Housing Problems

Josh Barro observes that home ownership is a really bad investment strategy insofar as it involves putting an awful lot of eggs in one basket — indeed, for many people it involves putting more eggs than they’ve got in one basket, since the mortgage market allows you to sink more than your entire net worth into a single house.

In fact, it’s even worse than Josh says. If your house is located anywhere near your workplace (in other words, if you’re almost anyone) then a local economic downturn can devastate your home value at exactly the same time that it’s costing you your job. That’s a whole lot of unnecessary risk.

As Josh acknowledges, that doesn’t mean you shouldn’t own a house; it just means you shouldn’t fool yourself into thinking it’s a wise investment.

But Dan McLaughlin at the Federalist isn’t satisfied:

Economists … should never make the mistake of ignoring consumer behavior they regard as irrational…What Barro should have asked himself (as any real economist should) before declaring that vast numbers of homebuyers and homeowners have been acting irrationally for millenia in buying their own homes is: what are they getting out of it that my analysis is missing?

I enthusiastically endorse the sentiment that when we observe “inexplicable” behavior, our first instinct should be to ask “What am I missing?”. But Barro at least tried to do that — he pointed to “a sense of security” and the desire to customize one’s residence. I agree with McLaughlin’s assessment that these are pretty weak answers, but unfortunately McLaughlin’s own “answers” are even weaker. According to McLaughlin, we own houses because we don’t like to move, and he elaborates at length on the reasons why —- moving is expensive, it means adjusting to new neighborhoods, uprooting your family, etc. etc.

The thing is, though, none of this is a reason to own rather than rent. You could accomplish all of the above with a 99-year lease (binding for the landlord but not for the tenant) which would give you all the residential stability of home ownership while transferring the risk to a professional landlord with diversified holdings.

So why do people buy houses? Offhand, I can think of three answers:

1. The rental market is beset by moral hazard problems. When you rent a house, you pay a premium to compensate the landlord for the possibility that you’ll tear up the floorboards and kick holes in the walls, or in less extreme cases you’ll fail to report routine maintenance problems until after they’ve grown into major headaches. People don’t want to pay those premiums.

2. The tax code provides a big incentive to own rather than rent — and no, it’s not the incentive you’re thinking of. The mortgage interest deduction is not a net incentive to own, because it’s offset by the fact that mortgage interest is taxed as income to the lender — so there’s no net tax on the transaction, but no net subsidy either. Instead the relevant tax argument is this: If I rent you my house, I pay income tax on the rental payments. If instead I sell you my house for the present value of the stream of rents, I pay capital gains tax on the transaction — usually at a lower tax rate. There’s my incentive to sell, which of course the market will translate into an incentive for you to buy.

3. 99 year leases are not available. This, however, does not actually answer the question of why people buy houses; it merely replaces it with a different question, namely: Why are 99 year leases not available? I have a sneaking suspicion this can be traced to some screwy government policy, but that’s just a guess. Maybe some reader can fill in the details.

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96 Responses to “Housing Problems”


  1. 1 1 Robert Easton

    A house could be a bad “investment”, but I’m not buying it as an investment, I’m buying it to consume. If the price of houses goes up or down, that’s not necessarily relevant to me, since I still own one house. Which is exactly the number I wanted to use. Which was the thing I wanted. When I rent, I still have risk. The risk that home prices (and my rent) will go up or down. When I buy, I’ve withdrawn from participating in that market entirely.

    This isn’t very EMH, so explain what I’m missing, but it’s just obviously a good deal when you go look at doing it? I keep seeing friends buy homes where the mortgage payments (interest and principle) are lower than they would have paid in rent on the same home. Even if they didn’t get to own a house at the end of this process, it still almost seems better than renting. Your point 1 could explain this; is that all that’s going on?

  2. 2 2 Jonathan Cardy

    The cost of ownership is roughly the same as rental. Ok, maybe a little higher. But if there’s a downturn and I have to leave for whatever reason, I can default on my mortgage and I’m in the same scenario as having been renting the entire time! And that’s a worst case scenario. Realistically, I will have somewhere to live rent-free by the time I retire on the pitiful pension I can expect to draw. Maybe you don’t have that problem.

  3. 3 3 Kernow Castellan

    Here in the UK, it is less of a gamble. The strong restrictions on new houses mean that supply has failed (for decades) to keep up with the increase in demand driven by longevity. People who already own houses don’t want new ones built.

    The structural control of supply has lead to a culture of steady increasing house prices. The “bursting” of a housing bubble usually means a fall of 5-10%, or even just staying flat for a year or so.

    So now people have an incentive to further restrict supply – most people’s wealth is tied up in their house.

  4. 4 4 Nicholas Croom

    I don’t agree that housing is an irrational (rather than bad) investment. What would be the response if I asked my bank to lend me 4 times my salary to invest in a well diversified portfolio of equities? So housing is the only way for me to leverage an investment. Plus it’s letting me do so into a market which is imperfect, with limited supply and therefore long term excess returns.

  5. 5 5 Alnair

    There are also a risk in renting instead of owning a house. In the 1950′s Spain has a depressed economy after a civil war and a period of autarky. In those times half of the homes were owned and half were homes.
    There are also a risk in renting instead of owning a house. In the 1950′s Spain had a depressed economy after a civil war and a period of autarky. In those times half of the homes were owned and half were rented.

    But in the 1960′s a surge in economy and a baby boom increased the demand of houses and the prices went up rapidly. Those who rent the house and can’t increase his income (retirees, low qualified workers, …) had a huge financial stress due the renting prices surge. During those days a lot of people ended up in a slum.

    Nowdays there are a 80% of homeowners in Spain, most of them in trouble after the housing bubble, of course.

    So, owning a house could be risky, but also could be a safe investment for your retirement.

  6. 6 6 Navin Kumar

    Can’t speak of the US, but here in India, credit isn’t that easy to get if you’re poor. Plus, the poor have low, volatile incomes, and not much access to saving tools. So buying a house is out the question for them. A house is probably a good deal for those with enough capital to buy instead of renting.

    Re: 99 year leases. In most cities in India, tenancy rights kick in after 12 months. Therefore most contracts are for 11 months. Tenants have absurdly restrictive rights in many places – it’s often difficult, if not impossible to evict them. My current landlord rents out only to students because they’re guaranteed to leave eventually.

  7. 7 7 Scott A

    What about stability and security. The threshold for being evicted for non-payment of rent is fairly low- a month or two, whereas to be evicted from a home one owns often takes nearly a year, during which time one still has options to remedy the situation. Renters are a few bad months away from disaster whereas homeowners have many more protections in law, as well as an asset that can be refinanced, etc to help them turn around a bad situation.

  8. 8 8 Harold

    This paper says it is a hedge against rent fluctuations, but it does not explain why longer rental contracts are not available.
    http://finance.wharton.upenn.edu/~rlwctr/papers/0301.pdf?_ga=1.157264187.142600158.1399451607

    The rental sector in Germany is much larger than most other countries, with only 43% home-owners (compared to 69% in USA and 83% in Spain). This apparently goes back at least in part to post war policy. Both UK and Germany had large housing deficits after the war. UK subsidised only public sector building, but “In Germany, “the role of public policy was to follow a third way that involved striking a sensitive balance between ‘letting the market rip’ in an uncontrolled manner and strangling it off by heavy-handed intervention,” wrote economist Jim Kemeny, of the German approach to housing policy.” UK placed caps on costs for public housing, which may have reduced quality and stigmatised rental housing as “for poor people.”
    http://qz.com/167887/germany-has-one-of-the-worlds-lowest-homeownership-rates/

    Apparently it is harder to get a mortgage in Germany too.

    The whole home ownership meme causes all sorts of crazy policies. In the UK at the moment there is a “help to buy” policy. Banks are requiring high deposits (say 20%) which people do not have. So the Govt. will guarantee the deposit for the bank. This allows higher house prices than would otherwise be the case, and subsidises the bank. This is the only sector where inflation is generally considered a good thing by the public.

  9. 9 9 Anders

    In the UK there are 99 year leases available. In fact, they are very common if your residence is an apartment rather than a house. It is, however, treated by almost everyone as exactly the same thing as owning the apartment outright, I think partly because you have the right to extend the lease (at a marginal cost). I don’t agree with your statement that it removes the risk, most of the PV is concentrated in the first 99 years so the cost of the lease is almost the same as the cost of the residence, hence the value of the lease will go up and down almost exactly as the rest of the market.

