An example of the distortive effects of taxes

This won't be a particularly novel example of the distortive effects of an inconsistent tax code, but I just ran across it in practice, so I found it striking.

Suppose you are going to buy a 4-plex, a building consisting of 4 apartments, for $1M (yes, I live someplace with ridiculously expensive real estate). You wish to live in 1 apartment, and have friends live in the other 3. There are two options: you buy the whole building, and rent out the 3 units, or the 4 of you split the purchase price. Let's look at the costs for the entire group. And let's say the down payment is 10%, leaving a loan of 900K to be paid off over 30 years at $5200/mo.

In the single-owner scenario, the owner will charge $1300/mo to each renter, for a total of $3900/mo in rent. She gets to deduct $5200/mo in mortgage interest, but has to declare $3900/mo in rent, for a net income effect of -$1300/mo, which at a marginal tax rate of 33% is a savings of $429/mo in tax. As a whole, the group pays $5200 - $429 = $4771/mo.

In the multi-owner scenario, each owner pays $1300/mo, for a total of $5200/mo in mortgage interest deductions. At 33% marginal tax rate, that is a savings of $1716/mo, so the total outlay is $3484. The difference is $1287/mo, 27% less than the single-owner scenario.

This is a huge difference, and thus gives a huge incentive to have divided ownership. Without this distortion, the party with the most interest in managing the property and staying there for the long-term could be the only owner. The work of maintaining property would be done by specialists, rather than individuals. People with less capital to invest could wait until they had enough money to have a diversified portfolio of stocks and real estate to buy, instead of putting most of their eggs in the real estate basket. And real estate would, presumably, be less expensive.

Actually, it might make real estate a *lot* less expensive. One of the reasons why real estate is expensive is that it's a "fox in charge of the hen house" setup. Permitting and zoning policies in a region are set by bodies elected by the local voters, who are the local residents and thus usually homeowners, and thus benefit from restricting building and driving up prices. If most properties were rentals, then the voters would be renters, who benefit from loose building codes which encourage a competitive development market and drive down prices. It's possible that the concentrated interests of developers would win out, but on the other hand, while developers get increased value for existing properties by restricting supply, they get to expand their business if they can build. So they have mixed incentives, whereas a homeowner, who can only have one tax-advantaged primary residence, has a pure incentive to increase its selling price.

Share this