Fiscal Cliff and the Housing Market: What Will Happen With My Rent or Mortgage if We Fall Off the Cliff

In the event Congress cannot reach a consensus to avoid the fiscal cliff, up to $600 billion in expiring Bush-era tax cuts, new taxes, and other fiscal policy measures are likely to shrink the U.S. economy by an estimated 4.0%-5.0%. 

For the housing market, an industry still in recovery, the impact of revised homeownership tax provisions and a recession will likely undo gains made in one of the economy's major arteries. 

U.S. housing starts — the number of new homes on which construction has begun — decreased 3.0% in November after gaining momentum the previous two months. However, November's homebuilders index — the gage of builder confidence in the market for newly built single-family home sales — shined some light on the sector. The National Association of Homebuilders (NAHB) reported confidence among U.S. homebuilders increased to 47% this month, the highest since April 2006.

Failing to avoid the fiscal cliff, many argue, will obliterate the housing recovery before it has the opportunity to gain significant traction.

The housing sector contributes to the U.S. economy in two distinct ways — private residential investment and consumption spending on housing services. With positive gains in home construction and home improvements spending for six straight quarters, policymakers are now focused on preventing another housing market collapse. But what exactly are the homeownership policies at stake as the December 31 deadline approaches? How will a recession further reduce the home values?

Two policies that have encouraged homeownership are being heavily discussed during the fiscal crisis debates:

1. Mortgage Interest Deduction: The largest and oldest housing related subsidy in the U.S. tax code, the Mortgage Interest Deduction "allows homeowners to reduce their taxable income by the amount of interest that has been paid towards their mortgage."  This deduction costs the government roughly $100 billion each year and has been a focal point of tax code negotiations. Policy makers have considered capping the deduction, limiting the number of eligible taxpayers, or eliminating the tax benefit altogether. Yet few subsidies are more fiercely guarded by homeowners, the real estate industry, and homebuilders industry. As noted by Moody's Chief Economist Mark Zandi, "The deduction nevertheless has become ingrained in the psyche of home buyers over generations, and reducing it would have real effects. People account for it when they think about how much house they can afford to buy." 

Bottom line? Eliminate mortgage interest deduction, home prices will weaken.

2. Mortgage Debt Relief Act of 2007: Passed by Congress at the beginning of the housing crisis, the Mortgage Debt Relief Act shields forgiven mortgage debt from taxable income and is set to expire at the end of 2012. This protection can appear in three scenarios: "when a bank modifies a mortgage to reduce the principal; when a borrower sells her home in a short sale and the purchase price is less than the outstanding balance on the mortgage; and when a bank waives the portion of the mortgage balance it couldn't recoup in a foreclosure." The legislation saved borrowers over $1 billion in taxes in 2011, and extending the measure will cost the government $2.7 billion over the next two years, according to the Congressional Budget Office (CBO). Advocates state that allowing the tax break to expire will endanger progress made this year with troubled mortgages. But opponents of the Act describe the provision as a reward for irresponsible financial behavior. 

Bottom line? Allowing the legislation to expire will increase taxable income to individuals struggling with mortgage debt, but may further curb riskier home purchases.

Three hits to housing in the event of a recession:

1. Reduced Home Sales: If this week's home sales data is any indicator, economic uncertainties in 2013 will likely cause individuals to be reluctant to make major purchases, specifically homes. Higher taxes stand to leave potential homebuyers with less available money to spend on real estate, compounding fears that the housing recovery will be reversed. But if the fiscal cliff brings the U.S. economy back into a recession, higher unemployment and lower wages will have the most profound impact on new home sales. 

Bottom line? Lawrence Yun, Chief Economist at National Association of Realtors (NAR) notes, "Home sales and construction activity depend on steady job growth, which we are seeing, but thus far we've only regained half of the jobs lost during the recession." 

2. Increase In Foreclosures: Another major impact of higher unemployment onset by a recession could be an influx in foreclosures. Forbes noted, "fewer jobs could translate into less demand for new homes, possibly even a wave of foreclosure filings as newly unemployed workers struggle to make mortgage payments." The CBO reported that an inability to avoid the fiscal cliff could cost Americans 2 million jobs in 2013 and keep unemployment around 8.0% through 2014. Allowing the Mortgage Debt Relief Act to expire may compound the issue. Homeowners who are selling homes through short sales –  purchasing a home for less than is owed on the existing mortgage – may choose to foreclosure on homes rather than be taxed on the unpaid portion of their mortgage. 

Bottom line? An influx in foreclosures may reverse gains in the housing market and further decrease home prices.

3. Higher Rental Prices: Depressed home prices and low interest rates have made buying a home more affordable, yet stringent mortgage credit requirements have challenged the growth in homeownership. According to Federal Reserve Chairman Ben Bernanke, "overly tight lending standards may now be preventing creditworthy borrowers from buying homes thereby slowing the revival in housing and impeding the economic recovery." As a result, more Americans will continue to stay in the renting market – especially if the country goes into a recession. But supply of rental units has not kept pace with the demand. Rents climbed more than 4.0% in 2012 and NAR estimates that number will continue to increase by at least 4.0% through 2015. 

Bottom line? The Center for American Progress reports, "there could be as many as 2.3 million new renters between 2015 and 2020. The result will be an increasingly tighter rental markets and higher rents for many Americans."

These next few days may impact not only the future of home values, but also the burgeoning confidence in a pillar of our economy. Will the anticipated changes derail the housing recovery?  All eyes are on Congress.