In The News...

Republican Congressional leaders released details of their tax plan. Here are the major reforms:

Income taxes: The number of tax brackets would fall from the current seven to four: 12% (assessed on taxable income between $24,000 and $90,000 for married couples), 25% (on income from $90,000 to $260,000), 35% (on income from $260,000 to $1 million) and 39.6% (income above $1 million). The most notable change is that the 25% bracket would cover income up to $260,000 for married couples. Today, income that exceeds $153,000 is taxed at 28% and income exceeding $233,000 is taxed at 33%.
401(k) contributions: No changes to contribution limits or deductions.
Small business taxes: A portion of pass-through income from business profits would be taxed at 25% rather than the owner's likely higher personal tax rate.
Mortgage interest deductions: Today you can deduct interest on up to two home mortgages, not exceeding $1 million in mortgage debt. The $1 million limit would be cut in half, meaning you could only deduct interest tied to a maximum of $500,000 in mortgage debt.
Standard tax deduction: This would double to $12,000 for individual tax filers and $24,000 for marries couples.
Personal exemptions: Would be eliminated. Today, you get to deduct $4,000 apiece for you, your spouse and any dependents in your household. So, a family of four would go from $16,000 in exemptions to $0.
Alternative Minimum Tax (AMT): Would be eliminated.

There are more changes, but these are the major ones. For my personal thoughts on this initial GOP tax plan, scroll to the OPINION section below.

New Fed Sheriff In Town: Four years after taking the reigns of the U.S. Federal Reserve, Chairwoman Janet Yellen is being replaced. President Trump's nominee, Jerome Powell, will take over the Fed in Feb. 2018 when Yellen's term expires. Yellen has held the position since 2014. She took over the post from former Chair Ben Bernanke (2006-2014), who in turn took it over from Alan Greenspan (1987-2006).

What does this regime change mean to future monetary policy? Probably not much. From what I have read Powell was a supporter of Yellen and the two were largely in lockstep with regards to the timing of interest rate hikes. I highlight that because among those who have bashed the Fed, the biggest backlash has been how long it took the Fed to begin raising interest rates. While the change in leadership initially seems like no news, remember that this is Trump's appointee. Trump had promised major shake-ups to monetary policy and it appears that will not be the case. In my view that is wise. I am also not surprised at the pivot, either.

Latest on real estate: Housing prices gained +0.5% in August, per the latest S&P/Case-Shiller report. The tide might be turning a bit, as Seattle homes appreciated just +0.2% for the month and Portland homes were up +0.1%. San Francisco was the only of the 20 major cities tracked that saw prices decline, slipping -0.1%.

Annually speaking, homes have appreciated nationwide by an average of +6.1%. Seattle real estate has gained +13.2%, while Las Vegas ranks second with prices rising +8.6%. Here is a complete city-by-city look:

I would expect housing prices broadly to settle in to the +4% to 5% annual growth range in the coming year. That is more representative of a smooth housing market. I would expect prices in/around Seattle to slow a bit as well, meaning prices that rise at a slower pace than the currently torrid +13% growth. Seattle homes should remain near the top compared to the other major cities, given the ongoing tech migration and recent success of Amazon, Boeing and Microsoft.

In The Market...

The S&P 500 gained +0.3% this past week. Let's look under the hood:

Ten months down, two to go. So far 4th quarter seasonal strength I have preached has been as advertised. The S&P index rose +2.3% in October. Staring down the barrel of November and December, here is a recent historical look at how the S&P 500 has performed in these two months, cumulatively (including dividends):

2016: +5.9%
2015: -1.4%
2014: +2.4%
2013: +5.6%
2012: +1.8%
2011: +0.7%
2010: +6.7%
2009: +8.1%
2008: -6.6%

As you see, broad market performance has been positive nearly every year in these two months over the past decade. Coming off a somewhat mixed week, with four of the 10 sectors being in the red, I still believe market conditions look strong moving forward. Next week I will dig into earnings season results, which will begin to wind down.

In Our Opinion...

Among the proposed tax reforms, the most significant may be the slashed mortgage interest deduction. You can currently write-off interest tied to $1 million in mortgage debt. Under this tax proposal that $1 million limit falls to $500,000, meaning a reduced tax deduction if your mortgage exceeds $500,000. Here is what Jerry Howard, CEO of the National Association of Home Builders, had to say about it on CNBC:

"There are seven million homes on the market right now that are more than $500,000. Those houses are automatically going to be devalued." -- Jerry Howard, National Association of Home Builders

Howard went on to say that this would lead to a housing recession, as such depreciation would become contagious and spread across real estate markets. This is a bombshell quote considering the source.