  10. 10 10 Richard Quigley

    You should include, as a reason for purchasing a house, wifely nesting instincts.

  11. 11 11 Charles G. Phillips

    Unless a 99 year lease does not create a 99 year obligation to pay rent, it is the worst of all alternatives. The renter has incurred an obligation the present value of which is a liability not unlike the purchase price of a comparable property. Rent is not a deductible expense and neither are the real estate taxes that are presumably captured in the rent. If the renter has the right to sell his lease, the value of the lease will be subject to the same elements of market risk described by Mr. Barrio, and the value of the right to sell will decline as the term of the lease declines. Sounds like all the risks of ownership with none of the benefits.

  12. 12 12 Ryan Decker

    Robert Easton says, ” I’m buying it to consume.”

    Yes, but you’re paying for a massive inventory of “housing consumption,” many years before you will consume it. Holding large inventories has an opportunity cost; in this case, paying for housing as you consume it (ie, renting) may allow you to invest extra money somewhere, like diversified real estate (REITs) or equities, and use investment returns to pay for housing consumption 30 years from now.

    This type of inventory has high adjustment costs, so people often find themselves owning more house than they can really consume. People in their 30s have houses with extra bedrooms in anticipation of family growth; people in their 60s have extra bedrooms that are no longer occupied by children. Some of those people could save money by renting before and after their family is large.

    In any case, the actual financial decision can go either way; it depends heavily on holding time and other things. See this NYT calculator: http://www.nytimes.com/interactive/business/buy-rent-calculator.html

  13. 13 13 Robert Franklin

    “Why are 99 year leases not available? I have a sneaking suspicion this can be traced to some screwy government policy, but that’s just a guess.”

    Lines like that undermine the integrity of your blog. Instead of the “Big Question”, you have one big answer (“Blame the government”) and you figure out how to apply that answer.

  14. 14 14 CC

    ” The mortgage interest deduction is not a net incentive to own, because it’s offset by the fact that mortgage interest is taxed as income to the lender — so there’s no net tax on the transaction, but no net subsidy either.”

    Hold on, cowboy. Let’s take a very simplified example: A house costs 100k and interest rates are 5%.

    Case 1: I buy the house with an I-only mortgage. I pay 5k/yr in interest and get to write-off the interest. (So maybe it only costs 4k/yr.)

    Case 2: Rutteger buys the house with an I-only mortgage and rents it to me. Rutteger has to pay 5k/yr in interest payments and gets no write-off. (He’s running a little company after all.) So he has to charge me the full 5k/yr to rent the place. Net result: I’m out 5k/yr with no tax write-off.

    So it does seems that the mortgage interest deduction favors owning over renting.

    The underlying reason for this (I think) is that the income tax is a tax on individual revenue, whereas companies get taxed on profits.

  15. 15 15 Steve Landsburg

    Anders:

    I don’t agree with your statement that it removes the risk, most of the PV is concentrated in the first 99 years so the cost of the lease is almost the same as the cost of the residence,

    I had in mind a 99 year lease that binds the landlord but not the tenant. I’m editing to clarify.

  16. 16 16 Alan Gunn

    When you sell your house, the first $250,000 (§500,000 for a married couple) of gain isn’t taxed at all, so the tax on the sale isn’t just at a lower rate, it’s zero for most people.

    On the other hand, until the Tax Reform act of 1986 went into effect, the effective rate of tax on owning rental property was negative, mostly because you were taxed as if your property was going to become worthless in a short time (as low as 15 years at one point), although in fact the value of buildings tended not to fall at all. Not only was the rent money you got not taxed, owning rental property meant that some of your other income also escaped tax. This was the real-estate tax shelter, which meant, in practice, that almost no deal involving buying real estate for profit could fail, even if it made no sense before tax. So, if we just look at tax considerations, the real mystery is why anybody bought a house before 1987, but many people did.

    On balance, then, I don’t think tax considerations tell us much. Non-tax laws concerning landlords and tenants may be much more important. Years ago, a New York City lawyer told me that if a tenant in New York stopped paying rent, giving no reason, it would take a year and a half to evict him. And in San Francisco today, if a tenant moves out of an apartment in your house, your assessed value will increase, because a house without a rent-paying tenant is worth more than one with a tenant. New York and San Francisco may be extreme cases, but it’s no fun to be a landlord elsewhere, either.

  17. 17 17 Steve Landsburg

    Robert Franklin:

    “Why are 99 year leases not available? I have a sneaking suspicion this can be traced to some screwy government policy, but that’s just a guess.”

    Lines like that undermine the integrity of your blog. Instead of the “Big Question”, you have one big answer (“Blame the government”) and you figure out how to apply that answer.

    Like, I suspect, most economists, I have a lot of experience observing behavior that appears to be irrational, going to some effort to construct a rational explanation for it, and then discovering that the true explanation is that this behavior is required by law.

    Sometimes it’s required by law for a very good reason, such as the way the behavior impacts some third part. That doesn’t change the fact that from the point of view of trying to explain the behavior, it all comes down to some screwy (in that context) law.

  18. 18 18 Chris Hodder

    Some interesting thoughts here, particularly from Mr Easton and Harold.

    Firstly, we can’t ignore loss aversion. Having a hedge against instability in the rental market is very valuable, particularly in markets where rents rarely fall. However, the 99 year lease problem could solve that and indeed, in the UK market many properties do indeed have a 99 year lease. That said, those 99 year leases themselves have a market.

    Secondly, as for the having “all your eggs in one basket” problem, there are few investments that you can consume whilst you own it and at the same time normally appreciate. Admittedly, a portfolio of shares or bonds might have better returns (and that is a big “might” in many housing markets), but a pile of papers isn’t very useful during the average week. Conversely, a car might be very useful, but is guaranteed to depreciate unless you’ve got a bargain classic. Ergo, a house strikes a good balance between utility and ROI.

    Thirdly, the beneficiary of the ROI cannot be ignored. Many houses don’t get sold until the owner dies. Therefore, the volatility of house prices is actually a problem for the subsequent generation in many cases. In fact, in depressed markets, sales slow and the only sales are repossessions (where the volatility is the bank’s problem) or deaths (where the volatility is the inheritor’s problem). Therefore, logic would suggest that the majority of sales by the purchaser are in bear markets.

    In these respect, purchasing a house is almost a one way bet, i.e. you wouldn’t sell it in a bad market and would simply keep consuming it (unless dead or bankrupt, in which case the ROI is a moot point). If you sell it in a good market, you get a healthy return. But you’ll still need a house to live in.

  19. 19 19 Steve Landsburg

    CC:

    Case 1: I buy the house with an I-only mortgage. I pay 5k/yr in interest and get to write-off the interest. (So maybe it only costs 4k/yr.)

    Case 2: Rutteger buys the house with an I-only mortgage and rents it to me. Rutteger has to pay 5k/yr in interest payments and gets no write-off. (He’s running a little company after all.) So he has to charge me the full 5k/yr to rent the place. Net result: I’m out 5k/yr with no tax write-off.

    Yes, this is a disincentive for Rutteger to act as middleman. But it’s not a disincentive to rent from the original owner.

    Think of it this way:

    Case I: My income is $50K and I have $200K in the bank, earning $10K a year in interest. The bank lends me $100K to buy a house, on which I pay $5K a year in interest. I get to deduct that $5K from my income, so I pay tax on $10K – $5K, i.e. on $5K.

    Case II: My income is $50K and I have $200K in the bank, earning $10K a year in interest. I withdraw $100K to buy a house. Now my bank balance earns $5K a year in interest, on which I pay tax.

    In both cases I buy the house. In Case I, I get the mortgage interest deduction, whereas in Case II I don’t. But my tax bill is the same either way. Therefore the mortgage interest deduction cannot make buying any more attractive than it was to begin with.

  20. 20 20 Steve Landsburg

    Charles G Phillips:

    Unless a 99 year lease does not create a 99 year obligation to pay rent, it is the worst of all alternatives.

    Yes, as noted in my reply to Anders, I meant a 99 year lease binding only on the landlord. I’ve edited the post to note this.

    Rent is not a deductible expense and neither are the real estate taxes that are presumably captured in the rent.

    Non-deductibility of rent is irrelevant, as noted in the post and my reply to CC. And the real estate taxes are deductible no matter who owns the house, so those are also irrelevant.

