California’s Faulty Proposition

No one has benefited from California’s rapidly rising property market as much as homeowners who had the good fortune to buy back in the late 70s, 80s or even well into the 90s. Not only are they often sitting on equity gains of 7 figures (if they own a home near the coast) but they also have the good fortune of having their tax basis capped at no more than a 2% increase over their initial purchase price (plus any re-assessment for renovations) thanks to Prop 13. This is the tax structure that brought us insane situations like Newport Beach’s Lido Isle where it’s possible to have houses assessed at $150,000 adjacent to an almost identical house assessed at $10MM.

As I’ve written here before, the impact of such a policy is that those with a low basis are far less likely to move, even if they have substantially more house than they actually need, meaning that they tend to stay put increasingly longer, ultimately resulting in lower supply. Voters saw this coming back in the mid-80s and passed Props 60 and 90 which gave California homeowners over the age of 55 a chance to sell their primary residence and transfer their property tax assessment to another home. However, 60 and 90 were fairly restrictive in that they:

  • Required that the replacement home be of equal or lesser value than the one being sold.
  • Required that the replacement home be in the same county as the one being sold.
  • If not in the same county, the replacement home would need to be in one of 11 counties in CA allowing for transfers.
  • The homeowner is required to buy the replacement home within two years of selling the existing home (or vice versa).
    While some of the above restrictions certainly made sense, they have not resulted in a whole lot more downsizing by empty-nesters to help ease the housing shortage. That could be about to change as a new proposition being pushed by the California Association of Realtors and quickly gaining signatures – it already has close to 1MM and only requires around 585k to get on the ballot – would do away with virtually all restrictions from Props 60 and 90. However, it is not without some serious negative consequences that must be considered. From the California Legislative Analyst Office (emphasis mine):

“The measure expands the special rules applied to existing homeowners 55 and older who buy a new home. Under the measure, the assessed value of any home purchase by an existing homeowner 55 and older- including those moving across counties or to more expensive homes-would be tied to the assessed value of the buyer’s prior home. If the new and old home has the same market value, the assessed value of the new home would be the assessed value of the prior home. If the market value of the new home is higher than the prior home, the assessed value of the prior home would be adjusted upward. This adjusted value would be greater than the prior home’s assessed value but less than the new home’s market value. Conversely, if the market value of the new home is less than the prior home, the assessed value of the prior home would be adjusted downward.The measure specifies a formula to be used to make these upward and downward adjustments. There also would be no limit on the number of moves by an individual homeowner.”

The problems with this proposition begin with the fact that it amounts to an even bigger giveaway to those who had the good fortune to purchase a house at the right time than the tax system that we currently have. The CAR would also be a substantial beneficiary since it would likely result in more high priced homes being listed that would otherwise stay off the market. However, the picture does not look so great for the rest of California taxpayers who would have to foot the bill. Giving older homeowners the ability to move multiple times and maintain their initial Prop 13 protection indefinitely creates some major market distortions. The California Legislative Analyst’s office offered a mixed view of the proposal. On the plus side, they found that home sales would likely increase: From the LAO report (emphasis mine):

“Because the measure further reduces the property tax increases faced by older homeowners who purchase a new home, it likely would encourage older homeowners to sell their existing homes and buy other homes. In recent years, between 350,000 and 450,000 homes have sold each year in California.Under the measure, home sales could increase by as much as tens of thousands per year.”

However, the downside would be a further erosion of property tax revenues to local governments, already constrained by Prop 13. Again, from the LAO report (emphasis mine):

“By further reducing the increase in property taxes that typically accompanies home purchases by older homeowners, the measure would reduce property tax revenues for local governments. Additional property taxes created by an increase in home sales would partially offset these losses, but on net property taxes would decrease. In the first few years, property tax losses would be a few hundred million dollars per year, with schools and other local governments (cities, counties, and special districts) each losing around $150 million annually. Over time these losses would grow, likely reaching between $1 billion to a few billion dollars per year (in today’s dollars) in the long term, with schools and other local governments each losing $1 billion or more annually.”

The Legislative Analysts Office missed one critical aspect in their report: the way that local governments will respond to the reduction in revenue. My guess: California municipalities will respond with more of the same tactics since Prop 13 was passed – by increasing impact fees on new development. Municipalities typically don’t sit around and do nothing when a funding source dries up. If this proposition passes, it will likely only accelerate the age-old California problem of relying on a relatively small revenue base (newly constructed housing units) to subsidize the locked-in low cost that existing owners enjoy. In an ironic twist, the increase in impact fees makes it less economical to build and ultimately results in fewer viable housing developments and lower inventory. So a proposition that is being sold to the public as a way to increase inventory could end up having the opposite impact over time.

That’s great news for older homeowners with a low tax basis and Realtors but not so great for the rest of Californians who will ultimately have to pay for it.