Policy Proposal: MADRE
In which I make a policy proposal to make homeownership affordable again
Was talking to a friend of mine in real estate today, just two guys shooting the shit. Somehow, I brought up a random idea I put on the comments to a post here on Substack about how we can make homeownership affordable for younger people.
He thought I should actually put it on paper, expand on it, and put it out to the ether for actual consideration. So I’m gonna do just that.
I call it the Make the American Dream Real for Everyone, or MADRE for short.
MADRE Policy Proposal
Basically, we do this by changing the tax code.
Currently, if you sell real estate, you have to pay capital gains income tax on any gains made. If what you sold was your primary residence, then you can exclude $250K if you’re single and $500K if you’re married and filing jointly. And of course, since we’re talking about the tax code, there are all kinds of exceptions and loopholes and such.
In some states and municipalities, you also pay a transfer tax when you sell real estate. Which discourages selling, which means lower inventory of housing on the market, which means higher prices, which means unaffordable housing.
One reason why we have elderly empty-nesters holding on to too-large family homes today is that they don’t want to pay the enormous capital gains taxes. They would rather die and leave the home to their children, who get a one-time step-up in basis, resulting in no or very little taxes due.
Part One: Tax Free Transfer of Real Estate
Under MADRE, step one is to eliminate all taxes on the sale of any residential property. Not just primary residences, but investment properties as well. And by virtue of the Supremacy Clause of the Constitution, MADRE eliminates all local and state transfer taxes on sale of residential real estate as well.
This exclusion from capital gains taxes extends to multifamily properties. As long as the property is residential in nature, it transfers tax-free. That would encourage large apartment operators to consider conversion into condos, which are ideal for young people just starting out in their careers.
Part Two: Punitive Taxes on Rental Income
MADRE encourages selling residential real estate, but the flip side is that MADRE strongly discourages the renting of residential real estate.
I propose an 80% tax on all income derived from a residential rental property; this will include “fees” that are in fact additional rent. I would probably write that clause as “any fee amount in excess of the cost of providing the underlying service” being taxed at the 80% rate. So as an example, if you charge tenants an “Internet Fee” of $100 per month, but it only costs you $15 per unit per month, then the remaining $85 per month is taxed at 80%.
Yes, this is a ridiculous amount. That’s the point. MADRE aims to make landlords an endangered species.
Part Three: Make Purchase Mortgage Income Tax-Free
What completes the program is to make all income from providing purchase mortgages tax-free.
Under the current tax code, interest income is taxed at the ordinary income tax rate. In addition, some wealthier taxpayers are also subject to Net Investment Income Tax. We wipe them both for interest income from purchase mortgages.
It is important that this tax-free status only attach to purchase mortgages, not HELOCs or second mortgages. Because what we want to do is to encourage becoming a purchase mortgage funding provider.
It is also important that this tax-free status should apply to all income taxes: federal, state and local. Again, refer to the Supremacy clause.
Making real estate sales tax-free and making purchase mortgages tax-free happen immediately. The punitive tax on rental income happens in 1-4 years.
This gives current landlords and real estate investors time to unwind their investments in housing, and to reallocate the capital into purchase mortgages.
Granted, there will still be losses because the market would adjust quickly to the new realities, but at least investors are not left holding the bag immediately out the gate and staring at an 80% tax rate.
We can also make the punitive taxes gradual over time so as to provide more time for landlords exit the rental business. There is room for negotiation.
The Expected Outcome
As a general rule of economics, you get more of what you incentivize and less of what you disincentivize. MADRE encourages funding purchase mortgages while strongly discouraging becoming a landlord. It also encourages selling residential real estate, instead of holding on to it.
A Flood of Inventory
The first expected outcome is a lot more inventory hitting the housing market. Seriously, every investor would want to sell their properties as soon as possible.
But it isn’t only investors. Quite a few older people who have been holding on to their primary residences would find it compelling to sell their family homes tax-free to move into a smaller place with lower maintenance costs. That inventory would hit the market.
Replacing Rentals With Seller Financing
We will also see landlords converting rental properties into owner-financed sales. This is an outcome I think is generally positive.
Let’s start with the small landlord — the individual or a family who owns one or two rental properties.
Some 3/4 of rental properties are owned by individuals and most of those are SFR or small apartments (4 units or less). These are not your corporate landlords much in the news these days, but families and retirees who rely on these investments for cash flow.
They could and would convert their rental properties into seller financing investments.
It is very hard to compare net yield on a rental property to net income from a tax-free mortgage, but let’s do a bit of overly simplified math. According to Mashvisor, 7-8% net rental yield would be ideal in a perfect world. Let’s say 7% because you’re a landlord in a perfect world; that’s only 4.2% after tax if you’re in a 40% bracket.