    If the renter has the right to sell his lease, the value of the lease will be subject to the same elements of market risk described by Mr. Barrio, and the value of the right to sell will decline as the term of the lease declines.

    Again, this is correct if the lease binds both parties, but not if it binds only the landlord.

  21. 21 21 Josh

    It’s funny the high cost of moving is mentioned as a reason for not renting. In fact that’s one of the reasons I am currently renting. Moving is less expensive when you either don’t have to search and screen for a tenant to rent your place or you don’t have to pay closing costs to sell the place (and that can take months or years in some markets). Also for me personally since I don’t have 20% down to put down, I’d be paying non-tax deductible PMI to the tune of $200 per month for many years. So non-tax deductible to me and also taxable to the recipients. Worst of both worlds.

  22. 22 22 CC

    SL #19: You’ve shown that buying a house in cash is just as good as borrowing to buy it. Fine. I was arguing that the tax deductibility makes is preferable for me to buy (in cash or on credit) vs. rent from someone. The person renting me the place has to charge more than I would have to pay in interest to buy a house myself.

  23. 23 23 Dictum

    Steve, I’ve always thought that renting markets should be tied to short term unemployment numbers (if your employment is uncertain, why would you buy a house?) Is there a good reference to someone who has studied this?

  24. 24 24 Josh

    I think you could be right that the law is probably to blame a large degree. If a landlord wanted to get out of a 99-year residential lease, there are usually ways to do it. So really there is no such thing or it’s very rare or have a true, binding 99-year residential lease. The tenant would know there’s some risk he could
    lose the residence and be forced to move in most legal environments… With probably limited remedies.

  25. 25 25 Bill

    “The mortgage interest deduction is not a net incentive to own, because it’s offset by the fact that mortgage interest is taxed as income to the lender — so there’s no net tax on the transaction, but no net subsidy either.”

    Steve, thanks for that insight. I hadn’t thought it through like that before.

  26. 26 26 Steve Landsburg

    CC:

    You’ve shown that buying a house in cash is just as good as borrowing to buy it. Fine. I was arguing that the tax deductibility makes is preferable for me to buy (in cash or on credit) vs. rent from someone.

    Yes, I’ve shown that buying in cash is just as good as borrowing to buy it. I’ve also noted that in the first case, you don’t get the mortgage interest deduction and in the second case you do. I claim it follows that the mortgage interest deduction can’t make buying more attractive.

  27. 27 27 Chris Hodder

    Also, I should add that many financial decisions are made at the margins. Renting is consumption and the interest on a mortgage is also consumption. In most cases, you’d imagine that the price of renting is significantly more than paying interest on a mortgage. Most of the repayment on a mortgage is actually a saving on rent plus an investment.

    For instance, $500 on rent is $500 consumed. $1000 on a mortgage repayment for the same property, of which $50 is interest, is a net saving of $450, plus a total of $950 towards an asset that will likely appreciate in value when you sell it. Even if the house depreciates, it would have to lose half its value before it becomes a bad bet over the long run. The saving is even bigger if the rent is higher whereas the investment stays the same (although the risk profile is worse).

    This description chimes with most people’s explanation of why they choose to buy, i.e. that they want to stop throwing money away on rent.

  28. 28 28 Rowan

    As much as I tend to favour government, I think you’re right about the reason 99-year leases aren’t common. Many (most?) places in North America have laws about how much you can raise the rent for an existing tenant each year.

    In the case where rents are increasing, landlords lose out because with no tenant turnover, they have no opportunity to raise the rent to market value (hence all the fervor over rent-controlled apartments in NYC). In the case where rents are falling, in your scenario the tenant just moves to a comparable, now-cheaper place, and the landlord gets stuck renting to someone new for less. A 99-year lease that is binding on only one side is a no-win situation for a landlord.

  29. 29 29 Kirk Taylor

    Almost every comment about taxes is grossly misinformed. There is very little tax benefit to owning a home at current interest rates and values. The tax benefits don’t come in until net itemized deductions exceed the standard deduction, which is $12200 (2013) for married couples. Over half my clients (there are a lot of them) who own houses get ZERO tax benefit from it. The vast majority get a small benefit and some do very well from it.

    The reason I would apply tax benefits to the decision equation is that Real estate Agents, who have a HUGE incentive to get you to buy a house, grossly overstate the tax benefits to their clients who usually do not know any different (especially since financial advisors, for the same reason as real estate agents, continue to overstate the tax benefits of not paying of your house.)

  30. 30 30 John Burton

    “indeed, for many people it involves putting more eggs than they’ve got in one basket, since the mortgage market allows you to sink more than your entire net worth into a single house”. This is the big attraction to owning a house in my view because the leverage it gives you. Prices are sticky downwards because of demand and restricted supply (in London). All of the equity increases go to the owner. The debt gets eroded by inflation. What’s not to like about this proposition (unless interest rates go through the roof)?

    Speaking from the landlord perspective, giving your tenant 99 years security of tenancy might deter most prospective landlords from entering the market. Who loses from that? Everyone I guess. Maybe those government regulators are not so screwy?

  31. 31 31 Zero M. Ocean

    I personally don’t really get why purchasing a home near your workplace is considered imprudent for the average home-buyer.

    If I’m the average person, I probably don’t have a coffer somewhere that looks an awful lot like an overcooked microwaveable burrito due to all of the money busting from the edges. But because I read this blog, I decide I’m going to follow Dr. Landsburg’s advice, and I purchase a home in a separate state entirely.

    I have the home. I’m paying my mortgage, but it occurs to me that I need somewhere to live. My house is in San Antonio, Texas, but my job is in Maryland. My next option is to either buy another home, or rent another home. So, now I have to buy another house close to my job anyways. And if I rent it, then I’m just throwing money away. Not to mention if I purchase two separate properties, I double the probability of being effected by an economic downturn in the country: my tenant may lose their job in San Antonio. Now I’m stuck with either two mortgages, or a mortgage and a rent.

    I don’t know that the average person can afford that.

    Obviously I could not buy a home at all, and just rent. We’re assuming that I want to make an investment. Few investments (whether in a market, or people) are seldom impervious to negative outcomes. I don’t find the existence of risk in an investment decision should then immediately be followed by the assertion investment is risky, or the certainty of disaster to be . . . well. . . certain.

    You could argue a person could easily invest elsewhere, but again. . . we’re discussing investment in real-estate.

    I don’t know. It just doesn’t seem to me that point was really a point at all.

    Very Sincerely & Respectfully,

    0

  32. 32 32 Charles G. Phillips

    Professor Landsburg,

    I get your point regarding the irrelevance of interest and real estate tax deductions, although it requires one to make assumptions about the tax status of lessors that I question. In my long experience I have never encountered a 99 year lease that is binding only on the lessor (you attribute this to some screwy government policy): but what would be the point of such a lease? The lessor would be transferring to the lessee the value of a long-dated option that would be worth a significant percentage of the net present value of the future rental stream (Black-Scholes). The reason that 99 year leases are not available has nothing to due with government and everything to do which basic economics.

    In your original Point 2 you make the following observation:

    If instead I sell you my house for the present value of the stream of rents, I pay capital gains tax on the transaction — usually at a lower tax rate.

    You suggest that this is the tax incentive that creates a preference for lessors to sell and, thereby, an incentive for renters to buy. You have, in my opinion, gotten it exactly wrong. The tax code encourages lessors to keep leasing because the rental streams created allow the lessor to avoid even capital gains taxes, by borrowing capital against the future value of the rental streams and using that money (obtained without tax consequence) to invest either in additional property or as they see fit (the cost of this borrowed capital is fully deductible to the lessor). It would be the rare lessor who organizes his affairs such that taxes attributable to his rental stream would overpower the advantages of incremental borrowing. With respect, Chas Phillips

  33. 33 33 CC

    SL:”Yes, I’ve shown that buying in cash is just as good as borrowing to buy it. I’ve also noted that in the first case, you don’t get the mortgage interest deduction and in the second case you do. I claim it follows that the mortgage interest deduction can’t make buying more attractive.”

    Sorry, I’m not trying to be difficult, but you really lost me here. Can we agree that if I’m deciding between getting a mortgage to buy a 100k house vs. renting a very similar house that the mortgage interest deductibility significantly favors buying vs. renting?

    Yes, I understand that buying the house in cash would *also* be better than renting. I’m not sure how relevant that is for most people though (since they don’t have that kind of cash).

