financing residential real estate lesson 4: government policy and real estate finance

Financing Residential Real Estate

Lesson 4:

Government Policy and Real Estate Finance

Introduction

In this lesson, we will cover:

federal government’s fiscal policy

taxation

federal government’s monetary policy

Federal Reserve system

tools for implementing monetary policy

Introduction

The government affects real estate finance by influencing the cost of mortgage funds.

The major cost of borrowing money is the interest rate charged by the lender.

Introduction

The government affects real estate finance by influencing the cost of mortgage funds.

The major cost of borrowing money is the interest rate charged by the lender.

Market interest rates = current cost of $

Introduction

The cost of borrowing money is influenced by the federal government in two ways:

1. fiscal policy, and

2. monetary policy.

Introduction

Fiscal policy

Government actions in raising revenue, spending money, and managing its debt.

Monetary policy

Government’s direct efforts to control the money supply and the cost of money.

Fiscal Policy

Set by the government’s executive and legislative branches (President and Congress), who establish federal tax laws and federal budget.

Fiscal Policy

Set by the government’s executive and legislative branches (president and Congress), who establish federal tax laws and federal budget.

U.S. Treasury Department carries out fiscal policy, in managing government finances.

Fiscal Policy

Federal deficit

The resulting shortfall when the government spends more money than it takes in.

Spending and debt financing

Fiscal Policy

Federal deficit


Treasury covers the shortfall by issuing interest-bearing securities.


Fiscal Policy

Federal deficit


Treasury covers the shortfall by issuing interest-bearing securities.

This borrows money from private sector, leaving less available for private borrowers.


Fiscal Policy

Some economists believe federal deficit has little effect on interest rates.

Others believe federal borrowing pushes interest rates up.


Fiscal Policy

Low taxes = more $ to lend and invest

High taxes = less $ to lend or invest

Taxation

Fiscal Policy

Low taxes = more $ to lend and invest

High taxes = less $ to lend or invest

More likely to invest in tax-exempt securities, instead of taxable investments.

Taxation

Fiscal Policy

Taxes also used to implement social policy by providing benefits and incentives, such as:

mortgage interest deductions, and

exclusion of gain on sale of principal residence.

Taxation

Fiscal Policy

Taxpayers allowed to deduct (from taxable income) interest paid on mortgage of home.

Deduction of mortgage interest

Fiscal Policy


Can deduct all interest paid on loans for buying, building or improving 1st and 2nd residences:

Up to $1,000,000 loan total (or $500,000 for married taxpayer filing separately).


Fiscal Policy


Can deduct all interest paid on loans for buying, building or improving 1st and 2nd residences:

Up to $1,000,000 loan total (or $500,000 for married taxpayer filing separately).

Can also deduct interest on home equity loans of up to $100,000.


Fiscal Policy

Homeowners allowed to exclude from taxation a gain or profit on the sale of a principal residence.

Gain on sale of a home

Fiscal Policy


May exclude a gain of up to $250,000 (or $500,000 if married and filing jointly).


Fiscal Policy


May exclude a gain of up to $250,000 (or $500,000 is married and filing jointly).

Excess is taxed at capital gains rate.


Fiscal Policy

To qualify, the taxpayer must have owned and used property as principal residence for at least two of the last five years.


Fiscal Policy

To qualify, the taxpayer must have owned and used property as principal residence for at least two of the last five years.

If married, one spouse must meet ownership test, and both must meet use test.

If only one spouse meets both tests, maximum exclusion is $250,000 (if filing jointly).


Fiscal Policy

Reduced exclusions are allowed under special circumstances when taxpayers have owned the house for less than 2 years.

For example, if home sold because of:

change in health,

place of employment, or

unforeseen circumstances.


Fiscal Policy

Owners of income property are allowed to take cost recovery deductions.

Deduct cost of buildings and property improvements that will eventually have to be replaced.

Cost recovery deductions for investors

Fiscal Policy

Owners of income property are allowed to take cost recovery deductions.

Deduct cost of buildings and property improvements that will eventually have to be replaced.

Cost spread out over number of years, not deducted all at once.

Cost recovery deductions for investors

Summary

Fiscal Policy

Fiscal policy Federal deficit Taxation Deduction of mortgage interest Exclusion of gain on sale of home Cost recovery deductions

Monetary Policy

Government uses its control over the money supply to keep the national economy running smoothly.

Monetary Policy

Monetary policy is set and implemented by the Federal Reserve System (“the Fed”).

Federal Reserve System


In early 19th century, there was little government regulation of depository institutions.

Security of bank deposits depended on the integrity of bank managers.

Historical background


In 1863, Congress passed the National Bank Act.

Established basic banking regulations and procedures for supervising commercial banks.



Economic downturns would lead to financial panics where depositors of a bank would withdraw all of their money at once.

Made even financially sound banks fail.



Economic downturns would lead to financial panics where depositors of a bank would withdraw all of their money at once.

Made even financially sound banks fail.

Public resistant to idea of central national bank.

Losses from panics of 1907 changed public opinion.



Federal Reserve Acts of 1913 and 1916 created the Federal Reserve System and established the modern banking system.



Federal Reserve Acts of 1913 and 1916 created the Federal Reserve System and established the modern banking system.

Reserve requirement

Certain proportion of bank’s deposits must be held in reserve, available for immediate withdrawal on demand.



