Sunday, March 16, 2008
A modest proposal to solve the "housing crisis"
This post is free association, thinking-out-loud among our smart readers. Indeed, all three of my co-bloggers know more about the mortage crisis than I do, so I stand prepared for wholesale public ridicule. But, since I claim no real knowledge and am therefore simply flapping my figurative gums, I am liberated insofar as this is one topic about which I have no pride of expertise.
It seems to me that one version of the mortgage "meltdown" and attendant housing crisis is that there are a large number of home "owners" -- and I use the term loosely -- who ought to be renters. The problem is that it is relatively uneconomical to convert a home from owned to rented because there is a shortage of willing landlords. The reason, presumably, is that many of these houses with too-big mortages still carry a notional price that implies a rent well above the market.
Perhaps, therefore, we should consider making it much more attractive to be a landlord. The most obvious way to do that, it seems to me, is to accelerate the depreciation schedule for personal income tax purposes (with limitations discussed below), and to allow full deduction of passive losses against ordinary income. If I am correct in my reasoning, a lot of affluent Americans would very quickly step up to become landlords and create enormous demand for presently occupied but financially troubled houses.
Today, the houses in most places are still priced above rental value. Generally, in the absence of rising real estate prices a landlord needs to earn rent equal to 10% of the purchase price of the property to be let. If a house would cost $450,000, the landlord needs rent of almost $4000/month in order to cover his cost of capital, taxes, and other expenses. In many places today that $450,000 house would rent for no more than $2,000/month, so prospective landlords are not lining up to buy houses that really ought to be rented rather than owned by the occupants.
You might ask why housing prices remain above their rental value. How can that be? Well, we have a big subsidy for home ownership (the mortgage interest deduction), and no corresponding subsidy for either tenants or landlords. Indeed, if individual landlords suffer losses (such as by renting a property for less than their interest expense, other expenses, and depreciation deduction) they cannot deduct those "passive" losses against ordinary income (such as the income the landlord earns in his day job as a dentist, union official, used car salesman, or plutocrat).
Now, passive losses always used to be deductible against ordinary income, but Ronald Reagan got rid of that back in 1986 as part of the deal to get the top federal income tax rate down to 28%. Since then, the top rate has crept back up to a hair under 40%, back down to 35% (with qualifications) on account of the Bush tax cuts, and will return to just under 40% with the now almost inevitable expiration of those cuts.
It seems to me that if we have to live with high marginal tax rates, we ought at least be allowed to deduct certain passive losses against ordinary income.
My proposal, therefore, is to allow for the accelerated depreciation of rental properties (which would create more passive losses), and to restore the full deductibility of those losses against ordinary income. If structured properly, affluent Americans -- especially the "working" affluent who do not necessarily have access to more exotic investment vehicles -- would jump in with both feet.
Using the example above, it is quickly obvious that such a tax subsidy would have a big impact on the housing market. Assuming the expiration of the Bush tax cuts, our marginal income tax rate in New Jersey will be a bit over 48%. If we were to buy a $450,000 house with $100,000 down and a $350,000 at 6%, our annual interest expense would be $21,000. Our property taxes would be no less than $10,000. Suppose our up-keep is $10,000. Assume no depreciation, because in this scenario depreciation is a passive loss that I can only deduct against profits from the rental activity. That quickly gets us to $41,000 in expenses even before calculating the lost income on the down payment (call that $5,000), so we would need to rent the property for -- you guessed it! -- almost $4,000 per month to break even. Nobody wants to pay that, so it is a bad deal for me, especially since I cannot deduct the passive losses from my landlording against my ordinary income.
Now, change the scenario a bit. Assuming the house itself is worth $300,000 and the law were to allow me to accelerate depreciation over 15 years. If I can deduct all losses against my other income, I can pick up another $20,000 per year in deductions. Then I have total expenses of $61,000, rental income of (say) $24,000, passive losses of $37,000, and incremental tax saved of around $18,000. My $42,000 in cash flow in (rent plus income taxes not paid) is $1,000 above my cash flow out. True, I still earn a lousy return on my invested $100,000, but if we assume that the property appreciates an average of 2% per year over time, the return on the invested $100,000 suddenly looks pretty good. Not amazing, but enough to get a lot of upper middle class types interested.