  34. 34 34 Zero M. Ocean

    @ 29,

    What financial adviser(should be read:saboteur) imparts the advice to NOT pay for your home?

  35. 35 35 Steve Landsburg

    CC:

    Can we agree that if I’m deciding between getting a mortgage to buy a 100k house vs. renting a very similar house that the mortgage interest deductibility significantly favors buying vs. renting?

    Absolutely not.

  36. 36 36 Alan Wexelblat

    I don’t have a lot of answers that your other commenters haven’t supplied but I will note that in Hawai’i there are laws against permanent transfer of property so in fact many people who live there are using 99-year leases. I believe this is also true for commercial property. So perhaps Hawai’i can serve as a kind of case study.

    In Hawai’i most of the land is owned in trust by the government, which has reason to expect 99-year stability. A private owner is unlikely to live that long, so it’s unclear what the incentive would be to issue a 99-year-long rental agreement. I can see several disincentives; for example, if I wish to retire from the landlord business but my tenant has a 99-year lease then I am restricted since I can only sell my building to someone else who wants to take on that obligation. If I had no tenants I would be able to sell to many more potential buyers.

    Another difference is that the 99-year lease in Hawai’i conveys to the lessee obligations of upkeep and so forth that a typical rental agreement does not. Typically, a landlord is responsible for maintaining things like utility services (hot water heater, AC unit, etc) as well as often being responsible for building externals such as mowing the grass, shoveling the sidewalks etc. These obligations should be counted (I think) as costs to the lessor and as further disincentives to undertake long-term obligations.

  37. 37 37 CC

    “Absolutely not”

    Sigh… Can you explain?

    If I buy the 100k house with a mortgage then I pay 5k in interest but get to write it off. If I rent a similar 100k house then I have to pay the owner 5k a year with no write off. Sounds like buying wins.

  38. 38 38 Johnson85

    CC,

    The interest and real estate is deductible either way. Either you deduct the mortgage interest (and it counts as income to the bank) or the landlord deducts the mortgage interest (and it counts as income to the bank).

    Renting is a better deal taxwise because the landlord gets to deduct things like maintenance and insurance. On the other hand, home ownership is a better deal taxwise because usually (at least in the U.S.) owner occupied primary residences are taxed at a lower rate than rental properties.

  39. 39 39 Johnson85

    “interest on real estate”, not “interest and real estate”

  40. 40 40 CC

    “The interest and real estate is deductible either way. Either you deduct the mortgage interest (and it counts as income to the bank) or the landlord deducts the mortgage interest (and it counts as income to the bank).”

    In my example i would have to pay the full 5k to the landlord. This counts as revenue for him and it offsets 5 k in interest expenses. Therefore he can’t charge less than 5 k. As a renter there’s no way for me or anyone else to get a tax break on that 5k. But as a buyer if effectively be paying less than 5 k.

  41. 41 41 Andrew_M_Garland

    Mr. Landsburg,

    As you mention, a house is a desired consumption good, for status, personal taste, privacy, and space.

    Relentless advertising tells people that it is also a safe investment. Mortgage deductibility makes it seem like a ploy that the rich people use to save money. Buyers are told that the borrowed money will be used to leverage a great investment. The government promotes house ownership and say it is for the little guy.

    Despite the recent housing losses, government supported lending is still easy and people are told that those losses are in the past. They are told that housing will now continue on its historic, steady, upward track.

    There is government supported financing for purchases, but not for leases.

    Housing is promoted by the government as a desireable consumption good which is also a great, safe, leveraged investment. Other than Mr. Landsburg, few talk about the risks. So, people buy as sooon as they can.

  42. 42 42 Steve Landsburg

    CC:

    If I buy the 100k house with a mortgage then I pay 5k in interest but get to write it off. If I rent a similar 100k house then I have to pay the owner 5k a year with no write off. Sounds like buying wins.

    Imagine I own a candy store that sells both lemon candy and raspberry candy. You like them exactly equally well and they cost me exactly as much to produce.

    Now the government passes a law that says every time I sell you a lemon candy, I have to give you a dollar. Someone tries to tell you that this is a great deal, and definitely a reason to prefer lemon over raspberry.

    But that person is completely wrong, because he overlooks the fact that instead of selling lemon candies for the same 25 cents that I charge for raspberry candies, I will now price the lemon at $1.25.

    Likewise: When I give you a mortgage and you pay me interest, I pay (say) a $1 tax on that interest and you get a $1 tax break. That’s exactly the same thing as requiring me to give you a dollar (it doesn’t matter that the dollar passes through the hands of the govt).

    So—if someone tries to tell you that your mortgage interest deduction is a good reason to buy rather than rent (or to buy the lemon instead of the raspberry), what he’s overlooking is that the value of your deduction is incorporated into the interest rate on the mortgage — and *fully* incorporated, because every dollar you save is a dollar the seller pays, so it’s just as if the law required him to give you a dollar.

  43. 43 43 CC

    SL, I actually like your example but I really think this case is different.

    In this case, competitive pressure pushes rents down to 5k/yr (in my idealized example). They can’t go any lower than that or else landlords would lose money. (They take in 5k in rent and pay out 5k in interest. Zero profit.) So it really costs me 5k/yr in after-tax dollars to rent, and no lower.

    Again: All houses are identical and cost 100k. Interest rates are 5%. I can buy a house on credit, pay 5k/yr in interest, and get a write-off. Or I can rent for 5k/year (and no less!!). Buying wins.

    In other words, there’s no “tax write-off” for the landlord, and the reason is that the rental income exactly offsets his interest expenses. He has to charge the full 5k and no less.

  44. 44 44 Alan Gunn

    @CC:

    The landlord doesn’t pay tax on the rent. He gets to deduct depreciation (which is usually an entirely imaginary cost) and other expenses, too. All these deductions will usually exceed the rent, and will therefore offset some of his other income, as well as the rent. So the landlord can certainly pay out more in cash expenses than he gets in cash income: the tax savings on his other income can more than make up for the “loss.”(It is also likely the case that the bank that holds the mortgage will pay little if any tax on the interest it gets. Banks get terrific and unjustified tax breaks, too.)

    Before the ’86 tax act, even people who were not in the real estate game could get all these tax deductions, too, just by becoming passive investors in real estate. As a result, while it was OK for a real estate venture to earn a pre-tax profit, it certainly wasn’t necessary. The tax breaks alone made even losing ventures look good after tax.

  45. 45 45 iceman

    As I recall the argument was that the interest deduction can incent lower-income people to rent since the deduction is worth more to a landlord who is in a higher bracket. I think part of this is that banks “discriminate” based on credit score not rate.

  46. 46 46 Fonzy Shazam

    CC & Landsburg #42 & #43:

    A proposed change to mortgage interest deductibility will have realtors and homebuilders up in arms. Are they widely mistaken? Are they counting on the irrational marketing appeal the deductibility has for homebuyers? Or perhaps removing the deductibility truly would make buying a home less desirable. The alternative doesn’t have to be renting. It could be staying with parents, etc.

    There are three parties in a simple conception of mortgage interest: the lender who must be compensated for foregone use of money today, the homebuyer who must value the home today more than the interest expense, and the government who taxes the lender and homebuyer’s incomes. Currently the government allows the homebuyer to reduce his taxable income by the amount he is paying to the lender. But if the government took away that deduction, why would we assume the government would necessarily stop taxing the lender? That seems to be a necessary condition (but perhaps not sufficient condition) for Landsburg’s argument that deductibility is incentive neutral.

    I say that it might not be sufficient because reducing the borrower’s tax and raising the lender’s tax by the same amount doesn’t necessarily just affect the price transaction between these two parties. The tax incidence possibly falls on other groups. The type of lenders this policy encourages may be relatively low-tax-liable lenders. And the type of borrowers encouraged may be relatively high-tax-liable borrowers. Even if a removal of tax deductibility is tax revenue neutral, that doesn’t seem to imply that it is incentive neutral.

  47. 47 47 Josh

    People/entities have different marginal tax rates. I wonder what the average marginal rate is for those who deduct interest expense and those who receive interest expense. If it’s vastly different then tax deductibility would matter I assume.

  48. 48 48 Al V.

    Per SL #35, I live in Queens, New York, where the demand for do-ops is so high that it is much more expensive to buy than to rent. I rent for $1500 per month. If I were to buy my apartment, My mortgage would be about the same as my current rent, but I would also have to pay $680/month maintenance.

