Home Ownership & Tax Policy: Capital Inequity & One Consequence (3Q21 Quarterly Newsletter)
Updated: Mar 18, 2022
July 15, 2021
I have thought long and hard about whether to write on the subject of income inequality. It is not that the data itself is particularly controversial. Actually, the data is reasonably unambiguous, and there is general agreement among economists and others competent in the matter that the phenomenon is real and fairly described. As is the case with complex social issues, however, once past the “simple” description of whatever the “facts on the ground” happen to be, controversy arises as different constituencies have different answers to such questions as “how did it happen?” and “what (if anything) is to be done about it?” And in framing answers to these and related questions, numerous conflicting policy proposals, passionate advocacies and often bitter disputes flow.
And I really don’t want to get snarled up in “conflicting proposals, passionate advocacies or bitter disputes.”
Instead, I am going to try and illustrate, by the use of personal examples, the extent to which my family has benefited from tax policies which added materially to our cash flow and, so, to our net worth – and how this turns out to bear on the subject of income inequality. I will keep this as objective and non-ideological as possible. (The phrases "cash flow" and "net worth" remind me that if this piece had a title it would be "Capital Inequality and One of Its Consequences, Income Inequality.” Because it is in popular usage I use the term ‘“income inequality” herein. But income inequality and capital inequality are two sides of the same coin. Income is both the source of and the fruit of capital. If, as the issue of income inequality is argued out and policies proposed, “solutions” which do not contemplate some methods of capital accumulation for low income earners will, in my view, fail in their purpose.)
One problem, in tackling this subject, is where to begin. As any CPA will tell you, the tax code is a maze of subsidies whose benefits extend to virtually any entity filing a tax return. So I am going to focus on just one subject among many possible: home ownership, and the subsidies associated therewith. And I am going to demonstrate, as accurately as possible, the benefits we have realized from residential-property-based subsidies. Most of this is from my memory, but even at 84, my memory is good, particularly for the milestones in my life between the ages of 21 and 65.
In 1964, after four years of marriage and apartment living, my wife and I decided to buy a home. We had been living pretty much hand to mouth, monthly income barely covering monthly expenses, and no savings. How to proceed? First, I discovered “no down payment” acquisition financing. We found a house in what my then-boss called a “blue collar community” (he did not mean it kindly) in Westchester near LAX. The price: $24,000 for 900 square feet, two bedrooms, one bath – built in haste after World War Two as a huge population surge to Southern California occurred. Financing? 80% first from the bank, 10% second from the seller, 10% third (a loan from my boss). We sold the house in 1968 for $28,000. We paid no tax on the gain. With the gain and the debt paydown we had about $8,000 of equity.
With the $8,000 we moved up market and bought our second home in the hills above Studio City. The price? $41,000 for 1,400 square feet of what was distinctly not a “blue collar community.” Financing? An 80% CalVet first at 6% (a good rate at the time, and assumable, which made any subsequent sale easier) and all our recent home sale equity. We sold the house in 1972 (by 1972 we had three children and 1,400 square feet was a bit tight) for $44,000. We paid no tax on the gain. With the gain and the debt paydown we had about $12,000 of equity. The $12,000 home equity was our largest single asset.
With $12,000 we bought our third home, about a mile and a half away, for $65,000. This home had 2,800 square feet on a third of an acre and was custom built. Financing? An 80% first from the bank and all the equity from our recent home sale (plus most of our then nominal savings). We sold this house in 1997 for $555,000 after adding about $150,000 in improvements over the years. We paid no tax on the gain. With the gain and the debt paydown we had about $450,000 of equity.
After the sale of our third home, we moved to Del Mar and bought the home in which we now live for $550,000. Financing? We were prepared to pay all cash but the seller offered us a first on favorable terms so we used the equity from our recent home sale and the seller’s short term first for the balance.
Anyone looking at this history, and particularly younger readers, might well argue that our experience is simply not replicable because the economics of home ownership have changed so drastically from then to now. Our current home, the one we paid $550,000, is worth $1.8 million. You are not going to get me to affirm that multiplying today’s home prices 75 times over the next 57 years is even thinkable, much less possible. Moreover, our experience in the California real estate market over those years may not be reflective of the experience of other parts of the U.S. (especially regions outside of coastal population centers). But as you will see, that’s not the point of this exercise. Keep reading.
