April 14, 2024

by Stephen Stofka

This week I will continue my look at housing, focusing on the dual role of homeowners. There are several advantages to owning a home, one of which is a type of self-imposed rent control. Our mortgage payments are fixed for the term of the mortgage, so we do not have to worry about a 10% rent increase from our landlord. We are the landlord, and we are our favorite tenant. While the mortgage payments remain stable, the maintenance costs for the home do not. The house may need a new furnace, hot water heater, updated plumbing or a new sewer line, major expenses that remind us that we are the owners of an investment property.

In this dual role, a  homeowner takes money out of her right tenant’s pocket each month and puts it in her left landlord’s pocket. As landlord, a homeowner does not report that income nor does she report the mortgage payments and expenses necessary to maintain the property. The Census Bureau estimates that homeowners with a mortgage spend $1900 a month. Those without a mortgage spend about $600.

The federal government calls the difference between this implied income and expenses a net imputed rental income and estimated (pdf link) that the tax exclusion saved homeowners $135 billion in 2023 (p. 22).

What is the average yearly tax saving for a homeowner? The Census Bureau estimated that there are 143 million households with an owner-occupancy rate of almost 65%. That results in 93 million owner-occupied homes, making the tax exclusion worth almost $1500 yearly to a homeowner that is not available to a renter. The tax exclusion is worth much more than average to those with higher incomes and more expensive homes.

When we sell the home, we hope to realize a capital gain from the home in addition to the cash flows we received while we were living in the home. After Congress changed the law in 1997, most homeowners do not have to pay tax on the capital gains from their home, an exclusion estimated at $45 billion in 2023. Real estate property is treated differently than other assets under the tax code, an implicit recognition that property ownership has a value to the community where the property is situated. A house attached to the land by a foundation is immoveable and taxed differently than a moveable asset like a car. In fact, a mobile home is taxed similarly to cars while the land the mobile home sits on is taxed like real estate (Investopedia bulletin).

Some assets provide a series of cash flows while we own them; some do not. In the case of a house, an owner’s implied cash flows start as soon as we take possession of the house. The house provides us with a housing service while we live in it. In the Consumer Price Index (CPI) published each month, the Bureau of Labor Statistics (BLS)  includes a calculation of what it calls owner equivalent rent, OER. This is an estimate of what a homeowner would rent out their home to a stranger. The estimate is based on rental prices for similar units in the area, but the calculation uses survey data that is slightly out of date. Some analysts do not think this implied income should be 25% of the CPI calculation, and the Eurozone countries do not include it in their CPI estimates. Below is a chart comparing the EU method, what is called the Harmonized CPI (FRED Series HICP), and the headline CPI (CPIAUCSL) produced by the BLS each month.

Notice the divergence between the two series starting in 2014. During the financial crisis, homebuilders started  the fewest number of multi-family units per capita in modern history. This laid the foundation for the next crisis, and the pandemic sparked a remote work trend that disrupted the customary supply and demand for housing. In the chart below I have charted the number of multifamily units per capita and highlighted the fallout from the S&L Crisis and the financial crisis.

We can see that the rent of a primary residence and the estimate of OER track each other pretty closely. In the following graph I compare the survey of actual rents to the OER estimate and index it to the beginning of 2014 to illustrate the trends more closely. In 2014, rents (redline) began to grow faster than OER, indicating the pricing power migrating to landlords several years after the financial crisis. In the decade that followed, housing costs grew 50%, an annual growth rate of 4%, higher than the 75-year average of 3.6% or the 30-year average of 3.7% (see notes). Most of the above average growth has been in the three-year recovery from the pandemic.

The cost of housing rises faster than the overall price level and faster than incomes. Homeownership limits the actual impact of rising housing costs on an owner’s budget. A homeowner plays the dual role of landlord and tenant and receives favorable tax treatment of imputed income and capital gains. Given these long-term averages, can a buyer calculate the price they would be willing to pay for a home from its future cash flows? I will look at that next week.

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Photo by krakenimages on Unsplash

Hui Shan (2011) has written a brief history of the tax treatment of housing capital gains and measured the effect of the 1997 tax law on home sales in the Boston area.

Owner’s Equivalent Rent of primary residence in U.S. City Average is FRED Series CUSR0000SEHC01. Rent of primary residence in U.S. City Average is CUUR0000SEHA.

Annual growth rates: Average annual growth rates are calculated over a rolling 10-year period.