Tax Revision Bill: Experts Predict Some of the Winners and Losers : Refinancing May Shock Homeowners

Jerry Baker, a Westside auto mechanic, is befuddled by all the recent talk about federal tax reform.

“I don’t own an apartment building, I don’t own a vacation home, and I don’t have shares in a real estate partnership,” he says. “The only real estate I own is my home, and I have absolutely no idea how tax reform is going to affect me and my house.”

Baker, 36, is not alone. While volumes have been written about how the legislation recently passed by the Senate and House Joint Conference Committee would affect most other forms of real estate investments, analysts have spent little time contemplating tax reform’s effects on homeowners like Baker.

Overall, experts say, homeowners who don’t have other real estate investments will emerge from the Tax Reform Act of 1986 relatively unscathed. The nation’s most cherished write-off--deductions for mortgage-interest payments--has been spared. So have several other popular housing-related tax breaks.

Curbs on Refinancing

But the bill may also carry some nasty, expensive surprises for some homeowners who have already refinanced their homes or were planning to tap their equity for retirement purposes. It would also put limited curbs on future refinancings, and could limit a home’s appreciation potential.

“From what we understand, tax reform should be a major stimulus for the residential, single-family housing market,” said Lou Piatt, senior vice president of the Beverly Hills-based realty brokerage firm of Jon Douglas & Co. “The single-family home will be the most attractive sheltering opportunity a family can have.”

A key factor in Piatt’s optimism is that families still will be allowed to deduct the interest they pay on their home loans, even though deductions for non-mortgage interest payments will gradually be phased out. Families fortunate enough to own a second home or vacation property will get to write off interest payments on that property, as well.

In addition, Piatt notes, property-tax payments will also remain fully deductible.

On the Downside

The measure also would continue to allow people who sell their home to defer taxes on any profit as long as their new home is worth at least as much as their old one. And people 55 or older who sell their homes without reinvesting their cash will still be allowed to avoid taxes on the first $125,000 of their profit.

On the downside, housing-related deductions will be worth less because most people will be in a lower tax bracket. Under current law, for example, a taxpayer in the 50% tax bracket gets a 50-cent deduction for each dollar paid in interest charges. Under the new law, that dollar would provide the homeowner with no more than a 33-cent deduction--and possibly less.

Tax-writers also put restrictions on the interest deductions consumers can take when they refinance their home. The new code would limit mortgage-interest deductions to the original purchase price of the home, plus the cost of improvements the owner has made since then. The only homeowners exempt from this limitation are those who use the refinancing proceeds to pay for home improvements or educational or medical expenses.

Example of Guidelines

The National Assn. of Home Builders offers this example to show how the new refinancing guidelines work:

A family bought a house in 1978 for $50,000 and has since made $10,000 in improvements. The home’s current market value is $120,000, and the owner wants to refinance it for $100,000. The new law would only allow the family to deduct interest payments on $60,000 of the loan (the original purchase price and the $10,000 in improvements). Interest payments on the other $40,000 wouldn’t be deductible unless that money was used to pay for additional home improvements, educational expenses or medical bills.

This new rule might not seem important, but it could cost many homeowners who have already refinanced their homes thousands of dollars. That’s because the current wording of the refinancing change makes the measure retroactive .

This would particularly hurt longtime owners who have recently refinanced to “tap the equity” they have in their home; these taxpayers may find their interest deductions sharply reduced in coming years.

‘It Could Hurt People’

“We’ll have to see the final wording of the bill and the transition rules before we really know what effect reform will have on homeowners,” said Joe Knott, managing partner in the Los Angeles tax office of real estate consultant Kenneth Leventhal & Co. “Clearly, if the limits (on refinancing) are retroactive, it could hurt people who have already refinanced large amounts.”

Realtor Richard Rosenthal of Venice, president of the California Assn. of Realtors, said the restrictions could prompt some current property owners to sell their home and buy another house.

“Some people who refinanced more than the original purchase price of their home might be encouraged to sell their current house and buy a new one in order to retain their full mortgage-interest deductibility,” Rosenthal explained.

But homeowners who can qualify for a second mortgage will have at least one big advantage over renters. Since non-mortgage interest will eventually be eliminated, homeowners are expected to take out second mortgages on their homes and use the proceeds to pay for consumer goods and services. Since the money comes from a second mortgage, it will remain deductible.

