Landmark Links November 21st – Sacred Cow

Cow

Lead Story….  I’ve used the past few Landmark Links lead stories to talk about tax reform in general and it’s impact on the real estate market in particular.  Last Friday’s post focused on how proposed (now passed in the House) reforms favor commercial real estate investment over home ownership.  I ended that post by suggesting that Federal policy could put pressure on California’s most iconic and most controversial referendum-generated law: Prop 13.

Generally speaking, people respond well to incentives – especially when those incentives have economic consequences.  So do governments.  If you want more of something, make it more economically advantageous.  If you want less of something, do the opposite.  If the current Federal tax reform proposals pass, Washington is ultimate telling high tax states exactly what they want.  David Dayden wrote about this issue in an OpEd in the Los Angeles Times recently (emphasis mine):

The federal tax plan, introduced by House Republicans last week (Editor note: the plan passed the house last week), was carefully constructed to penalize Americans who live in Democratic-leaning states. It would repeal the state and local tax deduction, which 1 in 3 Californians use. And it would cut in half the deduction for mortgage interest, capping it at $500,000 for new loans. This change would hardly affect most of the country — less than 3% of all homeowners carry over half a million in mortgage debt — but it would bite places like New York and California hard because of their expensive real estate markets.

California’s endangered GOP lawmakers have been remarkably muted about the pending assault on their constituents. Only one, Darrell Issa of Vista, has come out against the tax bill. Meanwhile, East Coast moderates have negotiated a compromise that would simultaneously help their states and make California the biggest loser.

Under the compromise, Americans will be able to deduct property taxes of up to $10,000, but not income taxes. That’s rough if your state happens to have the nation’s highest income tax and one of the country’s lowest property tax rates. That is, if your state is California.

So, the bill would cap the mortgage deduction at a lower level that only really impacts blue coastal regions, take away the state income tax deduction which also primarily impacts blue coastal regions and put a cap on property tax write offs but still allow a relatively healthy deduction.  David Dayden outlined the logical response to these incentives in his LA Times OpEd (emphasis mine):

The natural response to this turn of events would be to re-balance the revenue mix. California Democrats could offer a bargain: Lower personal income tax rates combined with a property tax rate more in line with the rest of the country. Of course, that would require voters to first repeal Proposition 13, which since 1978 has severely limited property taxes.

The result could be highly progressive. If income tax cuts are on the first $50,000 of income, everyone would benefit, but the main winners would be the working poor and the middle class. Plus, tax increases on property do not directly affect renters, who are, in general, lower income-earners than homeowners. (Landlords surely could pass property tax increases on to renters, but if the changes to housing taxes work as expected to actually reduce prices, the effect would be muted.)

Because property taxes remain deductible, Californians likely would save money.And the new tax system would be more predictable, less reliant on volatile income and more on home values, which outside of the historic housing bubble of the 2000s are generally more stable.

Dayden’s conclusion is that this is essentially the most substantial threat that Prop 13 has faced since it’s passage in the 1970s.  Indeed, he does make a good point.  California’s finances are a volatile mess.  The state is overtaxed and far too dependent on the income and capital gains of wealthy residents to generate revenue.  This is the epitome of an unstable tax base.  Also, the property tax deduction remaining at $10,000 is significant.  It’s easy to forget if you live near the coast but the median home price in California in 2017 is still “only” $460,000.  At a 1% tax rate as stipulated under Prop 13, most home owners in the state fall well below the proposed $10,000 limit.  As such, Dayden pointed out that Prop 13 opponents would be able to run a campaign based on saving the average California money rather than simply rely on appealing to “fairness” or balancing the budget as they have done in the past.

While I think that Dayden’s conclusion is certainly possible, I suspect that we may eventually be headed for a different outcome since much of the political power in California still rests with the donor class that lives along the high-priced coast and many of those people consider Prop 13 to be sacrosanct.  Instead, I think that we could end up headed for a compromise – the split roll where residential property retains prop 13 protection but commercial property does not.

Perhaps the most interesting part of the tax reform proposal from a real estate perspective is that one class of real property will maintain the ability to fully deduct both the full amount of real estate tax paid and the full amount of loan interest – commercial property.  The concept of a split roll is not a new one  by any means.  In fact there has been discussion about it in some corners pretty much from the moment that Prop 13 passed.  However, commercial real estate owners have been able to effectively lobby to keep attempts to raise their taxes from being successful by utilizing a variation of the slippery slope argument: if you vote for our property taxes to increase, it will embolden the state to go after yours next.  However, I am of the belief that the Federal Tax Reform proposal could weaken that argument if it becomes law.  The loss of ability to deduct state taxes will hit Californians hard and could lead to a groundswell of pressure for the state to cut the state income tax which currently reaches a whopping 9.3% at only $53,980 of income for a single person.

