Now That We Know What’s In The Proposed Tax Plan…

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The House Republicans finally unveiled their tax plan and a few excerpts from this NY Times link on what’s in store for us are highlighted below.

“Those making up to $24,000 will pay no income tax. For married taxpayers filing jointly, those earning up to $90,000 will be in the 12 percent bracket; those earning up to $260,000 will in the 25 percent bracket and those earning up to $1 million would fall in the 35 percent bracket. Those making above $1 million will be in the 39.6 percent bracket, which is currently the top rate for millionaires. For unmarried individuals and those filing separately, the bracket thresholds would be half of these amounts, other than the 35 percent bracket, which would be $200,000 for unmarried individuals.”

“The bill would also eliminate the alternative minimum tax, or AMT, which is expected to hit 4.5 million families in 2017.”

“The proposal roughly doubles the standard deduction for middle-class families, expanding it to $24,000 for married couples, from $12,700, and setting it at $12,000 for individuals, from $6,530 today.”

“Under the Republican plan, existing homeowners can keep the deduction, but future purchases will be capped at $500,000, down from the current $1 million limit.”

“One of the biggest flash points will be how the bill treats the state and local tax deduction, which lawmakers are proposing to limit to property taxes and cap at $10,000.”

There’s more but these potential changes are what applies to most of us. So let’s use these and chalk out a few scenarios and compare the tax differences between the current and the proposed tax plan.

Say you are a family with a combined household income of ‘ONLY’ $250,000. It’s weird to use the word ONLY to describe a family making a quarter million dollars but that’s the reality, especially in the Bay area. So let’s use that to see what this family’s current tax burden is. This is also a family with two young kids with both spouses working and are in the market to buy a home worth say a million dollars. And they both contribute to the max in their retirement plans at work.

  1. Gross Income = $250,000
  2. Home Value = $1,000,000
  3. Mortgage Interest @ 4% assuming 20% down payment = $32,000
  4. Mortgage Interest that is deductible = $32,000
  5. Property Tax @1.25% = $12,500
  6. Property Tax that is deductible = $12,500
  7. Retirement Plan Contributions = $18,000 x 2 = $36,000
  8. Standard Deduction = $12,700
  9. Exemptions = $4,050 x 4 = $16,200
  10. California State Tax = $16,507
  11. California State Tax that is deductible = $16,507
  12. Federal Taxable Income = 1 – 4 – 6 – 7 – 9 – 11 = $136,793
  13. Child Tax Credit = $0
  14. Federal Tax = $25,689 – 13 = $25,689
  15. Total Income Tax = 10 + 14 = $42,196
  16. Effective Tax Rate = 15 / 1 = 16.9%

So what happens to this family’s taxes under the proposed plan?

  1. Gross Income = $250,000
  2. Home Value = $1,000,000
  3. Mortgage Interest @ 4% assuming 20% down payment = $32,000
  4. Mortgage Interest that is now deductible = $20,000
  5. Property Tax @1.25% = $12,500
  6. Property Tax that is now deductible = $10,000
  7. Retirement Plan Contributions = $18,000 x 2 = $36,000
  8. Standard Deduction = $24,000
  9. Exemptions = $0
  10. California State Tax = $16,507
  11. California State Tax that is now deductible = $0
  12. Federal Taxable Income = 1 – 4 – 6 – 7 = $184,000
  13. Child Tax Credit = $3,200
  14. Federal Tax = $34,300 – 13 = $31,100
  15. Total Income Tax = 10 + 14 = $47,607
  16. Effective Tax Rate = 15 / 1 = 19%

You pay $5,411 more in taxes under the proposed plan and most of that increase is due to the elimination of state income tax deduction and a reduction in the amount of deductions you can claim for mortgage interest and property taxes.

Not that it’s recommended based on the income this family derives but what if they instead decided to buy a home worth say 1.5 million dollars. What are the differences between the old and the new tax plan?