Now, we eliminated the deductibility of passive losses for a rental properties for a reason -- they created the basis for abusive tax shelters, and they caused massive overbuilding. Various modifications could reduce the likelihood of those problems resurfacing; my suggestion would be to focus the benefit on properties that already exist. So, for example, you might say that the deductibility of passive losses would apply only to houses for which a certificate of occupancy has been issued prior to June 30, 2008, or which have been occupied by the owner or owners for at least five years. That, presumably, would prevent builders from pumping up the supply of new houses in the hope of meeting the demand for tax shelters.
Your considered reactions would be most welcome.
11 Comments:
By 
, at
Sun Mar 16, 02:18:00 PM:
Let me get this straight.
Gov't meddling caused the "problem" and you propose more gov't meddling is the cure. If my mechanic fixed my radiator but broke my transmission, I wouldn't go to him to fix the problem. I'd kick his incompetent butt to the curb.
More poison is not the remedy to poison. Don't believe the lies. Trained economists (that's me) can't model the economy with enough accuracy to predict the results of gov't meddling. To trust a politician (whose training consists of being likable, not right) to do it is absurd. Landlords (again, that's me) who are currently making money don't deserve to have their competition financed by the government through tax incentives.
By 
TigerHawk, at
Sun Mar 16, 02:30:00 PM:
Well, I'm not sure how "government meddling" caused the problem, except insofar as all economic activity turns on the initial "right" or "entitlement" set by the government. We allowed for the deduction of passive losses before, and so was it "meddling" to eliminate that in 1986? I'm not sure we can be free of "meddling" and still have enforceable rights in property and contract.
By , at
Sun Mar 16, 05:27:00 PM:
TH -
I, for one, am disappointed in this suggestion. "Modest proposals" really ought to be saved for those suggestions that involve the consumption of at least one set of involved stakeholders.
By Unknown, at
Sun Mar 16, 06:43:00 PM:
It a toss of the dice when adding up your costs when guessing what the state and local town are going to do with taxes for buying and keeping a house to own or even rent.
That a gamble I would not take in NJ.
By , at
Sun Mar 16, 06:44:00 PM:
TH,
Are you really not sure how the US government is responsible for the current housing crisis? Really? You nailed it pretty well before.
(1) Tax incentives to increase home ownership.
(2) Irresponsible monetary policy resulting increased home mortgages.
Also, there is no way you can truely believe this statement:
"All economic activity turns on the initial "right" or "entitlement" set by the government." So if we didn't have a government we wouldn't have voluntary transactions? I refuse to believe that you believe such nonsense.
And while government meddling may be a requiste for modern society, that doesn't mean that more is desirable.
By randian, at
Sun Mar 16, 10:13:00 PM:
You might ask why housing prices remain above their rental value. How can that be? Well, we have a big subsidy for home ownership (the mortgage interest deduction), and no corresponding subsidy for either tenants or landlords.
You've forgotten the (IMO) biggest reason for such a disparity: local and state land use policy. Every area that has a gross disparity between the costs of owning and renting a home suffers from extremely restrictive land use and building regulations. These cause housing supply to be greatly in deficit relative to demand, a condition that's unsustainable in a free market unless potential suppliers of that demand are prevented by law from satisfying it. Another side effect is that housing developers tend to cater to luxury buyers in such markets, because the cost in dollars and time of regulatory overhead, and high land prices created by artificial undersupply, make developing middle class housing a money-losing proposition. The high prices charged for these homes further distorts pricing and leads to more modest housing also being priced unaffordably.
By Georg Felis, at
Mon Mar 17, 12:59:00 AM:
I'm confused. Under present rules, if you buy that 400k house, rent it out for 20 years, and sell it for 800k, you pay taxes on a 400k capital gains, right? (ignoring other factors)
Under your proposed rules, it looks like you buy the house for 400k, rent it out for 20 years for less money per month, sell it in 20 years, and get hit with a 800k capital gain (in exchange for a lower income tax, due to deductions).
Like I said, I may be wrong (I don't deal with money day by day for a good reason), but it looks like you are gambling that Congress will not ramp up the capital gains rate to something stupid, and trap you with a pile of capital you can't afford to sell.
