To appreciate what's at stake for housing in the next few weeks, consider the year just ending, when rising property values were one of the few consistent bright spots in a still erratic recovery.
Home prices rose about 5 percent during 2012, more than reversing the 3.7 percent decline in 2011, buoyed primarily by falling inventories and a modest uptick in housing demand. Meanwhile, housing starts are on track to be up 25 percent this year. At the current rate, housing starts will return to a normal pace of 1.5 million within three years.
“(For the housing market), 2012 has been a breakout year after four years of stagnation,” said Lawrence Yun, chief economist for the National Association of Realtors. “I anticipate this momentum to continue into next year, provided we don’t have fiscal cliff.”
However, the so-called fiscal cliff -- a combination of sharp, sudden tax increases and spending cuts scheduled to simultaneously kick in on Jan. 2, 2013 -- could have the immediate effect of reducing the size of the U.S. economy by around $600 billion, or 4 percent of GDP.
“Our analysis shows that without fiscal cliff, there’s probably going to be 2 million net new jobs next year,” added Yun, which would help support a 10 percent rise in home sales and a 5 percent housing price gain in 2013. “But with fiscal cliff, we’ll see 1 million job losses.”
And by Yun’s analysis, that would mean flat property sales and prices and a new crop of demoralized underwater homeowners who had hoped that in 2013 the value of their houses would rise above the amount they still owe on their mortgages. If President Obama and Congress fail to avert the fiscal cliff, the U.S. economy could fall back into recession, the Congressional Budget Office warned earlier this year. Housing has contracted sharply in every recession but one over the past 50 years; the recession of 2001 was the sole exception.
The negotiations in Washington over the fiscal cliff are approaching the 11th hour. Assuming that this impasse gets resolved, either by Jan. 2 or soon after, there are still further thorny talks in the offing early next year over reform of the tax code, long-term deficit reduction and funding of entitlement programs. Both sets of discussions involve certain tax code provisions that expressly affect homeowners. The way these tax issues are handled and how the agreements get worked out between Obama and, primarily, majority Republicans in the House of Representatives will ultimately impact U.S. GDP growth and directly determine the curve of home prices.
“Housing fell so far that it can remain in an upward trend, even if economic activity slows for one or more quarters,” Michael Gapen, an analyst with Barclays PLC, wrote in a note to clients. This was the case in the first half of this year when the U.S. economy only grew by 2 percent in the first quarter and 1.3 percent in the second, while residential investment rose 20.5 percent and 8.9 percent, respectively.
For the housing sector, three key areas of the negotiations in Washington could extend or extinguish the current recovery.
No. 1: Tax-Deductible Mortgage Insurance Set To Expire
On Jan. 1, this mortgage insurance tax deduction is set to expire, which will raise costs for those who put less than 20 percent down and are required to purchase mortgage insurance. This insurance can be canceled once the equity in the home exceeds 20 percent, which normally happens after a few years of appreciation. But the collapse in home prices since 2008 has left many homeowners far short of the 20 percent threshold; as a result, eliminating the insurance deduction could raise costs for millions.
Borrowers who are single or married and filing jointly with adjusted gross incomes of $100,000 or less can write off 100 percent of their annual mortgage insurance premiums. Married homeowners filing singly can write off 50 percent of premiums. Meanwhile, borrowers with incomes above $100,000 may qualify for partial deductions on a sliding scale.
In many cases, the after-tax savings for these borrowers are significant. New home buyers with an income of around $100,000 and a mortgage of $200,000 save between $600 and $1,000 a year, depending on their credit score and loan-to-value ratio, according to MGIC Investment Corp. (NYSE:MTG), a private mortgage insurer. For households with lower incomes, the effect would be less, depending on their marginal federal tax brackets.
“I don’t think it’s likely that we’ll see the mortgage insurance tax deduction go away, but I think it’ll be much more limited than it is today,” said Rick Sharga, executive vice president at the Santa Ana, Calif.-based Carrington Mortgage Holdings, adding that such a development will have both a short-term and a long-term impact on the housing market.
In the short-term, it will probably prevent some people from entering the market or trade up to a more expensive property. In the long run, it will likely result in prices declining at the upper end of the market, which will have a domino effect on the value of lower-priced properties.
No. 2: Expiration of the Mortgage Debt Forgiveness Act
The Mortgage Forgiveness Debt Relief Act of 2007 was enacted when the housing market imploded five years ago, leaving millions of families suddenly on the verge of losing their homes to foreclosure. Under the law, homeowners are exempted from income tax for the portion of their mortgage that is wiped clean in a foreclosure, short sale or principal reduction. So if a borrower owes $150,000 on his home and sells it for $100,000 in a short sale, he would owe taxes on the remaining $50,000 unless the debt relief act is extended beyond its expiration at the end of this year. For someone in the 25 percent tax bracket, that would mean paying $12,500 in taxes.