  49. 49 49 Roger

    I would likt to see the economic analysis that shows that 99-year leases are somehow more rational than home ownership. It doesn’t make any sense to me.

  50. 50 50 Johnson85

    CC:
    “In my example i would have to pay the full 5k to the landlord. This counts as revenue for him and it offsets 5 k in interest expenses. Therefore he can’t charge less than 5 k. As a renter there’s no way for me or anyone else to get a tax break on that 5k. But as a buyer if effectively be paying less than 5 k.”

    For most landlords, if they are charged $5k in interest, it will cost them less than that on an after tax basis, so if they wanted to try to set their rent as if they were simply passing their costs through (which is obviously not how rents are set), then they would only have to pass the after tax value through.

    More realistically, the interest deduction impacts the overall cost of developing or purchasing residential real estate, and that is going to put downward pressure on the that market rate of rent, so renters will get that value one way or another (and possibly more value if they are in a low tax rate compared to their landlord).

  51. 51 51 Al V.

    I contend that the mortgage interest deduction doesn’t benefit home buyers, only realtors and banks. Assume I purchase a $400,000 home, paying a mortgage of $2,000 per month. In the early years, almost all of my payment is interest, and therefore deductable. Assume my tax rate is around 30%, then my out of pocket cost is $1,400. And $1,400 is what I look at in deciding how much I can afford.

    Take away the mortgage interest deduction, and I can still only afford to pay $1,400 per month, now that’s for a $275,000 house.

    Who benefits from the $125,000 difference in purchase price? The lender, who is getting a larger payment, and the realtor, who is getting a larger commission.

  52. 52 52 Kirk Taylor

    @34, the “of” should have been “off” and it probably would have clarified it to say “pay off early”

    People are still grossly overstating the value of the mortgage interest deduction…

  53. 53 53 Steve Landsburg

    Fonzy:

    A proposed change to mortgage interest deductibility will have realtors and homebuilders up in arms. Are they widely mistaken? Are they counting on the irrational marketing appeal the deductibility has for homebuyers? Or perhaps removing the deductibility truly would make buying a home less desirable.

    Of course it would make buying a home less desirable, or at least it would make borrowing less desirable, which in turn discourages homebuying.

    But that’s not the question.

    I claim:

    A) If you abstract from moral hazard issues, differences between tax rates on capital gains and ordinary income, and so forth, then with mortgage interest deductibility, buying (with a mortgage) and renting are equally desirable.

    B) With the same abstractions, if you eliminate the mortgage deductibility, renting becomes more desirable than buying.

    I have been saying A). You are saying B). These do not conflict.

  54. 54 54 Steve Landsburg

    CC: Try it this way:

    1) If you tax a transaction, then the burden on the buyer is determined entirely by the amount of revenue the govt collects. It doesn’t matter whether I tax the buyer a dollar, tax the seller a dollar, or tax each of them 50 cents — after prices adjust, the buyer’s burden will be the same in every case. This is standard economic theory; in fact it is the very first nontrivial application of economics that I cover in my freshman principles course, and you can find the argument in any textbook.

    2) Now: Alice owns a house, Bob wants to buy it, and Carol stands ready to lend him money.

    Scenario A: Alice sells the house to Bob for $10K cash. She pays tax on the $10K.

    Scenario B: Bob rents the house from Alice for a stream of cash payments with present value $10K. She pays tax on that stream with present value $10K.

    Scenario C: Carol lends Bob $10K to buy the house from Alice. Alice pays tax on the $10K. Carol pays tax on the stream of interest payments from Bob. Bob pays a *negative* tax on that stream of payments.

    Present value of revenue to the govt is the tax on $10K in all three cases (in Scenario C, the govt collects tax on $10K + $10K – $10K, which is $10K).

    Therefore the burden on Bob has to be the same in all three cases.

    (I believe your mistake consists of assuming that the interest rate will be the same in all three cases. It won’t.)

    PS: This analysis abstracts away from the fact that capital gains are taxed at a different rate than income. When we account for that, we see that the tax system favors Scenario A.)

  55. 55 55 Fonzy Shazam

    Landsburg #53:

    I think I see my confusion. When you said the tax code does not provide an incentive to buy rather than rent as a result of mortgage interest deductibility (MID), I interpreted the counterfactual as being a world without MID. But you were simply saying given that we have MID, rent vs buy is not impacted by the existence of MID? Only debt financing versus equity (cash) financing is affected? This seems hollow. Almost tautological. When I think of the incentive effects of MID I think that it both encourages debt financing *and* that it tends to favor buying over renting *as compared to* a world without MID.

  56. 56 56 Steve Landsburg

    Fonzy: I think we are communicating now. The question I was addressing was: Given the mortgage interest deduction, and with everything else equal, does buying beat renting? You say that the answer is obviously no. I agree that the answer is no, but my considerable experience tells me that many very smart people think otherwise.

  57. 57 57 Kirk Taylor

    The only problem with that scenario is that the tax on rental income as compared to capital gains (on business property) as compared to the lack of taxes on sale of personal residence means that some transactions are taxed (sale of business use rental property), some are not (sale of personal residence) and some are deferred (renting usually results in negative income despite earning rent income and taxes are deferred until the sale)

    The buyer doesn’t usually know the nature of the sold property so doesn’t have the knowledge to make it a true Fair Market Value transaction (willing buyer+willing seller+relevant knowledge of all facts) so tax issues do affect the sale.

    They also affect sell vs. rent because most buyers over estimate tax benefits of ownership.

  58. 58 58 Brian

    “home ownership is a really bad investment strategy insofar as it involves putting an awful lot of eggs in one basket”

    Putting all your eggs in one basket is a bad investment strategy if the investment is risky; owning a home is not.

    First, over the long term, home values have a positive rate of return, so they definitely qualify as investments.

    Second, the monthly cost of renting is similar to ta monthly mortgage. You can pay the former over 50 years (your adult life) and end up with no equity, or pay the latter over 30 years and end up with th value of the home. This is a no-brainer.

    Third, the downside risk is very small. If the value of your home collapses fairly early on, you can simply let the bank foreclose and you lose little to nothing relative to the cost of renting. The bank assumes all the risk on the value of the home. You only risk losing out if you are forced to SELL the home, which is only necessary if you intend to buy again.

    Fourth, unlike other investments, which are often shrouded in mystery, homeowners understand their own homes intimately and thus have a sense of control. Better to deal with the devil you know than the one you don’t.

    Fifth, most people have precious few options for making investments, especially if they are risk averse. Social Security and pensions disincentivize people to save for retirement by investing in a mutual fund. Health insurance and Medicare disincentivise people to save for current and future medical needs. For the vast majority of the middle class, homeownership is almost the only way to increase one’s net worth.

    Sixth, homeownership is emotionally satisfying, since it brings the homeowner closer to the American ideal of self-reliance. We all like to feed our inner cowboy, and a house is a very tangible representation of that ideal.

  59. 59 59 Kevin Erdmann

    I don’t understand what I’m missing:

    Investor buys property for $100k, takes $2,000 in rent and pays $1,000 in interest, then sells it for $110k:

    He has taxes on $10k in cap gains and $1k in net income. Renter has no tax consequence.

    Homeowner buys the same house for $100k, pays $1,000 interest, and sells it for $110k:

    He has taxes on $10k in cap gains and negative $1k in net income

    The difference is that the investor claims rent as income but the home renter doesn’t deduct rent from his income. For the homeowner, rent isn’t treated as income or a deduction. The mortgage interest deduction benefits the homeowner because he gets to deduct the cost of the interest without claiming the matching income from the implied rent.

    As far as whether this all makes owning versus renting a good idea, it comes down to price, like any investment. The average return on an owned home is higher than the return on something like a low risk bond, partly because the tax treatment favors homeowners so that prices can’t always be effectively arbitraged at the margin by investors and there are specific risks to owning a home in this way that can’t be diversified away. The tax treatment gives homeowners an advantage and barriers to entry created by our convention of only usually selling real estate in undivided units allow for sustainable excess returns for homeowners. Without the tax treatment, there would probably be much more renting because investors would have the ability to finance and diversify their holdings more efficiently than homeowners.

    One risk of owning a home that is especially problematic now in a low rate environment is that if interest rates go up significantly, leading to lower home values, the mortgage must still be paid off at face value. An investor with many properties, financed with secured, market-traded bonds, would be able to pay off the bonds at a discount.