If someone were to calculate the residence-related economic impact of tax policies/subsidies on our family’s economy, what (at least roughly) would that impact look like? And what is the relationship between our specific circumstances and income inequality?
Just to be clear ... here are the specific policies/subsidies on which I am focused, which I will translate into a back-of- the-envelope calculation by which our economic well-being has been – or, in one case (step-up in basis) will be – enhanced. (Another way to say this: if these subsidies had not been available, we would have paid the unsubsidized (or true) costs and our economic circumstances would have been diminished by these amounts).
Mortgage interest deduction. (Yes, of course, the mortgage interest deduction is a subsidy. It may be the greatest thing since sliced bread, but it is just another example of a tax policy designed to incentivize the pursuit of a desired social policy, in this case an increase in home ownership).
Tax deferral on home sale, assuming follow-on purchase of new home. (The law has since changed to a $500,000 homeowner exclusion.)
Age-related retention of original Proposition 13 property tax (escalated by 2% per year) on each subsequent home purchase, in each subsequent year.
Stepped-up cost basis on current home at death.
As to the mortgage interest deduction ... our home purchase costs, and thus the amount of our financings, were modest in relation to today’s costs. But even at that, total loan interest paid on our four home loans was about $190,000. At an average 40% federal and state tax bracket our tax saving would have been about $72,000.
As to our tax deferral on our home sales ... and the assumed sale value of our current home, the capital gains that we have deferred amounts to about $1,650,000, less about $300,000 in capital improvements to our last two homes, so say $1,350,000. Using an average federal and state capital gains rate over all these years of 33.3%, our tax saving was about $450,000. (As I mention above, the law has changed, capping the exclusion at $500,000.)
As to step up in basis ... assuming we continue to parlay the exclusion portion of home sale proceeds into a subsequent home purchase, the deferral of capital gains taxes during our lifetimes becomes a forgiveness of such taxes at the first of our two deaths. (We own our home in the title of our family trust, but this would be true of community property title as well.) This means that if either my wife or I were to die tomorrow, cost basis steps up to fair market value. When the survivor dies or our heirs sell the home, they would only pay taxes on gains (if any) from $1,800,000.
As to the age-related retention of our Proposition 13 property tax ... some may argue that a cap on property taxes is not a form of subsidy. My position is that for most of the history of property taxation, and in many U.S. states today, periodic revaluation of properties and adjustment of property tax levels accordingly have been/are routine. I don’t pass judgment on the virtues or vices associated with capping taxes without regard to property values, but I do say that in doing so the voters and so the taxing authority, in disconnecting tax paid from the value of what is taxed, favors long-term property owners while disfavoring newer buyers. (For ease of calculation, if I start the clock from 1978, the year Prop 13 passed, our property taxes have averaged about $1,600 per year. They are currently about $2,300 yearly. Our new neighbor just bought a property very similar to ours. His property taxes are about $20,000 yearly. If the property tax differential in our favor isn’t a subsidy, what is it?)
So what did our property tax subsidy save us? The only way I know how to attempt a calculation is to contrast our actual tax “burden” with the more traditional way that property has been (and usually is) taxed, on the basis of value. Assume that in 1978, or six years after purchase, our home was worth $75,000 and our property tax that year was about $600. Our current home is worth $1,800,000 and is still subject to a Prop 13 cap (even in view of the recently passed Prop 19). The increase in value (from $75,000 to $1,800,000, or an increase of $1,725,000) has occurred over 43 years. The average of this increase is about $850,000. If property taxes were based on periodic property revaluations and property tax increases during the 43 years were level at 1.50% yearly, then the average annual property tax in our case would have been $12,750. This means that in 43 years we would have paid about $535,000 in property taxes based on revaluation versus the approximately $67,000 we actually paid.
Total economic benefit to us by virtue of these subsidies, assuming a basis step up in our current home to $1,800,000 and deducting the $67,000 we actually paid in property taxes: very nearly $1,000,000.
