The Effects of Taxation on Real Estate

by Rob Viglione

Real estate markets are extremely sensitive to tax policy. Changes to either transfer taxes or property taxes can seriously impact valuations, so the serious investor must be familiar with at least the basics. Transfer taxes are what we pay when transactions occur, and are typically based on a percentage of the sales price. Property taxes are annually recurring charged as a percentage of assessed property value.

Generally speaking, higher taxes mean lower property values. Seems fairly intuitive, but what exactly does this mean for a property investor? The National Association of Realtors (NAR) released a study this May quantifying the impacts of marginal increases in both transfer taxes (taxes on the sale/disposal of property) and property taxes (assessed as a % of value). Increasing transfer taxes increases the cost of buying, which drives a percentage of potential buyers out of the market. In California, for example, it is estimated that nearly 80,000 potential buyers would be crowded out of the market by a 1% increase in transfer taxes.

Property taxes are the staple of revenue for local governments, and tend to be the largest non-acquisition cost of ownership. These vary by locality, but in Los Angeles County are 1.25% of assessed property value, charged annually. This translates into hefty recurring bills, especially for new buyers. For instance, 1.25% of $435,000 (the Apr ’08 median home price in Los Angeles County) is $5,438. Per the U.S. Census Bureau’s QuickFacts, 2004 median income for the County was $43,518. Because of the sickly confusing amalgamation of local, sales, state, and federal taxes, let’s just assume a rough 30% net tax on income, which adjusts the median take-home income down to $30,463. On this basis, an inocuous-looking 1.25% property tax translates into 18% of after-tax median income. Granted, income figures were taken from 2004 data and may need upward adjustment, but given modest increases in take home pay over the last four years this is not likely significant.

Financiers undrestand that as you increase the cost of ownership you decrease value. Using discounted cash flow methodologies NAR was able to estimate that for every $1,000 increase in taxes there is a $13K decrease in home values. For properties valued at the median, this means a 3% drop in value for every 0.23% increase in the property tax rate.

When times are good, the economy and asset values are soaring, no one seems to care about government spending hikes. All sorts of noble causes are championed by our noble politicians – everything from education at all costs, to healthcare for everyone – but when the economy turns sour and home prices plummet the inevitable consequence is government deficit. To cover deficits governments must increase taxes now or borrow and increase later. This only further hampers economic recovery. From an investor’s perspective, it’s imperative to understand how government cycles of spend, tax, fall-into-deficit, and tax more impact your bottom line. Keep up to date with your state’s and local municipality’s fiscal condition and anticipate changes to tax policies. Staying ahead of the tax game will give you a sharp advantage over your investor peers, and put you well in front of the pack as far as regular home buyers are concerned.

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