    If rates go down, homeownership is very valuable because mortgages usually can be called at face value when they are worth a premium. So, if owning vs. renting looks like a break-even value, the option-value of the mortgage probably makes owning more valuable. Also, owning a home is like an inflation-protected bond, much of the value comes from being protected from very long term rent increases. This means that the discount rate you would apply to the value of future rents would be lower than the discount rate on nominal bonds. Your 99 year lease would provide that protection, but the rent payment would have to increase to account for that value. That would be an awkward contract. You’d be over-paying the rent as a hedge against far-future rent increases, and you’d have to leave all those overpayments behind if you ever moved. Homeownership allows you to hedge those future rent increases without the awkward problem of a binary loss if you move and exit the lease.

  60. 60 60 Matthew

    Housing is a great investment because the US government intervenes both directly and indirectly to support/increase housing prices. Don’t fight the Fed. Buy a house. Actually, buy several.

  61. 61 61 Kevin Erdmann

    Matthew, that’s a funny thing to say after what’s happened the last 6 years.

  62. 62 62 Kirk Taylor

    AAAAAG! Homeowners who live in their houses don’t pay capital gains tax on the house when they sell! (Some restrictions apply)

  63. 63 63 Kirk Taylor

    People who own houses and rent them to people, and have mortgages generally have a net tax REDUCTION due to the rental income but end up paying MORE taxes when they sell (since depreciation deducted must be taxed as ordinary income when selling).

  64. 64 64 AMT buff

    Steve, do you have any reaction to the pros and cons listed in Megan McArdle’s latest article? http://www.bloombergview.com/articles/2014-05-07/buying-a-home-isn-t-bad-for-you

  65. 65 65 Matthew

    Kevin Erdmann,

    Why? You mean after they stepped in to save Fannie and Freddie? Then the Fed started buying mortgage debt in the billions to drive down long term rates and reflate housing prices? I think my comment is 100% right on the money.

  66. 66 66 Matt - NYC

    I think it is a fair to point out that the captial gains and tax benefit of owning a home is much larger than mentioned in the post. Under the assumption would only pay rent on your primary residence then proceeds upon your purchased home (being a primary residence) would not be taxed at all.

  67. 67 67 nobody.really

    2. The tax code provides a big incentive to own rather than rent — and no, it’s not the incentive you’re thinking of. The mortgage interest deduction is not a net incentive to own, because it’s offset by the fact that mortgage interest is taxed as income to the lender — so there’s no net tax on the transaction, but no net subsidy either. Instead the relevant tax argument is this: If I rent you my house, I pay income tax on the rental payments. If instead I sell you my house for the present value of the stream of rents, I pay capital gains tax on the transaction — usually at a lower tax rate. There’s my incentive to sell, which of course the market will translate into an incentive for you to buy.

    In his book Untangling the Income Tax, David Bradford argued that the tax code advantaged ownership in the following way:

    Consider home owners X, Y and Z, owning identical houses at identical terms.
    - X rents his house to Y, and lives in Y’s house.
    - Y rents his house to X, and lives in X’s house.
    - Z rents his house to Z. That is, he owns his house, and lives in it.

    Each party has made the same investments, bears the same risks, and gets the same stream of housing services. But X has to pay taxes on the rents he receives from his tenant, Y. Y has to pay taxes on the rents he receives from his tenant X. But Z never has to pay taxes on the revenues he (implicitly) receives from his tenant, Z.

    And the same follows from any good you own rather than rent: cars, lawn mowers, moving vans, etc.

    To be sure, you get to deduct depreciation from rental property, not from your home. But the depreciation reduces your basis in the rental property; that is, you gotta pay back much of the depreciation advantage when you sell. (Now, with Sec. 1031 like-kind exchanges, you can swap rental properties with other landlords and defer these tax consequences a really long time — perhaps even getting multiple depreciation allowances — but I’d be surprised if you could skate this long enough to beat the tax advantages of owning your own house.)

  68. 68 68 Zero M. Ocean

    @ Nobody.Really

    I love your posts.

    This may be a tragic error (my intimating my admiration), but I often wonder where do you find this stuff?

    Very Sincerely & Respectfully,

    0

  69. 69 69 nivedita

    Steve @53 and 54:

    If I understood your argument correctly, you are saying that, given a set of tax laws, house prices, rents and mortgage rates will reach an equilibrium where a housing consumer is indifferent between buying or renting the same house. This gives us 53(A). If you eliminate the mortgage interest deduction, though, doesn’t the same argument say that prices, rents and mortgages will adjust to the new tax law, leaving the housing consumer still indifferent between buying and renting? i.e. house prices must fall and/or rents go up and/or interest rates come down?

    In 54 as you present it, the tax revenue collected by the government isn’t actually the same. It will be higher in the rental case unless the rent is lower than the mortgage interest payment (assuming a perpetual interest-only mortgage). The missing piece is where the house came from in the first place, and what Carol is going to do with the money that she didn’t lend to Bob.

    i.e. the real scenarios B & C should be: Carol has $10K in cash that she wants to lend. Alice borrows the $10K for $10K PV in interest payments and builds a house.
    (B) Bob rents the house for $10K in rental payments. Alice has net income of zero and pays no tax. Carol pays tax on $10K PV in interest payments.
    (C) Bob buys the house for $10K. Alice pays off her loan from Carol. Carol lends the money to Bob instead. Alice has net income of zero and pays no tax (she invested $10K in the house and sold it for the same amount). Carol pays tax on $10K PV in interest payments. Bob, however, now gets to deduct $10K PV from his income.

    Or if you want to leave Carol out and just compare (A) and (B), assuming that Alice got the house for free.
    (A) Alice gets $10K and pays tax on $10K.
    (B) Same tax for Alice, but Bob invests his $10K and pays tax on that income too.

    Or an even simpler pair of scenarios: Alice owns the house and Bob wants to live in it. They have two choices:
    (i) Alice rents the house to him for $10K in rental payments.
    (ii) Alice lends him $10K in return for $10K of interest payments, and Bob turns right around and buys the house from her for $10K.

    The tax collected by the government from Alice is the same (assuming that the sale in (ii) is treated as non-taxable, since Alice has just exchanged one asset (the house) worth $10K for another (the loan) worth the same), but from Bob is higher in (i). But in this scenario I don’t actually see any way to set the rent, price and interest to make Alice and Bob both indifferent between (i) and (ii)?

  70. 70 70 nivedita

    Hm my cash-down comparison doesn’t work above, since Alice would invest the $10K instead of Bob, so there seems to be no difference between (A) and (B) there. This actually makes more sense, since there is no mortgage here.

  71. 71 71 Steve Landsburg

    nivedita:

    If I understood your argument correctly, you are saying that, given a set of tax laws, house prices, rents and mortgage rates will reach an equilibrium where a housing consumer is indifferent between buying or renting the same house.

    You did not understand my argument correctly.

  72. 72 72 nobody.really

    Zero M. Ocean @68:

    [W]here do you find this stuff [@67]?

    People often ask that about stuff I’ve posted, but usually not as nicely as this; thank you.

    This post reflects my recollection of David Bradford’s book, Untangling the Income Tax. Bradford was a neat guy, and an illustration of the admonition, “Be careful what you wish for; you just might get it.” In Ford’s Treasury Dept., he authored his “Blueprint for Basic Tax Reform” in 1975(?). But when that gig ended, he didn’t stop. He labored for years in public finance circles, nudging Democratic congressmen and a Republican administration into tax reform. He found allies among the staff members of Dick Gephardt (D House) and Bill Bradley (D Senate). They, in turn, enlist the support of Dan Rostenkowski (D House leader) and Bob Packwood (D Senate leader). And on the other side, he had contacts from being on GHW Bush’s counsel of Economic Advisors, and was able to nudge Reagan to the table (R Executive leader). And thus was born the Tax Reform Act of 1996 – broadening the tax base, lowering the rates, stripping away years of encrusted tax favors.

    Bradford was crowned with success, glory, and lucrative job offers from lobbying firms.

    The following year, all sides went right back to work putting the loopholes back in. Notwithstanding a booming economy, Reagan would end his term with then-record-setting (and bi-partisan) deficits.

    Bradford left DC, never to return, and shortly thereafter turned to the study of environmental economics. He continued to teach public finance at Princeton and NYU — and even published on the merits of consumption taxes over income taxes — but I sense he was pretty disillusioned.