Note that from the point of view of an economist this number badly understates the real value to us. It does not take into account the uses to which the benefits were put and the economic gain derived therefrom. That money went somewhere in our lives, meaning to savings and investment, consumer “upgrades” (buying a Mercedes instead of a Volkswagen) and debt reduction. Economists can quantify all this (I can’t), but I do know that if some portion of the benefit (say about half or $23,000 yearly on average) was invested at a rate of return of 5.5% annually, $1,000,000 would be worth about $4,000,000 today. In any event, our savings, investments and standard of living have been a good deal higher and our debt a good deal lower than would have been the case had we not enjoyed these subsidies.
The specifics of these examples are unique to my family. But hundreds of millions of people in the last 43 plus years have benefitted, to a greater or lesser extent than in our case, from long-term home ownership.
The recent focus on income inequality has shined a light on, among other things, its sources. One obvious source: the subsidies associated with home ownership – which inure (wait for it) only to those who own a home. Home ownership in this country has remained stable since 1960 at just under two thirds of the population, which means that about one third have not enjoyed the wealth enhancement benefits (including the subsidies) such ownership entails. (This number does not include those who could afford a home but choose not to. I don’t know what this number is but the “have-nots” is overstated to whatever this number may be. The overall rate may also mask variations among different age cohorts, as recent data suggests home ownership is rising in those over age 40 and falling in those under age 40.) About 55% of the population own securities of publicly owned companies, 15% directly, the balance through intermediaries like mutual funds, ETF’s and retirement plans, which, with real estate, and privately owned companies, constitute the vast majority of our population’s investments. So it is the case that somewhere between 35 to 45% of the population (the “have-nots”; in this case those who haven’t owned homes or other real estate and haven’t owned stocks) have watched, often enraged as we now know, as the “haves” prospered. (According to the Federal Reserve, about $13.5 trillion of new household wealth was created in 2020 of which about a third went to the top 1% of income earners and about 70% went to the top 10% of income earners.)
Well, it’s been a long and prosperous run for those of us who enjoyed at least some of the “components of success” (that is, a combination of education, family support, opportunity, skin color, access to influence, inheritance, motivation, cultural conditioning, ambition, luck – and a degree of tax favor).
Now income inequality (and its parent, capital inequality) has moved to the forefront of the public (and so, the political) consciousness and it is becoming obvious that “wealth taxes” in a variety of forms are, or soon may well be, the new normal. By “wealth taxes,” I don’t include a single tax assessed on wealth above a certain amount. I believe such a tax to be unworkable. I do mean a variety of tax “adjustments”(and there are a lot of them) either now in place (California Proposition 19, for example) or contemplated (reduction in the federal estate tax exemption; uncapping the contribution limit to Social Security; elimination of the step up in basis at death; elimination of the tax deferral benefits of Section 1031 governing trades of investment property, for example) which, in the aggregate, will have the effect of materially increasing the tax burdens of those of us in the middle, upper middle and upper income tax brackets.
My own guess is that these tax increases alone, likely will not significantly impact the well-being of the “have-nots.” By definition, inequality will shrink, but only because increased taxes will reduce the net incomes of higher income earners; not (at least not necessarily) because lower income earners’ incomes will rise. To have an impact on these folks, government policy will need to bring to the issue of income inequality the same intensity of focus, the same sense of priority, and the same degree of legislative collaboration that was brought on behalf of those of us who were, for example, the beneficiaries of home ownership subsidies.
It can be done, but given the competition for tax dollars (the military, the deficit, the infrastructure plan, rising healthcare costs, combating climate change and mitigating its consequences, etc.) it could well turn out that the possibilities for economic enhancement for this class will not materialize and that new “wealth taxes,” when processed and redistributed, will not translate into growing income and capital for the 35 to 45%, but prove instead to be business as usual: just another series of welfare and income maintenance programs, important but essentially palliative. (Folks smarter than me have pointed out that deploying some of those dollars into making post-secondary education more widely available to families of lesser means could have a transformative impact, but we will have to leave that topic to a future Report & Commentary.)
~ Chris Weil
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