How The Feds’ Tax Plan Could Impact Prop. 13

NEWPORT BEACH, CA—Some experts say the plan passed by the House earlier this month was carefully constructed to penalize Americans who live in Democratic-leaning states including California, Landmark Capital Advisors’ managing director Adam Deermount tells We spoke with Deermount about the proposed tax plan, how it would affect homeowners and what would happen to Prop. 13 if the plan passes. Could the proposed tax plan put pressure on Prop 13?

Deermount: 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, DC, is ultimate telling high-tax states exactly what they want. David Dayden wrote about this issue in an op-ed in the Los Angeles Times recently. He said, “The federal tax plan, introduced by House Republicans last week”—the plan since passed the House”—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.” What are your thoughts on this compromise?

Deermount: 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 L.A. Times op-ed: “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.” How would this all play out for Prop. 13?

Deermount: Dayden’s conclusion is that this is essentially the most substantial threat that Prop. 13 has faced since its 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 homeowners 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 Californian 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. What are the other implications for real estate?

Deermount: 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 deduct fully 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 discussions about it in some corners pretty much from the moment that Prop. 13 passed. However, commercial real estate owners have been able to lobby effectively 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 paying effectively 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 thinks 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.