  73. 73 73 Alan Gunn

    @ Kirk Taylor (63)

    You are right that rental income on real property you own is often not taxed (or, even better, is taxed at a negative rate because your deductions offset not only the rent but your income from other sources as well). But it is not true that depreciation recapture on that kind of property is taxed as ordinary income. It’s taxed at a maximum 25% rate.

    Nearly all the statements about tax consequences in this thread are flat wrong. Haven’t any of you heard of the real estate tax shelter (cut back a lot, but not eliminated entirely, in 1986)?

  74. 74 74 Zero M. Ocean

    @Nobody.Really

    Thank you very much for the source (and the detailed response). I’ll add that to my reading list.

    Until next time, my friend.

    Very Sincerely & Respectfully,

    0

  75. 75 75 Kirk Taylor

    @alan. You are correct. I was typing frustrated and neglected to remember we were talking about Sect 1250. I hope people are not using the tax information from these comments to make real life decisions.

  76. 76 76 Kirk Taylor

    The tax misinformation really clouds the economics discussion when taxes are involved because the people making decisions based on tax implications are generally wrong about the actual tax implications. Our tax code is so complex that it is nearly impossible for a layman to accurately anticipate their tax liability or benefit.

    Hell, I’m a Tax Super Genius and I managed to make a mistake while only making 4 comments!

  77. 77 77 nivedita

    Steve, now you might read the rest of my comment and respond to it, since your argument that the government taxes rentals and mortgaged houses the same is wrong.

  78. 78 78 Zero M. Ocean

    @77

    Probably not.

    Not to speak for Landsburg, but I believe he clearly stated that he in no way believed that renting was better than buying — in spite of some individuals’ respective arguments of the contrary.

    In fact, when reread, I don’t know that a benefit was ever attributed to renting in lieu of purchasing given the present circumstances mentioned throughout the discussion. I also don’t know that Landsburg implied that a consumer would eventually succumb to indifference. I think the linchpin of this position is directly connected with the ultimate result being if you own a house, your investment is yours in the form of the property while if you don’t, well, in the end. . . You’ve spent money that you’ll never see again. Whether you rent your home to someone, and you are taxed, or blah, blah, blah. It’s all irrelevant. If you have absolutely nothing to show for your money, buying will always be preferable.

    In the case of Nobody.Really’s post, it seems to be optimal, despite the risks indicated in Landsburg’s original posts, to live in your home while paying the mortgage as taxes conflated with interest payments and whatever else will in the end be deleterious to you as an investor should you make that property available to someone else and charge them.

    I could be wrong, though. I probably am.

    Very Sincerely & Respectfully,

    0

  79. 79 79 iceman

    I think “0″ is right to remind that the point of the post was clearly about housing as an *investment*. As I recall TBQ commented on how real estate should not be expected to produce ‘pecuniary’ returns on par with say stocks precisely because of the imputed rent it provides.

    Kevin Erdmann — you make several other interesting points as well, but as you say it all comes down to price. E.g. surely the optionality of mortgages to the holders is priced into the rate? Perhaps even the rate at which property investment companies can issue bonds will reflect the likelihood of circumstances leading them to look to repurchase them at a discount. Plus you can only do that if you have the cash.

  80. 80 80 Alan Gunn

    I’ve never lived any place where there was any kind of market for renting houses (other than perhaps some townhouses) on more than a short-term basis, as when the owner is an academic on leave for a year. Even back in the day when landlord-tenant law in many places didn’t favor tenants the way it does today, the only kind of rental you could get and expect to stay there for years was apartments. The change from widespread apartment rentals to condominium ownership was probably a response to changes in laws about rentals (including, especially, rent control), but that can’t explain why so few people ever built single-family houses to rent. Agency problem? Moral hazard, because it’s so easy to let a single-family house and yard go downhill fast?

  81. 81 81 Babinich

    Socratic teaching with a 21st century twist. Amazing!

  82. 82 82 nivedita

    I think I might see the source of the confusion.

    The tax code does provide a big incentive to buy instead of rent. But it is not directly the mortgage interest deduction, it is the fact that rent is not tax-deductible for the renter. This makes buying for cash superior to renting, all else being equal.

    What the mortgage interest deduction does is put buying for cash and buying with a mortgage on the same footing tax-wise. Since most people can only afford to buy a house if they take out a mortgage, this deduction is what allows them to actually realize the tax advantages of buying over renting.

  83. 83 83 Steve Landsburg

    nivedita:

    What the mortgage interest deduction does is put buying for cash and buying with a mortgage on the same footing tax-wise. Since most people can only afford to buy a house if they take out a mortgage, this deduction is what allows them to actually realize the tax advantages of buying over renting.

    This is absolutely correct.

    The tax code does provide a big incentive to buy instead of rent. But it is not directly the mortgage interest deduction, it is the fact that rent is not tax-deductible for the renter. This makes buying for cash superior to renting, all else being equal.

    Well, the issue is that if you buy, the seller pays tax at the capital gains rate (which in many cases is zero), whereas if you rent, the owner pays tax at the income tax rate. It’s the difference between those two rates that creates the incentive to buy. You can say that this is caused by the tax on rent or you can say that it’s caused by the non-tax (or in some cases lower tax) on the capital gain. So I mostly agree with you, but I wouldn’t have worded it this way.

  84. 84 84 Alan Gunn

    “whereas if you rent, the owner pays tax at the income tax rate.”

    If this were true, you’d have a good argument. But it mostly isn’t. You don’t pay income tax on your receipts, you pay it on taxable income. The owner gets deductions for an imaginary expense, depreciation (including depreciation on basis created by non-recourse financing). That’s why, for much of our history and for some people even today, the rate of tax on income from rental property has been negative, especially for owners with high incomes from other sources. Many of those doctors and other high-income people who paid no taxes until the ’86 act managed it by owning rental property (luxury apartments were big, as were restaurants and office buildings).

    Your analysis of the supposed tax advantage of deduction mortgage interest is absolutely right. But you have gotten the tax treatment of the owner of rental property backward, especially for pre-1986 years. Whatever the explanation for people’s preference for owning over renting, it’s not the tax law.

  85. 85 85 Alan Gunn

    (Afterthought);

    A tax lawyer I know used to propose (pre-1986) that we reform the tax code by making income from owning income-producing real property completely tax exempt. hen he’d try to get his students to figure out who would object. The answer was, “people who owned income-producing real property,” because their deductions would be disallowed as well, so the effective rate of tax on their investments would rise to zero.

    In a sense, the ’86 act did that for passive investors in real estate, though in a roundabout way, by enacting the passive activity loss provisions (as well as by lowering the top marginal rates, making excess deductions less valuable).

  86. 86 86 nivedita

    Steve: Well, the issue is that if you buy, the seller pays tax at the capital gains rate (which in many cases is zero), whereas if you rent, the owner pays tax at the income tax rate. It’s the difference between those two rates that creates the incentive to buy.

    This is not correct. The seller does not pay tax on the sale price of the house, she pays tax on the difference between the sale price and the cost basis for the house (that’s what the gain in capital gain means). The difference in the actual tax rate is a secondary issue.

    Here’s the comparison between buy and rent: Alice builds a house, spending $100k. Bob has $100k, earns $10k/y pretax from other sources, and wants a place to live. Let’s assume interest rates are 5% and the tax rate is 20%.

    Scenario 1: Bob buys the house for $100k. Alice has no capital gain and no tax on the sale. Alice invests the $100k and receives $5k per year, on which she pays $1k per year in taxes, leaving her with $4k post-tax income. Bob earns $10k/y and pays $2k/y in taxes, leaving him with $8k post-tax income.

    Scenario 2: Bob wants to rent. Alice will be indifferent if he pays $5k per year in rent, which gives her the same pre-tax and post-tax income as in Scenario 1. Bob is now earning a total of $15k/y and pays $3k/y in taxes. He pays $5k/y to Alice and ends up with $7k/y post-tax income.

    The government is collecting more tax in Scenario 2, and if the buyer and the seller are otherwise indifferent between a sale or renting, the rental scenario will not happen.

    This changes only slightly if Alice actually makes a profit on the sale. Say it only cost her $90k to build the house, so on a sale she has income of $10k, on which she has to pay $2k in taxes, leaving her with $98k which generates $4900 per year in pre-tax income. Now she’s willing to rent for $4900 per year, but that will still leave Bob with only $7100/y in post-tax income, so buying is still preferred. Buying and renting get taxed the same in this situation only if Alice somehow managed to build the house for free.