Lenders Could Benefit

Renters, however, won’t be able to pull such a slick maneuver because they have no equity to tap. The deduction for finance charges they incur by buying items on credit will gradually be phased out.

Lenders may wind up being the biggest beneficiaries of the continued deductibility of mortgage-related interest payments. Several institutions already are scrambling to set up checking accounts and credit cards linked to the equity consumers have in their homes, because interest payments on the accounts will still be deductible.

Lenders with similar programs already in operation say inquiries about such “home-equity accounts” are on the rise.

“I think a lot of people have always been interested in borrowing against the equity in their home, but all this tax-reform talk has finally got them to start calling their lender,” said Jerry Weeks, senior vice president of real estate services at Great Western Savings & Loan Assn.

But loopholes aren’t as easy to find in the proposed Tax Reform Act of 1986 as they have been in the past.

Fewer Loopholes

“We’ve been looking for the loopholes, but they’re not as easy to find as they used to be,” said Phil Himelstein, a partner in the Los Angeles-based real estate law firm of Cox, Castle & Nicholson.

Still, accountants say homeowners should already have begun using the tax-reform proposal to do some year-end tax-planning. The experts say there are certain strategies homeowners can adopt to whittle down their tax burden--and that many of those moves should be made before Jan. 1, when most of the provisions in the tax-reform package become effective.

One of the easiest actions homeowners can take is to pay all of their property tax this year instead of paying half of it in 1986 and the other half in 1987.

Homeowners in high tax brackets would benefit most from this strategy. For example, an owner who is currently in a 50% tax bracket and has a $2,000 property-tax bill would effectively pay only $1,000 in taxes if the entire bill is paid before Jan. 1. However, if the bill is paid in installments, deductions for the portion paid in 1987 will be worth less because the owner’s tax rate will have been cut to 28%.

Accelerate Purchases

Homeowners who expect to remodel should consider buying all the materials they need this year because deductions for sales tax will be eliminated in 1987. An owner who buys $5,000 in taxable materials--such as lumber, tools and carpeting--by Dec. 31 will get to write off at least $300 in sales tax. No deduction will be allowed if the purchase is delayed until next year, Leventhal’s Knott said.

Perhaps the most important tax planning involves taxes on capital gains, which are profits from an investment. Long-term capital gains, defined as profits from the sale of an investment that was held six or more months, are currently taxed at a 20% rate. But that preferential treatment will end Jan. 1, when such profits will be taxed at the individual’s personal tax rate of 15% or 28%.

People who can sell their homes for a big profit may wish to sell this year instead of next because the abolition of the favorable capital gains rate means some of them will have to give a bigger chunk of their profit to Uncle Sam.

“But don’t sell your home based solely on tax considerations,” cautioned Knott. “Taxes are important, but they shouldn’t run your life.”

Meanwhile, owners who have sold their home on an installment-sales contract should try to get the buyer to speed up payments this year because those payments will be taxed at the lower capital gains rate.

Residential Property Values

In some cases--particularly if large sums are involved--the previous owner might induce the new owner to speed up payments by trimming the actual amount of the debt. If the tax savings are substantial, they could offset the loss of part of the principal.

Experts are puzzled about the effect the entire tax package will have on residential property values. Those values will not only be affected by the real estate-related portions of the bill, but also by the relative attractiveness of other investment opportunities.

Realtor Piatt, like many other observers, said he expects tax reform to encourage people to buy the biggest home they can afford. “I think people will understand that housing-related deductions will remain safe, but that most other write-offs will disappear,” he said.

If a large number of people start buying bigger homes, the higher-end of the housing market will experience the most upward pressure on prices, some experts say. But others argue that higher-priced homes may appreciate more slowly under the new tax law because potential buyers will find that their mortgage-interest write-offs are worth less.

Changed Forecast

The National Assn. of Realtors, for example, estimates that home prices nationwide should rise by only 4% or 5% annually over the next few years if Congress passes the new tax law. The trade group had originally expected prices to rise 7% or 8%, but changed its forecast because it expects the reduced value of deductions to encourage wealthy people to buy less expensive homes.

Some experts say property values in the low end of the housing market will actually be boosted by tax reform.

“Apartment rents will eventually go up, and renters will lose many of their deductions,” said Corey Patick, chief executive of Gibraltar Community Builders, one of California’s biggest apartment builders.

“People in the lower-income brackets are going to say, ‘I’d be better off buying that $65,000 house instead of renting,’ ” Patick said. “Those lower-priced homes are going to move fast.”