Friday, March 20, 2009

How big a tax advantage do owners have relative to renters?

Bill Wheaton's comment at UCI a few weeks ago continues to haunt me.

Let's ignore financing for a moment (because interest is deductible for both owner-occupants and landlords). According to Morris Davis, Gross Imputed Rent is about 4.6 percent of house value. One is functionally allowed to deduct the value of that income for determining taxes.

The depreciation schedule for rental property is 27.5 years/ straight line, or 3.6 percent of value. Only buildings are depreciable, and in the US, this is about 80 percent of value, so 3.6 percent x .8 = 2.9 percent. Owner-occupants may not deduct operating expenses, while landlords are allowed to do so. Figure this adds another one percent to the deduction. We are at a 4.6 percent deduction for owners, and 3.9 percent for landlords. This is a pretty small difference

But the average owner occupant is almost surely in a lower marginal tax bracket than the average investor in apartments. If the average owner pays a 20 percent marginal tax rate, and the average landlord pays 25 percent, the tax deduction to landlords is actually a little higher than the tax deduction to owners.

Neither owner-occupants nor landlords pay much in the way of capital gains taxes (owner-occupants get a large exemption, while landlords can use exchanges to defer capital gains taxes forever).

The tax treatment of housing still encourages high income people to buy bigger houses than they otherwise might (because the value of the subsidy increases with one's tax bracket), and this is distributionally obnoxious. But given the magnitudes we are talking about, I am guessing the deadweight loss created is pretty small.

I don't think the depreciation allowance for rental housing is unreasonably high: building that are not recapitalized will wear out before age 27.5 (try going without a new roof or furnace for 27 years). So it is not clear to me how the tax code particularly favors housing relative to other investments.


wayronronaldo said...

The value of the subsidy increases with a person’s tax bracket and the tax treatment of housing is encouraging people with high income to buy bigger properties.Smart Tax,Tax Strategies,Smart Tax Strategies, Real Estate Investor, Real Estate,Real Estates Association

Anonymous said...

Landlords are subject to capital gains taxes and recapture, which effectively eliminate most of the previous tax deductions at sale.

Many homeowners pay no capital gains taxes at all, and never pay recapture taxes.

William said...

Are you taking into account that landlords also avoid self employment tax if they are sub s or allowed to treat rent as passive income rather than earned income. Something owner occupants certainly don't get to do. Does the regressiveness of the MID make the argument for getting rid of it for owner occupants.

David Barker said...

Great post, Richard. I gave a problem set in an Urban Econ course a few years ago that asked the same question. The answer was that the federal government collects about the same revenue from a condo owner as it does from an apartment renter plus the apartment owner.

You are right about 27.5 year depreciation, but depreciation is still interesting because it is not a cash expense and it depends on the asset value, not equity. A small investment can generate large tax losses, which a qualifying real estate professional can use to offset a spouse's income or other income.

Ares Vista said...

The fact that many homeowners don't pay capital gains tax really shifts the equation. Landlords have it rough, there's no doubt about it.

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Renters definitely don't lose out when it comes to taxes.

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Unless you have lots of money, the tax man will always catch you.