Working Around the Tax Bill, Other 2018 Hacks

Financial and business advisor Ray Sturm penciled out the real estate environment for 2018, in light of the revised tax legislation, budget cuts and challenges in affordable housing development.

Ray Sturm, CEO of AlphaFlow
Ray Sturm, CEO of AlphaFlow

Changes in the tax system and the 2018 United States federal budget plan have led to intense debates in the industry, particularly on affordable housing. Before the ink dried on the new tax bill, high-tax states like California were already looking into ways to work around the legislation. Senator Kevin de Leon presented his Protect California Taxpayers Act. If passed, the bill would allow taxpayers to make charitable donations to the California Excellence Fund and in return receive a dollar-for-dollar tax credit on the full amount of their contribution.

The industry might see more turmoil over the next 12 months, but it won’t be enough to cause more than a nudge, specialists say. For 2018, real estate professionals believe that the context will be favorable for the rise of tertiary and secondary markets, while the challenge will be financing affordable housing. Ray Sturm, CEO of AlphaFlow—and former founder of RealtyShares—provides more insight on what’s to come.

How will these changes in the tax system impact the real estate market?

Sturm: We’ve been clear that we think this tax bill will be tremendously negative for homeowners and thus the real estate market in general. It will disproportionally hurt coastal cities, but in places like San Jose, where about 90 percent of mortgages are above the proposed $500,000 mortgage interest deduction cap, you’re going to see a meaningful impact on homeownership incentives and thus prices.

What can you tell us about the impact of the new cap on state and local taxes (SALT) deductions?

Sturm: In the past, there was no cap on SALT deductions, but the new law creates a $10,000 cap on the deductibility of these expenses. The previous law helped high-tax states raise revenue without taxpayers having parts of their income taxed twice—both at the state level and at the federal level—so this will hit many homeowners hard. Specifically, over four million people pay more than $10,000 in property taxes. That means that Americans across the country, and particularly in high-tax states like California, New York and New Jersey, will feel a meaningful impact.

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One of the most talked-about budget cuts was the one impacting the U.S. Department of Housing and Urban Development (HUD). Fortunately, this didn’t happen. How do you see the affordable housing issue going forward?

Sturm: Trump had proposed cutting 13 percent of HUD’s budget, which would have made thousands of families homeless overnight. Thankfully, the cut didn’t make it through to the final bill. Aside from speculating about the spending cuts that always accompany tax cuts, the large issue is the value of Low-Income Housing Tax Credits (LIHTCs). Given the reduction of federal investment in affordable housing over the past 20-30 years, most new affordable housing today is financed with both tax credits and bonds.

In the case of LIHTCs, states allocate these credits to developers building affordable housing. Investors then bid on the LIHTCs and in return for their investments, garner tax benefits over the course of 10 years. Reducing the corporate tax rate from 35 percent to 21 percent will greatly reduce the attractiveness of these investments, thereby reducing support for new affordable housing.

Interest rates are still considered to be low. When do you expect this to change and what will be the effects of the rise?

Sturm: The Fed (Federal Reserve System) has signaled for some time that rates would rise, and while rates aren’t moving up as fast as many may have expected a few years ago, they appear to be on an increasing trajectory. The key seems to be around how quickly these hikes happen and to what extent the market expected them and thus priced them into stocks.

What are your expectations regarding the real estate industry in 2018 (trends, challenges)?

Sturm: The housing market, even in the face of rising interest rates and soaring prices, remains strong going into 2018. The new tax law removed a number of incentives for homeownership, particularly on the expensive coasts, but tight inventory means we’ll still have a strong market for sellers and developers.

I see two shifts coming in 2018. First, we’ll see more development and investment in secondary and tertiary cities. Cities like San Francisco, New York City and Los Angeles have experienced soaring prices, but both zoning and geographical constraints limit how much more can be built in those geographies. The result will be investment in smaller cities, where many people are moving to find both affordable housing and attractive investment opportunities created by companies following this same behavior.

Second, I think we’ll see more investment in entry-level homes. Luxury homes usually have the largest margin for developers, incentivizing both flips and new construction in that category. As that segment gets overheated and demand builds for entry-level housing, developers will move to fill the gap and increase supply in that type of property.

Immediately after the presidential election, many feared increased volatility and remained cautious, whether we are talking about investment or lending. How would you describe this past year? Was it as expected?

Sturm: I’m not sure anyone can look back at 2017 and say they expected all of the unique circumstances and corresponding ups and downs we experienced this year. A common surprise I’ve heard from colleagues in the investment community is how quickly the market appeared to disregard the economically-destructive rhetoric coming from the White House. The invisible hand can be frustrating but in this case, it appeared correct in deciding the economy would be more resilient than the White House was effective in driving meaningful economic change.

Image courtesy of Alpha Flow