As of this writing, Bankrate says the national average for 30-year fixed mortgage rate is 6.89%. Make that tax-free and our landlord should jump at the chance to become a mortgage lender instead, especially given the typical amortization curve front-loading the interest income.
Say you have a $300K home; 7% net rental yield = 4.2% after tax = $12,600 in annual income.
A $300K mortgage at 6.89% interest rate = $20,573 in Year 1, $20,352 in Year 2, and so on. After 7 years — the average tenure of homeowners these days — you’ve made $140K in interest income. The homeowner either sells the house or refinances the mortgage, which frees up your principal to reinvest into another purchase mortgage. In the meantime, that tenant-homeowner has built up $27K in home equity, which he will take with him after selling. Win-win!
Furthermore, I believe small landlord owner financing would tend to benefit those buyers who have the most trouble qualifying for a traditional mortgage — entrepreneurs, gig economy workers, etc. The landlord should have a good idea of their creditworthiness, since they’ve been paying rent all along, and be far more willing to extend owner financing to such buyers.
Foreclosure would be a pain in the ass… but you know, evictions aren’t exactly a walk in the park either. Whether a landlord or a creditor with foreclosure rights, if things go south, you’re going to have to deal with it. So that’s roughly the same.
Under Dodd-Frank’s “Safe Harbor” provisions, an individual may provide up to three seller-financing mortgages in a 12 month period without needing a mortgage broker license. That’s ideal for individuals and families and small family trusts with 4 or fewer properties. (The bigger companies can go get a mortgage license….)
Obviously, those landlords-turning-into-lenders will need to consult lawyers and such, but I think this is an easily predictable outcome.
A Surge in Mortgage Availability
Partly because of the seller-financing phenomenon, and partly because tax-free returns are always attractive, we should see a significant increase in funding going towards new purchase mortgages.
Big corporate REITs should convert into big corporate mortgage funds, while selling their rental stock into the marketplace.
The combination of increased supply of housing and increased supply of funding for mortgages means we should see housing more and more affordable. Home prices will decline, and mortgage rates will decline: a double whammy for affordability.
That’s the whole point of the policy.
As the great Thomas Sowell says, “There are no solutions; only tradeoffs.” MADRE isn’t all sunshine and roses. There are downsides.
Home Values Drop
According to the Harvard Joint Center for Housing Studies, some 35% of the national housing supply is rentals. That’s just under 44 million housing units, with 28.9 million being multifamily and the remainder single family: 13.1 million detached, 2.9 million attached, and 2.1 million mobile homes.
With MADRE, all of the investors who own these 44 million housing units would want to sell them immediately, before the tax on rental income kicks in.
There is no question whatsoever that unleashing 44 million housing units onto the market will drive prices down. When 35% of the nation’s housing stock comes on the market, prices will go down, period. This is a feature, not a bug.
Those who are homeowners today will see their property values drop. I’m one of those people. I accept it because home values have risen so much over the years (and because I do not view my home as a financial asset, but a place that we live). This is a tradeoff I am willing to make. Others might not. So that’s one downside.
On the other hand, in the tradeoff between buyers and sellers, there truly is no way to make both happy. In our current socio-economic environment, I think it’s time to prioritize buyers and potential buyers.
Negative Fiscal Impact
Since no one has modeled this, and I’m not about to, we don’t know what the impact on tax receipts would be. Sure, the government will take in less in taxes as landlords convert to tax-free mortgage lenders… but it truly is unclear how big an impact we’re talking about here.
We can nonetheless predict that there will be some tax losses from going tax-free on transfers of real estate and tax-free on mortgage income.
I happen to think that will be more than offset by the additional economic activity generated: all those new homeowners will be visiting Home Depot on the regular, buy furniture, pay property taxes and utilities, etc. But there’s no way of knowing, so I do have to count the fiscal tax loss as a downside for .gov people.
An End to the Property Management Industry
A final downside I can think of is that MADRE would exterminate the property management industry. It can’t be helped, since MADRE seeks to make landlords go extinct.
There will be time for those property managers to become experts in owner-financing conversions, or find something else to do. But it really is an unavoidable downside of MADRE.
An Idea Whose Time Has Come
Let me wrap up by saying that I think MADRE is a necessary reform we need to make as a society to make homeownership within reach of most people — especially the younger generations.
It has very few downsides, and the upsides are enormous for all consumers whether landlords, investors, tenants or buyers.
And it will save our social fabric.
Which is why MADRE is unlikely to ever be implemented. That’s a statement on our state of politics and society, rather than a statement on the idea itself.
Then again, you never know. Extraordinary times call for extraordinary measures, and perhaps our policymakers will eventually do the right thing after having tried everything else. That’s an American tradition, as per Sir Winston Churchill.