 is the benchmark for your deduction. Given the average mortgage rate of 3.8% and 1.94% property tax rate across the state, your home would need to be worth at least $110,627 for you to save on your taxes. Any home value above $110,627 would allow you to deduct a greater amount from your adjusted gross income – and thus save more on your taxes.
The Trump administration’s proposal would double the standard deduction and remove state and local property taxes from itemized deductions. This would cause the break-even home price to increase significantly.
Under the administration’s proposal, your home mortgage interest amount would need to reach the threshold amount of $12,600. Therefore, your break-even home price is now $331,579 – three times larger than it previously was.
Based on the current distribution of home values in Texas, approximately 54% of homes have values that are greater than or equal to the $110,627 threshold set by today’s tax system. Under the Trump Administration’s proposal, the break-even home price jumps to $331,579 – a level in which just 14% of current homes would qualify.
This will be another major obstacle that the Trump Administration will try to reconcile as they move forward with tax reform. Raising the threshold in which people can take advantage of this incentive will certainly stem home buying – as some will be priced out of the incentives built into this market.
Stay tuned as this mini-series will dive into another component of the tax reform next week. As always, feel free to send any questions or comments to amichael@angeloueconomics.com