Earlier this month, Fitch Ratings warned that eliminating mortgage forgiveness tax provisions act could reduce short sales, in which people sell their homes for less than their loans and owe the bank nothing. These arrangements have been increasingly used to reduce individual debt and enable people to get out of homes they can no longer afford -- and they have contributed significantly to the recovery of housing prices. Roughly a quarter of all home sales are short sales. And in November, Bank of America Corp (NYSE: BAC) reported that some 62,000 borrowers have completed short sales, saving $7.4 billion in debt, or an average of about $120,000 each.
“If (the debt forgiveness act) doesn’t get extended, I think you’ll see a lot less short sales out there, hence much fewer homes on the market,” said John Walsh, the president of Total Mortgage Services in Milford, Conn. “It’s going to lead to more foreclosures and prolong the problem for homeowners who would have been moving on with their lives after short selling their homes.”
“I would be stunned if they don’t extend the debt forgiveness act,” Sharga said.
Reducing the amount that struggling homeowners owe on their mortgages has proven to be a more effective way to prevent foreclosures than other methods, such as reducing interest rates or postponing payments, according to a report by the Amherst Securities Group released in June.
Amherst found that when principal reductions brought mortgages near the home's market value, borrowers were substantially less likely to fall behind on payments again and lose their homes. Only 12 percent of borrowers who received principal reductions re-defaulted in 2011. That's compared with 23 percent of borrowers who received mortgage modifications with interest rate reductions (but no principal reduction) and 30 percent who received forbearance, which postpones their debt repayment.
No. 3: Mortgage Interest Deduction
Not part of the fiscal cliff negotiations, the future of this tax break has already figured prominently in the Presidential election campaign and in debates over how to reduce the nation’s long-term deficits. The Obama-sponsored Simpson-Bowles report on fiscal solutions recommended reducing the limit on the mortgage interest deduction to $500,000 of a mortgage’s value from $1 million, eliminating the deduction for home equity loans and prohibiting people from deducting the interest on a second home. This deduction alone costs the Treasury about $80 billion a year.
According to a study by The Wharton School at the University of Pennsylvania, if the mortgage interest deductions were eliminated completely, the average household’s annual tax bill would increase by a little more than $1,000. However, that number masks the real impact.
Households earning less than $40,000 per year would see their tax bills rise by less than $110 on average -- few of those households itemize deductions and credits on their tax returns and thus gain little benefit from the mortgage interest deduction, and those that do itemize tend to have relatively inexpensive houses.
Households earning between $125,000 and $250,000, by contrast, would stand to lose nearly $2,700 in annual tax savings. And those making more than $250,000 -- who are also potentially subject to deduction caps under some tax reform proposals -- currently save $5,400 per year on average from the mortgage deduction.
“We do not expect immediate changes to (mortgage interest) tax exemptions, but we do anticipate that it will ultimately be part of the grand bargain,” Michelle Meyer, a senior economist at Bank of America Merrill Lynch, wrote in a note. “The high-income households will likely see less favorable exemptions and hence the high-priced housing markets will be the most affected.”
Unless Washington Flops, 2013 Will Be A Good Housing Year
Most economists agree that the housing market is turning into an engine of growth once again.
With continuous help from the Federal Reserve, the average 30-year fixed-rate mortgage is at a record low 3.32 percent. Yun thinks mortgage rates will likely be closer to 4 percent next year -- a level that will still represent a “once-in-a-lifetime opportunity” for many, as long as we have a job-creating environment.
Household formation, arguably the most important factor driving housing construction over the coming years, is picking up: Young people are finally moving into their own homes, as are other Americans who had lived with family or friends.
Since builders do not have perfect foresight, there are periods of overbuilding that are naturally followed by under-building. Based on the historical average of housing starts, an excess 1.7 million homes were created during the real estate boom in the early 2000s, but since 2007, builders have undershot by a cumulative 4.1 million, according to Meyer.
Rental demand is expected to drive housing growth as well.
“Rental units across the country are about 97 percent occupied,” Sharga said. “The bulk of investing in real estate right now is going to individuals and companies who are buying the property and converting them into single-family units to meet that market need for rental units. The market would be recovering without that, but that infusion of capital has accelerated the recovery.”
Housing construction will likely add 0.3 percentage points to U.S. gross domestic product growth in 2012 and 0.4 percentage points to 2013 growth, according to Meyer.
Home prices are forecast to rise 3 percent next year, with average annual appreciation over the next 10 years of about 3.5 percent. An increase in home values lifts household net worth and boosts consumer confidence. If consumers perceive the gain in wealth to be permanent, they will increase their current consumption.
“We are seeing the very early stages of a positive feedback loop between the housing market, credit market and real economy, which can be quite powerful in time,” Meyer said.
Or not. While housing and its related deductions and exemptions are barely uttered publicly in the voluminous fiscal cliff and deficit discussions, the way they are navigated may in the end determine the immediate future for the U.S. economy.