Rather than use $500,000, a more appropriate number to cite would be $625,000. At that purchase price, assuming the home buyer puts the standard 20% down toward the home, the resulting mortgage would be exactly $500,000. If your mortgage balance today is less than this, you are unaffected. If it is more, your tax deduction falls.

But is it that straightforward? Maybe not. First, remember that deducting mortgage interest is part of itemizing your tax deductions, rather than taking the standard deduction. Under this tax plan the standard deduction would double from $6,000 to $12,000 for individuals and $12,000 to $24,000 for married couples. On its surface it appears this would compel more people to take the standard deduction and fewer people to itemize. Let's just see...

Let's assume that your average mortgage balance during the year is $500,000 and the interest rate on that mortgage is 4.50%. That means you would have paid the following in mortgage interest throughout the year: $500,000 x 4.50% = $22,500 in mortgage interest paid.

Is it a coincidence that this is very close to the $24,000 standard deduction for married couples? Probably not. So, in a vacuum, if the only itemized deduction you had was interest tied to a $500,000 mortgage, you would be very close to the break-even point between itemizing vs. taking the standard deduction.

Back to Howard's quote... I disagree that this change would lead to a housing recession, for two reasons. First, if we are talking about residential homeowners, their list of reasons for buying a home likely does not include whether they can deduct all of the resulting mortgage interest. If their list of reasons does include such math, it is probably toward the bottom of their priorities. Existing homeowners will still upgrade into a bigger/nicer home if their life needs it and their finances allow it. First-time home buyers are new to the game and won't know any different.

Second, real estate investors (the other type of buyer) are unique. I would suspect many of them purchase with cash, meaning little-or-no financing. I would further assume real estate investors are already deducting the interest tied to the mortgages on their primary residence, if they have a mortgage at all. If they purchase additional real estate with the help of a mortgage they cannot deduct that mortgage interest today anyway, so reducing the debt limit from $1 million to $500,000 is irrelevant to them.

It is hard to give too much opinion on the overall tax plan because the details are fresh and there seems to be a number of potential tax offsets. I do favor a simpler tax code and like seeing fewer income tax brackets (I have actually long-favored a flat tax). I would be interested to know your thoughts -- feel free to email me with them.

In Our Portfolios...

Q&A/Financial Planning...

Do you know your 401(k) vesting schedule?

Mostly likely not. If you just started a new job or are unsure how long you will stay at your current one, make sure you know the vesting requirements on these employee benefits:

Employer contributions made into your 401k account
Restricted stock (RSUs)
Stock options

"Vesting" means how long you have to wait until you have earned the dollars or shares granted to you. When it comes to restricted stock or stock options awarded to you, the vesting is usually stated pretty clearly on a statement. When it comes to employer 401k contributions, namely the matching provisions, you usually have to dig into the 401k plan summary to know the vesting schedule.

For example, I recently reviewed the new 401k plan for a client who changed jobs earlier this year. He earns a 25% employer match on up to 6% of his pay. So, if he contributes the full 6% that is eligible for the match, his employer effectively contributes 1.5% of his salary into his 401k. Those employer dollars vest in four increments: 25% after 1 year of service, 25% after 2 years, 25% after 3 years and the remaining 25% after 4 years.

This is key because he is not sure if he will be with the company for four years (as most people aren't given how frequently workers change jobs these days). There is value in pointing out what money he would be at risk of losing should he leave at any time within the first four years of employment.

It is common for the quality of the employer match to persuade or dissuade people from participating in the 401k at all. That is for another conversation, but the point here is that if you are spending time evaluating the employer match you better look at the vesting schedule while you are at it.

What's New With Us?

As I mentioned a few weeks ago, I am going to start creating some short, YouTube-like videos that address different aspects of our firm. The first one will be on our investment philosophy and how it compares to traditional long-term investment theory. I'll be eager to get some feedback.

Last weekend it was 70 degrees here in Seattle. Today it is snowing. Go figure...

Have a great weekend,

Brian E Betz, CFP®
Principal

Market & Financial Planning Commentary

GOP Unveils Its Tax Plan. Could It Lead To A Housing Recession?