That's a major problem with our legal/political system, there is a tendency to pass laws to "punish" those dastardly people who made money off of "Loopholes" and not grandfather in existing plans.
At least we have that "No Ex Post Facto laws" section of the Constitution to protect us (unless you got caught in the retroactive tax changes of the first ten days of the Clinton administration, which of course could never happen again, right?)
By , at
Mon Mar 17, 12:31:00 PM:
I find it interesting that a 'trained economist' (as opposed to what? an non-housebroken economist?) and landlord would prefer to keep the government out of his business while it continues to pump $trillions of inflation into the world's monetary system. An economist might have noted the lower value that his rents and property will have when the dollar is 10% of its current value. S/he might find worth a nod, a reasonable idea that might keep a real estate market from imploding--and without too many other pieces of bad timing--the entire US economy with it.
As a landlord with two marginally negative cash flow properties in the SF Bay Area, we are going to end up selling out and forcing our renters out into a nasty market. We might have been willing to live with leverage during dropping prices if our losses--real losses--were deductible.
By , at
Mon Mar 17, 12:45:00 PM:
That would be trained in the sense that I have an advanced degree in economics. Not business, not an MBA, but economics. And as opposed to the untrained, pie in the sky, big government, gum flapping but vapid economists.
But enough about my unverifiable credentials.
I find no merit in the argument that more government intervention is justified by other, equally bad, government intervention. I repeat, the cure for poison is not more poison.
And I am surprised you find it interesting. I make money as a landlord. I do pretty well. I rent cute little houses to typically single female grad students and big but older houses to typically groups of male undergraduates. And no, I don't want to compete with people wouldn't be in the market were it not for government intervention. Why should my margins be shrunk because so other people who aren't as good as I am can compete with me?
Additionaly, I would be stunned, amazed and stupified if the dollar ever declined by 90%. Ever. I literally can't imagine a plausible senario that would cause such a result. I find it interesting that are both concerned about monetary policy and (apparently) are advocating for a policy that would reduce tax revenue.
I sympathize with your situation regarding your rental properties. Losing money is rarely fun.
By , at
Mon Mar 17, 08:57:00 PM:
Anonymous#1,
No need for sympathy. When we sell out after many years of appreciation, our passive losses will be recovered and we will do quite well. Your sympathy should be reserved for the two military families whose men are to be called up in summer and who will no longer be able to afford the rent--even though we have not raised the rent for several years despite increased costs. They will have a tough time finding similar values in the rental market. We just can't see continuing in a negative cash flow situation given falling prices, and we're too close to retirement to wait out the market.
As to what to do about the loss of revenues, I'd love to see substantial cuts in spending, since that is the only remedy to the deficit situation. We cannot tax our way to prosperity. I'm not an economist, but I thought that was fiscal--not monetary--policy.
I wish I was a confident as you that the risk of a precipitous dollar unwind is totally implausible. The Fed has nearly used all the arrows in its quiver and the losses are mounting. It may all work out, but it seems to me that there are a number of quite plausible ways that things could deteriorate dramatically: China decoupling from the dollar, etc. I hope you're right, but I'm hedging my bets.
Good luck to us all.
By , at
Thu Mar 20, 07:54:00 AM:
I know very litle about how this crisis impacts the rental markets, but somehow I think landlords would have more of a long-term financial interest in stabilizing housing prices than seeing a total collapse. More foreclosures = more opportunities for renters to buy cheap and not have to rent. Devalued single family homes will immediately devalue rental property, which will call for lower rents. Am I correct? Here's my thoughts:
Current Credit Crisis – A Clear and Present Danger to our Country
Common Sense - Part Two
Introduction:
I’m not Thomas Paine, nor do I pretend to be a writer of anything near his caliber, but I couldn’t help but draw the comparison that the abuses of the monarchy are very similar in substance to the abuses of the financial institutions of today. You could say that the monarchy was acting in bad faith toward the Colonies.
Thomas Paine was a voice for people, not governments. Over the last several months our government has done everything it can to help the financial institutions that are directly responsible for this credit/housing/real estate crisis and literally nothing of substance for the victims. You could say that the financial institutions and the Federal government are acting in bad faith towards average Americans.