First under the current tax regime

  1. Gross Income = $250,000
  2. Home Value = $1,500,000
  3. Mortgage Interest @ 4% assuming 20% down payment = $48,000
  4. Mortgage Interest that is deductible = $40,000
  5. Property Tax @1.25% = $18,750
  6. Property Tax that is deductible = $18,750
  7. Retirement Plan Contributions = $18,000 x 2 = $36,000
  8. Standard Deduction = $12,700
  9. Exemptions = $4,050 x 4 = $16,200
  10. California State Tax = $16,507
  11. California State Tax that is deductible = $16,507
  12. Federal Taxable Income = 1 – 4 – 6 – 7 – 9 – 11 = $122,543
  13. Child Tax Credit = $0
  14. Federal Tax = $22,126 – 13 = $22,126
  15. Total Income Tax = 10 + 14 = $38,633
  16. Effective Tax Rate = 15 / 1 = 15.4%

So you pay about $3,563 less tax because you got a bigger mortgage under the current tax plan. Buying a more expensive home is fine and that should be a lifestyle choice but tax policies should not incentivize a family to stretch their budget by taking on more debt and increase the associated systemic risk in this family’s household and the economy in general. These distortions aid and abet behaviors that are likely to cause problems when the next big one strikes…that is, a recession.

But what happens to this family’s tax situation who are out in the market to buy that 1.5 million dollar home under the proposed tax plan?

  1. Gross Income = $250,000
  2. Home Value = $1,500,000
  3. Mortgage Interest @ 4% assuming 20% down payment = $48,000
  4. Mortgage Interest that is now deductible = $20,000
  5. Property Tax @1.25% = $18,750
  6. Property Tax that is now deductible = $10,000
  7. Retirement Plan Contributions = $18,000 x 2 = $36,000
  8. Standard Deduction = $24,000
  9. Exemptions = $0
  10. California State Tax = $16,507
  11. California State Tax that is now deductible = $0
  12. Federal Taxable Income = 1 – 4 – 6 – 7 = $184,000
  13. Child Tax Credit = $3,200
  14. Federal Tax = $34,300 – 13 = $31,100
  15. Total Income Tax = 10 + 14 = $47,607
  16. Effective Tax Rate = 15 / 1 = 19%

No change in tax rates between buying a 1 million dollar home and a 1.5 million dollar home under the proposed plan and that is how it should be.

But what if you are a single-income family with 2 kids somewhere in the Mid West, say in Denver with a household income of $90,000 and are out looking for a home valued at $350,000? What is your tax situation under the current tax regime?

  1. Gross Income = $90,000
  2. Home Value = $350,000
  3. Mortgage Interest @ 4% assuming 20% down payment = $11,200
  4. Mortgage Interest that is deductible = $11,200
  5. Property Tax @0.7% = $2,439
  6. Property Tax that is deductible = $2,439
  7. Retirement Plan Contributions = $18,000 x 1 = $18,000
  8. Standard Deduction = $12,700
  9. Exemptions = $4,050 x 4 = $16,200
  10. Colorado State Tax = $3,334
  11. Colorado State Tax that is deductible = $3,334
  12. Federal Taxable Income = 1 – 4 – 6 – 7 – 9 – 11 = $38,827
  13. Child Tax Credit = $2,000
  14. Federal Tax = $4,905 – 13 = $2,905
  15. Total Income Tax = 10 + 14 = $6,239
  16. Effective Tax Rate = 15 / 1 = 7%

And under the proposed plan for that same family in Denver?

  1. Gross Income = $90,000
  2. Home Value = $350,000
  3. Mortgage Interest @ 4% assuming 20% down payment = $11,200
  4. Mortgage Interest that is deductible = $11,200
  5. Property Tax @0.7% = $2,439
  6. Property Tax that is deductible = $2,439
  7. Retirement Plan Contributions = $18,000 x 1 = $18,000
  8. Standard Deduction = $24,000
  9. Exemptions = $0
  10. Colorado State Tax = $3,334
  11. Colorado State Tax that is deductible = $0
  12. Federal Taxable Income = 1 – 7 – 8 = $48,000
  13. Child Tax Credit = $3,200
  14. Federal Tax = $5,760 – 13 = $2,560
  15. Total Income Tax = 10 + 14 = $5,894
  16. Effective Tax Rate = 14 / 1 = 6.5%

So a family that represents the true middle class benefits a bit with a lower tax rate under the proposed plan.