  87. 87 87 nivedita

    Ocean @78: I don’t understand what you’re saying.

    Not to speak for Landsburg, but I believe he clearly stated that he in no way believed that renting was better than buying — in spite of some individuals’ respective arguments of the contrary.

    Right, he said renting is on par with buying, and I and some individuals are arguing that it is worse. I think most of us agree that it is not better.

    I think the linchpin of this position is directly connected with the ultimate result being if you own a house, your investment is yours in the form of the property while if you don’t, well, in the end. . . You’ve spent money that you’ll never see again. Whether you rent your home to someone, and you are taxed, or blah, blah, blah. It’s all irrelevant. If you have absolutely nothing to show for your money, buying will always be preferable

    Well, most people would consider having a roof over their head to be quite a sensible use of money. Would you refuse to spend money to buy food to eat on the grounds that, by tomorrow, well, what do you have to show for it..

  88. 88 88 Zero M. Ocean

    @87

    That’s in no way analogous.

    The whole point is that the money spent is going towards a single item. When you buy, your money does not dissipate at the end of the month, or at the end of your lease. It’s far less temporal.

    The point of an *investment* is to transfer the value of your money into something else. If you transfer $1,000.00 of your money into a rent payment, in the long-term I’d argue you’d have been better of with a mortgage: you gain equity, which then can be withdrew, or steadily added (more mortgage payments).

    And in the form of food, if I were to devour the food, I’ve invested in myself. What do I have to show for it? I’ve not starved to death. If I don’t eat the food, I still have food — which is perishable. And, as I think about it. . . is exactly what I mean. If you rent, your investment is far more temporal (perishable). And however you argue it, it’s clearly been stated there’s nothing in our tax code that suggest “tax incentives” offset this.

    Oh, and for the record, I’m not trying to “prove you wrong,” or anything like that. I’m just here for the conversation, friend. If I’ve rubbed you the wrong way, it was unintentional.

    I’m just explaining to you what I see to be the advantage of buying vs renting as an investment. As always, I appreciate your response, your purview and what you have taught me.

    Very Sincerely & Respectfully,

    0

  89. 89 89 Alan Gunn

    @86.

    Sorry to keep repeating myself, but it’s a simple point that people keep ignoring. If Alice rents the house for $5000 a year, her income is not $5000 a year. It’s $5000 a year less depreciation (and less other expenses, but those expenses are matched by cash outlays, so they’re less fun). If Bob buys the house and lives in it, there are no depreciation deductions. So the government will collect less tax in your “scenario 2,” not more. Suppose Alice pays $10,000 cash for the house, taking subject to a $90,000 mortgage. For her 10K (plus deductible interest) she will get $100,000 in depreciation deductions over the life of the house. At the top of the real estate tax shelter game, she’d have been able to write off that $100,000 over 15 years. If the person using a building can’t take or use depreciation deductions, either because the building’s use is personal (housing) or because the user has insufficient income (many businesses), having someone who can take and use depreciation own the building and rent it creates tax deductions, not matched by any cash outlay, that aren’t there if there is no rental. Rental often reduces the total amount of taxable income in the world, by generating deductions that otherwise wouldn’t exist.

    Now, it was never popular to do this with single-family houses, for reasons I don’t understand, though they certainly weren’t income-tax reasons. But it was wildly popular with apartment buildings and business buildings (many businesses rented their buildings, rather than owning them, even one-business buildings). And even today, your effective tax rate on your rent is going to be close to zero, and in some cases negative if you have income from other sources. So it is just wrong to say that the income tax makes buying a building and renting it to people who can’t take or use depreciation inferior to buying it and using it yourself. Owning rental real estate was, and sometimes still is, a tax shelter, not a source of tax liability. Arguments that assume it leads to tax liability are wrong.

    You are right about the gain on the sale of the house being a secondary issue.

  90. 90 90 Steve Landsburg

    nivedita:

    This is not correct. The seller does not pay tax on the sale price of the house, she pays tax on the difference between the sale price and the cost basis for the house (that’s what the gain in capital gain means). The difference in the actual tax rate is a secondary issue.

    Ah. Point taken. Thanks.

    On the other hand, if you rent instead of selling, you don’t pay tax on the rent; you pay tax on the rent minus your (usually considerable) expenses.

  91. 91 91 nivedita

    Ocean @88: they are analogous. To apply your argument to food, you’d say that rather than buying food from someone else (effectively you’re renting the services of a farmer), you’re better off putting that money towards buying a farm.

    Alan @89: right, for the purpose of the simple model I’m ignoring depreciation — it just smells like an unintentional tax shelter to me. In theory, the depreciation should reflect the actual loss in value of the house for it to be fair: i.e. if the house is depreciated to zero after 15y, then really it should be worthless at that point and torn down and rebuilt. If the owner is spending $1k per year maintaining it in the same condition, they should be able to deduct the $1k but not be able to claim any depreciation. I understand the actual tax law doesn’t work that way though.

    I’m curious, what happens after the depreciation period? Do you sell out now, effectively having postponed the taxes for 7.5 years on average, or continue renting the place out?

    Steve @90: real cash expenses don’t matter: if the house requires $1k of maintenance per year for example, either Bob will have to spend it out of post-tax income if he owns, or he’ll have to pay it to Alice on top of his rent, still out of post-tax income. The tax-deductibility to Alice just means she only has to charge the $1k on the rent to cover her cost. If it hadn’t been tax-deductible to Alice, she’d have to charge Bob $1.25k to break even after tax, making renting even worse (though in this case Alice would just open a side business in home maintenance).

    For expenses to make a difference, you’d have to point to expenses that are higher for rentals than for owner-occupied housing. In our abstract “all else equal” model, there are no such expenses. Alan correctly points out that in real tax law, there are other such expenses.

  92. 92 92 nivedita

    In the last para, I should have said expenses for rentals that don’t have to be covered by payments from the renter, really. Like “fake” depreciation.

  93. 93 93 Jimbino

    Steven, you hint that buying a house near were you live is putting your eggs in one basket, running the risk of enhanced loss in a downturn.

    I don’t get it. When two folks marry, they often seek love, sex, friendship, companionship, breeding-options and mutual financial support. That’s really putting your eggs in one basket, as Tiger Woods found out: you can lose the sex, the love, the companionship, the house and the kid in one drunken event, and end up paying alimony and child support besides. So why do folks marry? It seems that the fundamentalist Mormons and the Muslims get it right.

  94. 94 94 BC

    In a sense, before one buys a home, one has an implicit liability for one’s own future housing costs, i.e., one is implicitly short the future rent of the house(s) that one plans to live in. (I’m still debating whether this statement is a framing fallacy, but it seems consistent with the notion that Social Security and pension funds have liabilities as a result of promised benefits. The “beneficiary” in the case of housing is oneself; one is “promising” to not leave oneself homeless.)

    If one accepts this view, then perhaps the reason people buy the homes that they live in is the same reason that they don’t short the homes that others live in. Their optimal portfolio is to have a (close to) zero position in every house, and buying their own house changes their position from short to zero (rather than from zero to long). Supporting this view is the tendency of people to buy homes only if they plan to live in them for a long time. In contrast, if someone plans to live in Boston for only 1 year, move to NYC for the next 2 years, and move to Ann Arbor after that, there is no natural asset that they can buy to offset that particular liability. Also, people tend to buy rather than rent other durable consumer goods like cars and refrigerators whenever such opportunities are available to offset future consumption liabilities. Finally, far fewer people buy homes to rent to others so the affinity for owning houses seems to be limited to one’s own house.

    Having said all that, I am a renter, and I don’t “feel” like I am short housing. Maybe, I am suffering from a framing fallacy.

  95. 95 95 Steve Landsburg

    jimbino:

    When two folks marry, they often seek love, sex, friendship, companionship, breeding-options and mutual financial support. That’s really putting your eggs in one basket, as Tiger Woods found out: you can lose the sex, the love, the companionship, the house and the kid in one drunken event, and end up paying alimony and child support besides.

    These are in fact excellent reasons not to marry, or at least not to marry anyone you care about. They are presumably offset by other (quite different) excellent reasons to marry.

  96. 96 96 CC

    Nobody.really #67 nails it. I might be a little biased since he’s making the same point I am. But he still explains it better.

    It’s funny how many people keep using the word “renter” not realizing how ambiguous this is! It makes reading this stuff confusing.

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