The last time the U.S. attempted major changes in the tax code in 1986, it set the stage for a major asset and banking crisis.

With the new tax plan, as income available to service debt falls and the after-tax costs of owning a home rise, property values will fall.

Since real estate asset value underpins the largest component of debt owed to financial institutions and capital markets participants, such disruption – as we saw in the late 80s and again during the global financial crisis beginning in 2008 – can become systemic.



The recently passed Tax Cuts and Jobs Act of 2017 (TCJA) may set off a new systemic financial crisis and push the country back into recession.

Got your attention? Good.

“History does not repeat itself, but it often rhymes,” – often attributed to Mark Twain – and we are about to experience rhyming time. The history in question here involves the last time the U.S. attempted major changes in the tax code in 1986 – trying to pull the tablecloth out from under the table settings without having the plates end up on the floor – and ended with shards of financial glass and china all over the place, in a major asset and banking crisis.

Some thirty years later we now have TCJA, in connection with which Congress is once again attempting the “tablecloth trick,” with what may be similar results.



The plan includes the elimination of tax deductions for state and local income taxes, the limitation of real estate property tax deductions to $10,000 per annum and the elimination of interest deductions in connection with many Home Equity Lines of Credit (HELOCs) and – if the House of Representatives version of the act prevails – restricting ordinary mortgage deductibility to loans in excess of $500,000.



This will have deleterious effects on the disposable incomes of households in the regions of the country accounting for the bulk of mortgage (and other) debt and will make the cost of carrying real estate, on an after-tax basis, significantly greater.

As income available to service debt falls and the after-tax costs of owning a home rise, property values will fall. In fact, property values – even prior to the passage of TCJA – have already stalled out in the highest price states with the highest levels of income and property taxes. There is a reasonable chance that the latest congressional version of tax “reform” will accelerate and exacerbate what is already in the works, to the point of igniting an, arguably at least, unintended disaster.

Given the overall slapdash nature of TCJA, one can hardly help but be surprised, yet I believe this potentially catastrophic rhyme of history is wholly unanticipated by members of both parties.

Here’s what happened last time:

Back in 1986, Congress and the Reagan administration teamed up in a major overhaul of the U.S. tax code. The Tax Reform Act of 1986 (TRA) was generally considered landmark legislation and made a number of substantial changes, many quite beneficial.

From the early days of the Reagan years, through 1986, the commercial and multifamily real estate industry was on a tear (amazing, in hindsight, because the 10 year Treasury yield fluctuated between 7.2% and 15.4% during that period). Most of the explosion in real estate acquisition and construction was driven by the enormous tax advantages conferred on the sector that emerged from the Economic Recovery Tax Act of 1981 and its twin, the Tax Equity and Fiscal Responsibility Act of 1982, allowing even individual investors to wipe out huge chunks of their tax bill by investing in real estate. As a consequence property values rose substantially with demand.

Construction of commercial buildings zoomed from $80 billion per annum in 1980 to over $125 billion per annum in 1985. And with the rise in real estate volumes and values came an enormous bubble in real estate backed debt, growing by 125% during the decade.



Ultimately, the industry became massively overbuilt in quite a few markets and vacancy rates began to rise.

It was clear to most policymakers that the huge tax advantages enjoyed by the real estate industry were not necessary any longer. Accordingly, the TRA pared back depreciation deductions, eliminated some tax credits, and phased out tax deductions to passive individual investors in real estate (among other investments).

As much of 1980s construction and investment was driven by tax benefits, the TRA’s elimination of these tax perks made real estate far less attractive and commercial and multifamily property values fell precipitously over several years, with loan losses accelerating correspondingly.

This led to one-third of all U.S. Savings and Loan failing from 1986 through 1995. Including commercial banks and conventional savings banks, over 2,000 U.S. financial institutions failed during that period. In 1989, Congress established the Resolution Trust Corporation in 1989 to resolve or auction off nearly $400 billion in bank assets over the period. The U.S. economy ultimately fell into recession by 1990 and the real estate industry fell into depression-like conditions throughout the country by 1991.

A direct threat to home values

Bank failures in the US Andy Kiersz/Business Insider The problem, then and now, is that we can’t just change the tax environment surrounding our major financial assets, real estate being by far the largest (totaling some $70 trillion, compared to the value of all public companies which is about $30 trillion) without impacting demand for those assets and, therefore, value. Since real estate asset value underpins the largest component of debt owed to financial institutions and capital markets participants, such disruption – as we saw in the late 80s and again during the global financial crisis beginning in 2008 – can become systemic.

This time, the TCJA is directly threatening the value of homes and the performance of residential mortgage debt, which have only recently semi-recovered from the crisis 10 years ago. (This contrasts with the 1986 act which disemboweled commercial and multifamily property and debt that actually fare well under TCJA)

In particular, the new law is targeting the economies of, and real estate in, the nation’s most expensive and highly taxed states which – not coincidentally – is where the lion’s share of mortgage debt resides.



The ten states with the highest amounts outstanding per mortgage – California, Connecticut, Hawaii, Maryland, Massachusetts, New Jersey, New York, Oregon, Virginia and the State of Washington, have over 46% of the mortgages balances outstanding in the United States – some $4.8 trillion of the U.S. total of $10.4 trillion. All except Washington State are high-income-tax states, averaging over 9% in state and local income taxes, weighted by number of homes. Many are also up there in terms of property tax levels, averaging 1.2% of assessed value per year on a similarly weighted basis.

While there are some potential offsets in TCJA (such as reducing the impact of the alternative minimum tax) the new law could be incredibly disruptive. If a homeowner can no longer deduct state and local taxes, nor more than $10,000/year in property taxes, this could amount to a reduction of disposable cash equal to as much as 5% of gross income ($12,500 per year for a $250,000 earner) in the highest tax states. Given that the above ten states account for an aggregate of 38.4% of U.S. GDP, this could be the equivalent of a reduction in gross demand by as much as $354 billion of GDP (1.9% of U.S. GDP). That is bad enough, of course, but then consider how falling home prices would impact the financial institutions and investors in the mortgage markets, especially if mortgage interest deduction is also pared back. You don’t have to think long, just back to 2007 – 2012.

If someone told you they could pull the tablecloth off your full laden dining room table, would you let them? Well, that’s just what Congress is telling us – be prepared to clean up the mess.