Real Estate Taxes
For home ownership, taxes are a state thing, not a federal thing. That is, it is the state that you live in that sets the pricing to live there. This idea makes sense – the local guy knows way more about what the market will bear than the tie-wearing bureaucrats in Washington. Okay, the local guy may wear a tie, too, but it is more likely one of these.
So every state has a different system and it’s not worth diving in here to every state, so we’ll just pick on California, which is on the higher end for state real estate taxes. It also has an interesting history worth thinking about, as you dream a little dream for your own picket fence. (By the way, weird that your dream is just about the fence.)
Then along came Proposition 13. Lucky number. Kinda.
A “proposition” is not something necessarily seedy, nor an invitation to enter into the bonds of marriage. It can also be a ballot issue that a group of sponsors have paid lawyers and others to set in front of a population to vote on. In the case of Prop 13, it radically changed the old tax system, and its new ethos was that taxes would be levied:
1.25% of purchase price as the annual tax
An inflation-based increase each year.
At the time, this was a kind of clever and really interesting new system. Housing prices in California had risen at a fast clip (like 10%+ per year, and more in the nicer, urban areas) in the 1970s before this law was enacted for 2 main reasons:
1. Inflation. Everything went up in the ‘70s, from moon rockets to the cost of a half-gallon of milk.
2. Business. Yeah, business was good. High tech. Defense. Telecommunication wars. (In the old days, it cost like a dollar a minute to make a “long distance” phone call to New York. Makes you think twice about wasting your “minutes.”) So lots of companies were hiring and the effect was that home prices rose.
Yet overall, housing prices rose at a meaningfully faster rate than did inflation. So the idea that a flat 1.25% tax could be levied and then rise more slowly than the value of homes seemed like a pretty good idea. It let old people have a “built-in estate” in the form of a home which had a nicely rising value, a mortgage that was likely paid off by the time they were carted off into the old folks home or glue factory, and they could retire with dignity. Assuming they had not yet started wearing their underpants over their slacks.
The new home-buyers bore the brunt of the new burden of the higher home tax. To illustrate, MaryJoe and BillyRae bought their heart-of-Silicon-Valley, Los Altos home for $78,000 in 1980. They would pay 1.25% of $78,000, or $975 a year in taxes. And those taxes would rise with the CPI or inflation each year. So after 20 years, maybe their taxes were something like $2,000 a year. Yeah, they doubled – but over the course of 20 years, so the taxes seemed really cheap by “market” standards.
Then Martha and William bought their home when BillyRae finally bit it and MaryJoe’s marbles were mostly lost as she was wheel-barrowed off by her kids to Pilgrim Haven. (They tricked her into submission by promising her she’d find the rest of her marbles there.) Martha and William paid $2 million and felt that they’d gotten a bargain.
So now Martha and William bear the 1.25% a year tax or $25,000. Yes, you read that right. All of the sudden, the state of California gets a new tax stream on this home of an incremental $23,000 a year. Woot. Well, woot for the state, anyway.
Think about this law and who it harms/helps. Clearly the old people who were likely in less-than-peak financial shape toward the end of their stay in the Los Altos home were helped. They paid vastly below “market” rates in their real estate taxes toward the end. They may no longer have the faculties to realize it helped them, but that’s beside the fact.
But then the new buyers – who are likely already strapped for cash as they stretch to buy the nicest home that they can afford – have a massive incremental tax burden that goes along with their mortgage and other costs of owning a home.
The effect was to put a higher barrier to entry to buying a new home, as this tax system created a lot of friction for new buyers. You can imagine that the California Realtors Association wasn’t too thrilled with this law. They could reasonably argue that the higher tax burdens for early buyers depressed prices. And when prices are depressed, there is no cheering them up. Don’t even bother hiring a clown – you’re just throwing your money away.
But whatever. The law passed. And it exists today.
Oh, and also note that state real estate tax is deductible against federal taxes. So when prices peaked somewhere in the early 2000s and then housing prices went down for a little while, the whole system was thrown into chaos. Someone who paid $2 million for a home was paying $25,000 in taxes on it. But all of the sudden the market value for that home was more like $1.4 million.
Their tax burden was suddenly a huge part of their home ownership costs, and since most people buy their homes with huge loans attached, the burden of that tax was all the more painful. Ever gotten a paper cut under your fingernail? Yeah – even worse than that.
For a typical (if there is such a thing) home that sold for $1 million in 2000 in Silicon Valley (crazy times, yes), the buyer would have likely put as a down payment something like $200,000, and then taken a loan for $800,000. Apply the same down shift in value of 30% and their home is now worth $700,000.
“Glub glub” is the way most writers ascribe the sound of bubbles coming up from deep in the ocean when a diver is vastly under water. We don’t want no glubs.
The homeowner is now paying 1.25% in taxes on the purchase price of $1 million, or $12,500 a year. And they have a mortgage of $800,000 for which they are paying interest of 7%, or $56,000 a year. So there’s $68,500 in costs just to keep their heads above water. That is, these payments don’t even go toward paying DOWN the loan.
And the home is only worth $700,000.
What’s an owner supposed to do? Walk? Give the keys to the bank and say “you own it, Bub; see ya in (Bora)2?” Head to the desert and start looking for a magic lamp? Or do they stay and pay?
Not a good sitch. And we’re not done. The times get rougher.