Middle income Californians are likely to look at the reforms and ask why they are effectively paying a higher amount of taxes due to the loss of deductions while commercial property owners both maintain deductions and get far more favorable tax treatment on passive income from investments that are held in pass through entities.  Couple that with the fact that California is turning an ever-deeper shade of blue from a political standpoint and I don’t think that it’s a leap to suggest that commercial real estate  owners who are the beneficiaries of Federal tax policy will increasingly be viewed as more of a target for potential state revenue.  The Federal government appears to be telling states like California exactly what it think of their system of taxation and ironically it could result in an erosion of Prop 13, possibly the one Republican political accomplishment that has stood the test of time here.

Economy

Yellow Light: The ever-flattening yield curve is likely to give the Fed reason to pause in their rate increase trajectory.

Big Gains: When it comes to jobs, the economy has performed extremely well under Janet Yellen’s watch as Chair of the Federal Reserve.

Commercial

And The Winner Is: The big economic winner in a pass through tax cut is commercial real estate and it isn’t even close.

Old School Becomes New: New fire proofing and re-enforcing technology could result in more towers being constructed of wood rather than concrete and steel.

Residential

Exodus: High housing costs have Bay Area residents streaming into Sacramento in search of a more affordable lifestyle, driving a downtown resurgence and causing home prices and apartment rents to soar.

Double Edged Sword: California’s restrictive housing policy is holding back it’s ambitious climate policy.

Livin’ on the Edge: Cape Coral, Florida is the fastest growing city in the United States.  It also probably shouldn’t exist and is a perfect microcosm of the Sunshine State (h/t Zach Maxam):

It really captured the essence of Florida, a precarious civilization engineered out of a watery wilderness, a bewildering dreamscape forged by greed, flimflam and absurdly grandiose visions that somehow stumbled into heavily populated realities.

……..

The Rosen brothers realized they could sell Florida as another miracle elixir, “a rich man’s paradise, within the financial reach of everyone.” They started with some rugged mangrove swamp and palmetto scrub known as Redfish Point, which they rebranded as Cape Coral. Their dredges and draglines dug drainage ditches through the muck, then dumped the fill along the banks of the new “canals,” moving enough dirt to fill a swimming pool every minute. Then they built homes on top of the fill to create a maze of “waterfront properties” where neither waterfront nor property had ever existed, the instant alchemy of Florida real estate. Sure, the water the properties fronted was basically plumbing for a suburbanized floodplain, but it still sparkled in the sun. Sure, the creation of paradise required the annihilation of nature, but Gulf American’s ads touted this “improvement” of wetlands as the essence of America’s can-do spirit: “This virgin land has become a leading symbol of man’s accomplishments!”

Profiles

Let Them Fight: The ongoing feud between Roger Goodell and Jerry Jones has the NFL on the verge of a civil war.  I sincerely hope that they both lose in humiliating fashion.

Virtual Tinfoil Hats: Doomsday preppers are now starting to switch from gold to bitcoin in preparation for the zombie apocalypse (or whateverthehell else they are flipping out about).  I hope that their bunkers have wifi or this will prove to be a huge mistake.

Pay Dirt: Investors holding default protection on Venezuelan debt got a $1 billion dollar pay day as the socialist workers paradise with the world’s largest known oil reserves missed recent bond payments.

What a Mess: How toxic politics, mis-spending and terrible decision making starved NYC’s subways.

Dogs Rule: How getting a dog could save your life, especially if you are single.

Chart of the Day

Housing starts adjusted for population are still weak

Source: The Daily Shot

WTF

Cocky: A Naval aviator got in trouble last week for utilizing his aeronautical and sky writing talent to make sky penises over Washington State. He was suspended but not before becoming a hero to every American male between the ages of 12 and 25, also me.

Hard Sell: In the “can’t make this shit up” category, disgraced televangelist Jim Bakker threatened grandchildren of his audience with the prospect of eternal damnation unless they call a 1-888 phone number and send him $60 (plus shipping) for a bucket of pancake mix.  There’s a video in that link just in case you think that I’m making this up.

Landmark Links – A candid look at the economy, real estate, and other things sometimes related.

Visit us at Landmarkcapitaladvisors.com

Landmark Links November 21st – Sacred Cow

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