Shocking Tax Break For Landlords Raises Home Prices

[An earlier version of this article appeared on Forbes.com.]

This has to be one of the stupidest tax breaks ever.

The depreciation tax deduction lets landlords (but not homeowners) deduct about 3% of what they paid for their houses from their income each year, essentially treating homes like cars, which famously start to lose value the moment they leave the lot. In real life, houses gain value — appreciate — over time.

Since they pay less in annual federal taxes, landlords can afford to pay a bit more when buying rental houses, which are often smaller properties that would otherwise be purchased by young, first-time buyers. That drives up home prices for millennials and other first-time home buyers.

And artificially high home prices are a drag on the U.S. economy because when people have to spend more money on homes built years or decades ago, they have less money to spend on stuff that people are making today and that create jobs today.

This means the economy grows more slowly because high home prices suck money away from the real economy.

Two Different Tax Systems

We have two entirely different tax systems for homes — the tax system for homeowners and the tax system for landlords. But homeowners and landlords compete against each other to buy the same homes. That means tax breaks for landlords can give them an advantage over people who are buying homes to live in.

In the logic of the business tax system, if you buy paper for your office printer, it’s a business expense, and you deduct the entire cost of the paper from your business income to determine your business profit (and taxes) for the year.

But if instead of buying paper you bought a laser printer, you could only deduct one-fifth of the cost of the laser printer from your business expenses each year for five years. The idea is that the laser printer (and office equipment in general) will last about five years before becoming obsolete and valueless, so you can deduct one-fifth of its cost each of those five years. That is, the laser printer is “depreciated” over five years for tax purposes.

The U.S. business tax code, however, applies that same laser printer logic to rental houses where it doesn’t work at all. In real life, houses appreciate in value; they don’t depreciate in value like office or factory equipment.

Real Tax Deduction For Imaginary Depreciation

The depreciation tax deduction that landlords take on their rental homes is silly.

It lets landlords deduct from their rental income each year roughly 3.6% of what they originally paid for their rental buildings. For instance, if a landlord bought a house and the building was worth $200,000, the landlord could take a tax deduction of close to $7,200 every year for 27.5 years. (The deduction is applied to the value of the building, not the land.)

Because the tax code pretends single-family rental homes depreciate in value each year, landlords pay lower taxes on them each year until they sell the homes.

In reality, U.S. home prices have increased 46% since the bottom of the real estate bubble in 2012, including 108% in San Francisco and 87% in Seattle. The U.S. government, however, taxed landlords as if house values had fallen 22% since 2012.

Depreciation Recapture — Maybe

The depreciation deduction does, however, have an important downside for landlords. It increases the federal capital gains taxes landlords pay when they sell their rentals. Well, sometimes, anyway.

This additional tax on landlords when they sell rental properties is often called “depreciation recapture.” Landlords are supposed to catch up and pay back all the taxes they didn’t pay all the years they took those depreciation deductions.

But there’s a huge loophole in this tax. Landlords can continue to put off paying the depreciation recapture tax if they buy another rental house of equal or greater value whenever they sell a rental house. This bit of tax code magic is called the 1031 Exchange.

The depreciation recapture tax encourages landlords to NOT sell their rental homes, and when they do sell, the 1031 Exchange rule encourages them to buy another rental house at the same time.

And — oh, yeah — if you hold on to your rental houses long enough and you die and leave them to your kids, they won’t have to pay your depreciation recapture tax. The depreciation deduction defers some landlord taxes indefinitely and sometimes permanently.

Two Bads In One Tax Break

If the tax code stopped pretending that homes depreciate and removed this insane tax break, it would benefit millennials and other first-time home buyers in two different ways.

1. Slightly higher annual taxes for landlords would increase their out-of-pocket costs and discourage some speculation.
2. Much lower capital gains taxes for landlords when they sell houses would encourage landlords to sell.

Just by changing WHEN one tax is paid, we can increase the supply of homes for sale in two different ways.

What would happen to the supply of homes for sale if landlords sold some rentals and moved from owning 16% of all single-family homes toward the more traditional 13%? Or what if instead of increasing, ownership by landlords had fallen 3 percentage points to 10%? Would there be a shortage of homes for sale and such high prices today?

Artificially Low Supply

The biggest issue in real estate today is the lack of supply of homes for sale, which is helping to drive up home prices. One small way to increase supply is to get rid of the depreciation deduction, which would eventually make homes less expensive than they otherwise would be.

We saw in the Great Recession how sensitive the entire economy is to home prices. When home prices fall, household net worth tanks because your mortgage debt doesn’t fall when your house value falls. The result was lower household net worth, less household spending and the worst recession since the Great Depression.

Conclusion

Homes are by far the largest part of American family wealth. The government should recognize that fact and treat single-family homes and condos differently than it treats apartments and commercial real estate.

We could start by removing government policies that destabilize home prices and make real estate booms and busts bigger.

It’s true that other government policies are more destabilizing than the landlord depreciation tax deduction, but none are dumber.

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