The Fed is “lender of last resort,” providing short-term backup loans to banks that run low on funds.



Creation of the Fed helped, but did not solve problem of financial panics.

In 1930s, the Federal Deposit Insurance Corporation (FDIC) and Federal Savings and Loan Insurance Corporation (FSLIC) were created to boost depositor confidence.



Federal Reserve System is made up of:

12 regional Federal Reserve Banks in 12 Federal Reserve Districts,

Organization




Federal Reserve Board,

Organization





Federal Open Market Committee,

Organization






Federal Advisory Council,

Organization






Federal Advisory Council, and

over 5,000 member banks.

Organization


Board of Governors

Controls Federal Reserve system.

7 members, appointed by President, confirmed by Senate for 14-year terms.

Chosen from different Federal Reserve Districts.

Chairman chosen for 4-year term from among governors.

Organization


Board of Governors

Governors set reserve requirements for commercial banks and control the discount rate set by the Federal Reserve Banks.

Organization


Federal Reserve Banks

Each district has one main Federal Reserve Bank. Some districts also have branch banks.

Organization




Owned by member banks.

Organization





Make discount loans.

Organization






Set discount rates with Board approval.

Organization






Set discount rates with Board approval.

Appoint bankers to Federal Advisory Council.

Organization



Each bank has 9-member board of directors.

6 directors elected by stockholders.

3 directors appointed by Fed’s Board of Governors.

Directors appoint president of reserve bank, subject to Board of Governors approval.

Organization

Summary

The Federal Reserve System

Monetary policy Federal Reserve System Reserve requirements Lender of last resort Board of Governors Federal Reserve Board Federal Open Market Committee


Fed’s goal is to maintain a healthy U.S. economy.

Economic growth that is too strong or too fast is accompanied by inflation.

Economic growth and inflation


Fed’s goal is to maintain a healthy U.S. economy.

Economic growth that is too strong or too fast is accompanied by inflation.

Inflation = trend of general price increases throughout the economy.

Economic growth and inflation


The Fed relies on three tools to implement its monetary policy and influence the economy:

reserve requirements,

interest rates, and

open market operations.

Tools for implementing policy


Banks required to maintain percentage of deposits on reserve in own vaults or at the district Federal Reserve Bank.

Reserve requirements


Banks required to maintain percentage of deposits on reserve in own vaults or at the district Federal Reserve Bank.

Varies from 3% to 12%.



Depository Institutions Deregulation and Monetary Control Act of 1980 subjected all commercial banks to same reserve requirements as Federal Reserve members.



Increase in reserve requirements = decrease in funds available for investment and increase in interest rates.



Increase in reserve requirements = decrease in funds available for investment and increase in interest rates.

Decrease in reserve requirements = increase in supply of funds and decrease in interest rates.



The Fed has control over two key interest rates:

federal discount rate, and

federal funds rate.

Interest rates


Federal discount rate

Interest rate charged when member of Federal Reserve System borrows money from a Federal Reserve Bank to cover shortfall in funds.

Interest rates


Federal funds rate

Interest rate banks charge each other for overnight, unsecured loans.

Interest rates


Federal funds rate


Banks can borrow funds from other banks to meet reserve requirements.

Interest rates


Federal funds rate



Rate set by banks.

Interest rates


Federal funds rate



Rate set by banks.

Federal Open Market Committee sets target for federal funds rate.

Interest rates


When the Fed raises or lowers either rate, it’s an indication of the overall view of the economy.

Interest rates



Lenders often make corresponding changes to the interest rates they charge customers.

Interest rates



Lenders often make corresponding changes to the interest rates they charge customers.

Some change rates in anticipation of rate changes by the Fed.

Interest rates


Short-term interest rates most affected by changes in discount and federal funds rates.

Long-term interest rates (mortgage rates) don’t respond directly to Fed’s rate adjustments.

Interest rates


The Fed also buys and sells government securities. in transactions called open market operations.

Open market operations


The Fed also buys and sells government securities. in transactions called open market operations.

Conducted by Securities Department of Federal Reserve Bank of New York.

Federal Open Market Committee (FOMC) issues directives for these transactions.



FOMC is the most important policy-making organization in the Fed.



FOMC is the most important policy-making organization in the Fed.

Meets every 6 weeks.

12 members:

7 members of Federal Reserve Board, and

4 other Reserve Bank presidents.



Open market operations are the Fed’s primary means of controlling the money supply.




The money supply:

increases when Fed buys government securities,




The money supply:

increases when Fed buys government securities, and

decreases when Fed sells government securities.



Increased money supply is supposed to lower interest rates.

But other factors can apply pressure on rates.

The Fed uses open market operations and other tools to balance complicated forces.



Monetary policy is experimental, and the Fed changes strategies from time to time.

Changes in monetary policy



During 1970s, the Fed moderated interest rates by increasing money supply when interest rates rose.




During 1970s, the Fed moderated interest rates by increasing money supply when interest rates rose.

After 1979, the Fed tried to control inflation by restricting growth of money supply.



In 1982, the Fed once again focused on preventing large fluctuations in interest rates.



In 1982, the Fed once again focused on preventing large fluctuations in interest rates.

Since then, inflation has been moderate.


Summary

Implementing Monetary Policy

Interest rates Discount rate Federal funds rate Federal Open Market Committee Open market operations Inflation

financing residential real estate lesson 4: government policy and real estate finance

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