And since we are on this topic of tax subsidies for homeownership’s sake, this paper by Renegade Inc. titled The Myth of Housing Prices provides an excellent justification for why governments should not be in the business of promoting homeownership and in turn creating distortions in the market for an essential commodity like housing. It’s a long one written with UK’s housing market as a backdrop but applies just as well here and everywhere else. Excerpts below…

“Recent history has seen successive Governments incentivise house price inflation in order to benefit from the powerful but short-term influences of the ensuing “wealth effect”. Equally, there is almost universal cultural conformity to the concept of house price inflation as a desirable and effective means to increasing personal wealth. Consideration has rarely been paid to the increasing debt levels that are necessary to generate house price inflation and the inevitable long-term impact on the cost of living and damage to an economy.”

“There is today a growing appreciation that house price inflation is not a sustainable basis for an economy, yet there remains a higher expectation and desire for financial gains from residential property at an individual level. Until the fallacy of house price inflation is recognised and more deeply understood, society will be increasingly afflicted by the destructive influences of house price inflation.”

“The fundamental flaw to the principle of house price inflation is the simple truth that there is no creation of wealth. Any capital gains that are realised through house price inflation are only achieved at the expense of successive homebuyers. There is therefore no wealth creation, only a transfer of wealth, typically enabled through the creation of new debt.”

“Servicing such debt levels has and will continue to significantly erode living standards. The impact on the economy is equally destructive. The high costs of housing have decreased UK’s competitiveness through increased living costs and subsequent wage demands, as well as channeling investment away from wealth creating activities. The damage caused to the UK economy from such unproductive allocation of capital and debt accumulation will be long-term. For a majority, the cumulative effect is to significantly reduce standards of living, not meaningfully increase wealth or improve living standards, as is commonly proposed.”

“Current interest rates of 0.5% have helped to sustain and potentially extend levels of private debt but the implications for the economy remain largely unchanged; any rise in interest rates will likely precipitate an immediate reversal of the house price cycle. In the interim, existing debt levels will continue to bear heavily on the economy and further increases to mortgage borrowing will potentially lead to unsustainable debt levels at even historically low rates of interest.”

“The subsidy and support for borrowing at the expense of savers, engineered through low interest rates, quantitative easing and cheap institutional funding, is the antithesis of a well-structured economy, which requires saving and consequent investment into wealth creating activities. The effect of inflation is also highly detrimental to the health of an economy, resulting in the erosion of wealth, declining disposable income and decreased long-term confidence. The promotion of further borrowing in misguided efforts to promote further house price inflation is only deepening systemic economic problems and will eventually lead to even greater hardship. Meaningful economic recovery requires the realization of unsustainable debt and the direction of new investment into productive activity.”

“In a debt funded and tax incentivised housing market, house price inflation arises through the inherent incentive to pursue capital gains through speculation on rising prices, whether homeowner, buy to let or other investor. In a rising market the incentive for profit seeking becomes ever stronger, driving prices primarily through speculative behaviour and not a lack of supply. A perceived lack of supply, arising from the inherent constraints to supply in response to price increases, acts to promote such speculative behaviour, further heightening the incentive for profit seeking.”

“It is no coincidence that a country such as Germany, which has shunned speculation on residential property, benefits from a strong economy and high living standards. Money that would have been consumed by the cost of property has instead enabled saving and consequent investment into German industry. Similarly, wage demands have remained lower on account of the lower costs of living, boosting global competitiveness. Through not engaging in speculation on residential property, Germany has thrived and remains a leading manufacturing and export-led economy despite the competition of low cost wages in Asia.”

“The foundation to a well-functioning society cannot be to encourage speculation on a fundamental basic commodity such as housing, accruing ever-larger debts out of the necessity for accommodation and to require working longer and harder to sustain such debt, or for the provision of ever-larger benefits for those without income. This increasing debt burden is detrimental to individuals, damages competitiveness and serves to benefit only financial institutions and secure tax revenues through compulsion to work. The premise of wealth creation and pension provision through house price inflation is entirely unsustainable. Buying and selling each other increasingly expensive property does not create wealth. Any financial gains that are achieved through house price inflation are only acquired at the cost of successive homebuyers. There is no creation of wealth, only a transfer of wealth, typically enabled through the creation of new debt.”

So that’s that. And we wait and watch for sensible policies through this and future tax reforms that disincentivizes speculation in a commodity that is real estate and channels our precious capital towards more productive endeavors.

Until later…

Image credit – IoSonoUnaFotoCamera, Flickr