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States and municipalities desperate for revenue are targeting real estate as a source of tax revenue to finance unfunded liabilities. Predictably, property valuations are suffering. Changes to the tax benefits of owning residential real estate compound the pain.

Residential housing has been the key investment for households.

For all of our lives the Internal Revenue Code has operated to support the growth of credit in the economy and subsidize personal consumption expenditures.

  • Interest on loans used to purchase or improve residences was generally deductible.

Interest on acquisition debt of two residences was deductible on principal up to $1,000,000.

  • Interest expense on consumer debt was easily deductible.

Through 1986 all forms of personal interest were deductible by individuals on federal income tax returns. The Tax Reform Act of 1986 ended the deduction for personal interest, but allowed personal debts to be rolled over into home equity loans where the interest was tax deductible up to $100,000 of home equity debt. The home equity loan became the revolving credit line of consumer finance.

  • Real estate taxes were deductible without limit.

The only fly in the ointment here was the Alternative Minimum Tax. Large state and local tax deductions generally threw even middle class taxpayers into an AMT situation where state and local tax payments could provide no tax benefit.

  • Capital gains on the sale of primary residences were generally exempt from tax.

Since 1997 there has been no tax on capital gains on the sale of a primary residence up to $500,000 on a joint return or $250,000 on other returns (single, married filing separately, or head of household).

This became ingrained in the American psyche. Buy a house with borrowed money, deduct the carrying costs, and get tax free appreciation. All these tax subsidies led to an explosion in real estate values and in the size of American homes. American households are “all in” on residential housing.

Governmental insolvency has led to a seismic shift.

The following is a January 2017 article we published discussing unfunded pension benefits. The problems noted in the article are playing out throughout America, but nowhere more acutely than in Illinois.

This year a new mayor was elected in Chicago. The greeting she received was predictable. The Chicago Teacher’s Union went on strike, and the police union (which can’t strike), sent their wage demands to arbitration.

  • The teacher’s contract featured 3% to 3.5% cost-of-living increases for the next 5 years, and step increases for teachers with more than 14 years in the Chicago Public Schools. In the prior contract, the raises increased some teacher pay by 3%.
  • The Fraternal Order of Police have requested an 18% pay raise over 3 years.

This is happening at the same time that the City of Chicago and the State of Illinois are grappling with paying down a mountain of unpaid operating expenses and unfunded pension liabilities. Where is all the money going to come from?

Property owners have already gotten the memo

We posted the following article in October 2017. It showed that property taxes amount to 41% of total state and local taxes and 89% of locally imposed taxes.

It also showed that statutory limitations on increases in real estate taxes by local governments were easily circumvented.

The bottom line here is when bills have to get paid, the property owners pay them. Real estate is an easy target because it can’t be moved to Florida.

What’s new in the mix since 2017?

The Tax Cuts and Jobs Act

First, we have tax law changes that went into effect in 2018. This article was penned in December 2017 at the time the Tax Cuts and Job Act was being debated in Congress.

Between the date of this article and the enactment of the TCJA, the following changes were made to the legislation.

  • The limit on qualifying acquisition debt was lowered to $750,000.
  • Existing mortgage debt up to $1,000,000 was grandfathered. The interest on up to $1,000,000 of acquisition debt related to purchase contracts existing prior to December 17, 2017 and closing prior to April 1, 2018 continues to be deductible.
  • Interest on mortgages used to purchase or improve second homes continues to be deductible, subject to the $1,000,000 limit on existing debt or $750,000 of debt incurred after enactment.
  • The $500,000 exclusion of gain on sale a primary residence was not changed. The 2 of 5 year ownership and occupancy requirement is still in place.
  • Personal exemptions were eliminated in favor of an expanded standard deduction ($24,400 for joint filers for 2019).
  • There is a $10,000 limit on the deduction of state and local taxes.

The last two items are the killers for real estate valuations. In the Chicago area the state and local tax limit (SALT) can be reached with real estate taxes alone. This leaves no tax benefit from state income taxes.

The expanded standard deduction works to limit the tax benefit on mortgage interest. If the deduction for state and local taxes is limited to $10,000, then mortgage interest deducted on a joint return in 2019 must exceed $14,400 before there is any tax benefit. At a borrowing rate of 3%, this represents interest on a $500,000 loan. Mortgage interest is being paid in after tax dollars.

The Illinois real estate tax credit is eliminated for taxpayers exceeding certain levels of federal Adjusted Gross Income (AGI).

Married filing joint taxpayers cannot claim a real estate tax credit if their federal AGI exceeds $500,000. All other filers are disallowed from claiming the credit if their federal AGI exceeds $250,000. Holding real estate no longer provides an Illinois tax benefit to high income taxpayers.

The Illinois Fair Tax referendum is up for approval in 2020.

A graduated tax rate requires a change to the Illinois constitution. The current proposal has a rate schedule that hits 7.75% at $250,000 of taxable income (up from the current 4.95% flat rate). The zinger is that the top 7.99% rate applies retroactively to all income once a taxpayer hits $750,000 of income ($1,000,000 on a joint return), not just income over $750,000.

Because of the SALT limitation, this tax increase will be paid in after tax dollars. You can appreciate the frustration of property owners.

Bringing pension debt into focus

The following Wirepoints article from November 6, 2018 has some startling statistics.

Chicagoans’ unfunded pension debts as calculated by Moody total $130 billion. This translates to $125,000 for each household. That’s an understatement of what taxpaying households will be called on to pay. “But with so many Chicagoans in or near poverty (27 percent), that burden won’t be distributed evenly. Expect Chicago’s middle class to be stuck with an even bigger burden that makes up for those who can’t pay.”

Here is a back of the envelope calculation. $125,000/(100% – 27%) = $171,232. Ouch. And this calculation assumes the liability is spread evenly. That is never the case. This makes individuals and businesses that are thinking about relocating to Chicago think twice.

Unfunded liabilities are being factored into real estate prices.

The tax benefits of owning real estate were obviously considered in purchase decisions. Their withdrawal obviously negatively affects pricing.

A similar depressing effect on prices occurs when unfunded government liabilities are attached to properties. The liabilities may not be recorded with the county clerks, but they are real nonetheless.

The following Wirepoints article has some depressing statistics.

Illinois home values increased 6% from 2005 through 2014. Inflation was 26%.

Illinois ranked 45th in median home value growth between 2005 and 2017.

However, the key statistics are comparisons to other Midwest states that border Illinois. Over the same 2006 – 2017 period there was far higher appreciation.

Indiana +23.3%
Iowa +39.9%
Kentucky +36.7%
Missouri +27.3%
Wisconsin +17.2%

It looks like unfunded government liabilities are weighing heavily on Illinois home values. This is a hidden tax that the politicians that got us into this mess are not keen to acknowledge.