What Impact Will the Property Tax Deduction Limitation Have on Wealthy Clients ?

One of my lingering concerns over the Tax Cuts & Jobs Act of 2017 (TCJA) was the capping of the “State and Local Tax Deduction” (SALT) for big cities like New York/New Jersey, Chicago, and the West Coast and what kind of changes or impact that will have on higher-end real estate, the housing business and home-builders like Toll, etc.

In 2018 / 2019, there are not a lot of folks still around Wall Street who remember the Reagan Omnibus Budget Bill of 1986, and the removal of the passive loss income deduction in the late 1980’s, which at the time drove a lot of “non-economic” or tax-driven commercial real estate development, i.e. construction that really was only designed to generate an operating or pass-through loss for real-estate limited partnerships, etc.

When the passive loss income deduction was killed with the 1986 Budget bill, there was a lot of commercial real estate that vaporized, and much if it was owned by the banking system and savings and loan institutions, many of whom had to be bailed out by the Resolution Trust Corporation (RTC) in the early 1990’s.

This late 1980’s, early 1990’s banking crisis was actually far worse than the 2008 Financial Crisis since the number of banks that went under were far greater in the late 80’s, early 90’s than 2008, 2009.

This week, I got the first example of what might be in store for the SALT limitation in big cities like Chicago, New York / New Jersey, LA, etc.

A wealthy client noted that, with the property tax limitation and the AMT removal, this client, who owns two very nice homes – one in Northern Chicago and one on the West Coast –  will see an increase in their marginal tax rate from 27% to 38% in 2019 and the loss of a $150,000 property tax deduction on just one of the above properties alone.

The tax changes are going to drive portfolio changes for the client across estate planning, etc.

This is a bigger deal than most people think. This could be similar to the late 1980’s where – like boiling a frog in hot water – the tax impact creeps up slowly on higher-net-worth individuals and then surprise (!) wealthy investors have to start making changes based on higher marginal tax rates, which might only go higher after listening to the political rhetoric being bandied about Washington these days and what seems to be an all-out assault on the wealthy.

SP 500 Earnings Update: Are SP 500 Earnings Bottoming ? 

  • Fwd 4-qtr est: $167.83 vs last week’s $167.93
  • PE ratio: 16.34x
  • PEG ratio: 5.37x
  • SP 500 Earnings yield: 6.12% vs last week’s 6%
  • Year-over-year growth of fwd est: +3% vs last week’s +3.1%

Analysis / conclusion: Jim Chanos of Kynikos Associates and a legendary short-seller has been the only major higher-profile investor on mainstream financial media the last year to raise a flag about the SALT deduction and what it could possibly mean for the US economy. Jim referenced the 1986 tax bill in an interview on CNBC about a year ago and noted that the new SALT deduction might do to residential real estate what the removal of the tax-driven loss on commercial real estate did to CRE (commercial real estate) in the late 1980’s and early 1990’s.

You have to be over 50 and been in the investment business for 25 – 30 years to remember the Resolution Trust Corporation and everything that happened around it, including bank failures, the high-yield debt crisis and ultimately the REIT IPO boom that reinvigorated commercial real estate in the early 1990’s.

With the preparation of 2018 tax returns high net worth clients and accountants are starting to see what the next few years might hold, particularly if they were AMT-eligible and owned higher-end residential real estate.

The SP 500 “earnings update” this week looks to show SP 500 earnings bottoming, but i would like to wait another week or two to make that call.

Keep an eye on “Q4 ’19 expected earnings growth” while the first three quarter’s of 2019 are still being reduced the 4th quarter of 2019 is still looking for +9.3% y/y growth. Q4 ’19 has not deteriorated to the extent the rest of 2019 has seen, thus it portends a bottoming in SP 500 earnings growth. Expect Q1 ’19 to be the lowest rate of earnings growth for 2019 and then a gradual improvement, much like what happened in 2016.

Real estate – as a percentage of the SP 500 by market cap – is just 3% – 4% and was only added to the SP 500 as a separate sector in late 2016, but it’s a much higher percentage of individual net worth looking at the Federal Reserve data and client’s individual balance sheet data.

Im not going to make a prediction on the ultimate impact of SALT but readers should feel free to weigh in on what they are seeing with their own tax return impact particularly if they are in the traditional cities like Chicago, New York and LA.

Thanks for reading…

 

 

2 Responses to “What Impact Will the Property Tax Deduction Limitation Have on Wealthy Clients ?”

  1. David D

    The SALT deduction reduction was a compromise to avoid immediate elimination of SALT deductions (and the related political fallout). Fundamentally the question is: Should tax payers in low SALT areas subsidize regions with high SALTs? For me, the answer is NO, that is income redistribution.

    Remember when all consumer interest was tax deductible? It encouraged people to maximize debt, leaving many on the brink of bankrupcy. Ultimately the elimination of that deduction forced many people to live within their means. Reduction of the SALT deduction will encourage high tax regions to live within their means as well. It will be bumpy in the short term, but eventually they will have to come to grips with the situation.

    It’s only logical that high income individuals will adjust their situation to compensate for the SALT reduction, they have the greatest ability to make adjustments. New business models will undoubtedly appear (soon) to take advantage of the situation….

    Reply
    • Brian Gilmartin

      thanks, David. good thoughts – i do remember when credit card interest was tax deductible.

      Reply

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