The Effects of Taxation on Real Estate

In order for government to function it must raise revenues. It does so through taxes. In America, we have multiple levels of government – local, state, and federal – each with its own funding requirements. Tax theory suggests the best way to raise revenue is to levy a broad, uniform, and low rate. Not only that, but taxes should avoid hindering productivity, such as taxing income (especially on a progressive scale), which depresses economic activity and provides incentive for avoidance. As far as real estate is concerned, the most relevant taxes fall into two categories: transfer and property taxes. Each has a unique effect on the real estate market, so it’s important to understand the full consequences of policy when making investment decisions.

Generally speaking, higher taxes mean lower property values. Seems fairly intuitive, but what exactly does this mean for a property investor? The National Association of Realtors (NAR) released a study last month quantifying the impacts of marginal increases in both transfer taxes (taxes on the sale/disposal of property) and property taxes (assessed as a % of value). Increasing transfer taxes increases the cost of buying, which drives a percentage of potential buyers out of the market. In California, for example, it is estimated that nearly 80,000 potential buyers would be crowded out of the market by a 1% increase in transfer taxes.

Property taxes are the staple of revenue for local governments, and tend to be the largest non-acquisition cost of ownership. These vary by locality, but in Los Angeles County are 1.25% of assessed property value, charged annually. This translates into hefty recurring bills, especially for new buyers. For instance, 1.25% of $435,000 (the Apr ‘08 median home price in Los Angeles County) is $5,438. Per the U.S. Census Bureau’s QuickFacts, 2004 median income for the County was $43,518. Because of the sickly confusing amalgamation of local, sales, state, and federal taxes, let’s just assume a rough 30% net tax on income, which adjusts the median take-home income down to $30,463. On this basis, an innocuous-looking 1.25% property tax translates into 18% of after-tax median income. Granted, income figures were taken from 2004 data and may need upward adjustment, but given modest increases in take home pay over the last four years this is not likely significant.

Since property taxes translate directly into cost of ownership, they must effect market value. The way to compute the impact of an incremental adjustment to property tax rates is to apply a discount rate (the buyer’s weighted average cost of capital, i.e. cost of debt plus equity) to the stream of negative cash flows (annual taxes) and compute its present value. Deduct this from current market values and voila, you’ve arrived at the magic value politicians will never cite when telling you childrens’ futures depend on such and such tax increase. NAR’s report arrived at a $13,000 decrement in property value for every $1,000 tax increase. Given current median home prices that translates into a 3% drop in property values for every 23 basis point (0.23%) increase in property taxes.

When times are good, the economy and asset values are soaring, no one seems to care about government spending hikes. All sorts of noble causes are championed by our noble politicians - everything from education at all costs, to healthcare for everyone – but when the economy turns sour and home prices plummet the inevitable consequence is government deficit. To cover deficits governments must increase taxes now or borrow and increase later. This only further hampers economic recovery. From an investor’s perspective, it’s imperative to understand how government cycles of spend, tax, fall-into-deficit, and tax more impact your bottom line. Keep up to date with your state’s and local municipality’s fiscal condition and anticipate changes to tax policies. Staying ahead of the tax game will give you a sharp advantage over your investor peers, and put you well in front of the pack as far as regular home buyers are concerned.