It was obvious from the comments of Treasury Secretary Paulson during an interview this morning, Tuesday, March 18, 2008, that the Federal government has no intention of coming to the aid of average American homeowners who may be facing foreclosure, regardless of where the cause lies.
Stabilizing housing prices to protect those owners who purchased homes in good faith only to see their investment be sucked out by this Wall Street fiasco is just immoral and yet, Paulson and the administration, backed by comments of some CNBC “analysts”, see nothing wrong with it.
Of course, the Federal government is now going to “tighten up” mortgage lending and qualification standards thereby further killing the hopes and aspirations of millions of Americans who only want a chance to buy a home or stay in the one they already own. Rather than help a drowning person by throwing a lifeline, the government is going to throw him/her a rock!
It’s not a perfect analogy because there are no new laws involved (yet!) but this does remind me of the Intolerable Acts or the Coercive Acts of 1774. (Wasn’t the British monarch also named “George”).
Is it possible that this current financial crisis constitutes the greatest “clear and present danger” to this country since the days leading up to World War II?
“Clear and present danger” was a term used by Justice Oliver Wendell Holmes, Jr. in the majority opinion for the case Schenck v. United States, concerning speech against the draft during World War I. Since then it has sort of morphed into describing situations whereby the threats to our Nation are immediate and potentially catastrophic – maybe this current credit crisis is an internal threat, not foreign, yet just as serious.
Mortgages are contracts. Mortgagor has the responsibility to maintain his/her property and to make the payments in a timely fashion according to the terms of the contract/mortgage. Question is, do mortgagees have to make a good faith effort to maintain the overall value of the real estate market by not jeopardizing the stability of the financing markets? – if I have the terms correct.
All finger pointing at sub-prime borrowers aside, this crisis is the direct result, and sole responsibility, of the immoral, highly leveraged mortgage-backed-securities industry. How do we fix it without destroying the equity of all the prime mortgagors and unencumbered property owners? These “lenders” are NOT banks in the traditional sense of the word. They are nothing more than greedy predatory lenders, with very few exceptions.
The real estate segment of our economy is arguably the most important. Yet, based on the actions of the last six months, no one seems to know how to fix the problems.
Now having said all that, I have an idea – only an idea because I’m far from an expert.
How about this:
The first thing to do is to buy time and stabilize housing. That means stopping resets, foreclosures and reducing the market supply of already foreclosed housing.
Immediately convert every mortgage and home equity loan to a 3%, 50-year, fixed mortgage! No prepayment penalties, no balloon payments nothing but a straight 50-year mortgage. For a period of the next 18 months - Immediately halt all foreclosures, add the delinquent amounts to the principal of the mortgage, apply the interest rate, and give people a chance to work things out. This should stop the flood of more distressed properties from coming on the market and further destabilizing the housing industry. Does this make sense? Cure the problem by addressing the end result of the credit crunch? Sounds like a “common sense” approach to me – no villains, no victims, gives the real estate markets time to stabilize.
This should stop cold the “resets” that are going to be the final blow to housing.
Ignore Valuations. Since home prices seem to double every 10 years and this is a long-range program, the underlying value of homes should increase once the real estate market is again stabilized. Set appraisals at current market values. Since the potential for upside vs downside is greater, this should work.
To those who can’t afford to stay in their homes allow a one-time 12-month “forbearance to sell” rather than foreclose. This should further stabilize prices by keeping these distressed properties off the markets. My apologies to the bottom feeders.
New mortgages: Allow only 4%, 50-year fixed for at least 18 months. After 18 months allow rates to rise one-half percent, per year, if the market justifies it. This should help sales and revitalize the real estate market especially new construction, which is the key to jobs and economic growth and strength of the stock market.
Fix real estate sales commissions at 4%. Brokers can contribute their share also to help combat this mortgage credit situation, which is a clear and present danger to our country. Believe it or not, some brokers are greedy and might take advantage of this potentially robust market.
It is going to take time, lots of time, and money, along with a demonstration that the Federal government is actually concerned with the well-being of the American family and not just the greed driven credit institutions on Wall Street in order to bring back consumer confidence in the real estate markets.
