In The News...
Are major tax changes coming?
We got the first glimpse of President Trump's tax plan, and well, it told us a lot while telling us very little. Here are the notable changes:
CURRENT tax structure:
- Income taxes: Today there are 7 different progressive tax brackets, ranging from 10.0% to 39.6%.
- Standard deduction: $6,350 for individual tax filers and $12,700 for married couples who file together.
- Itemized deductions: You can write-off many expenses, such as mortgage interest, donations and medical expenses exceeding 10% of adjusted gross income (AGI).
- Corporate tax rate: 35% for C-Corporations.
- Smaller biz tax rate: Varies for S-Corporation and Sole Proprietorship earnings as they flow through to the individual/family's personal tax rate.
- Federal estate tax: 40% is applied to the value of assets left behind, if taxable estate exceeds $5.5 million.
- Alternative minimum tax: AMT is paid by high-earners who receive what the IRS deems are too many deductions and exemptions.
TRUMP tax structure:
- Income taxes: Reduced to 3 different progressive tax rates of 12%, 25% and 35%.
- Standard deduction: Doubles to $12,000 for individuals and $24,000 for married couples.
- Itemized deductions: Most deductions would be eliminated. Only home mortgage interest and charitable donation deductions would remain.
- Corporate tax rate: Reduced to 20% for C-Corps.
- Smaller biz tax rate: The maximum tax rate assessed on S-Corp and Sole Proprietorship earnings would be 25%, even if family rate is higher.
- Federal estate tax: Estate taxes would be eliminated altogether at the federal level.
- Alternative minimum tax: Similar to federal estate taxes the AMT would be eliminated altogether, without replacement.
- Overseas income: Offshore income is given a one-time "repatriation" to come back to the U.S. at a low tax rate (currently, overseas income is only subject to foreign taxes).
Is the Trump tax plan good or bad? Unfortunately the devil is in the detail, which we do not have. We only heard what amounted to the positive tax changes, not the offsetting tax hikes or spending cuts likely needed to balance out the budget in future years. The argument will be made that economic growth will help subsidize lost tax dollars, channeling the age-old argument that...
Low taxes = More business production = Rising incomes = More gross income tax revenues
Is this true? I won't debate macroeconomics here. Besides, it may be a moot point anyway based on Trump's most probable path to passing tax reform. This path requires showing that his plan does not add to the federal deficit 10 years post-implementation. This refers to the "Byrd Rule", which essentially prevents laws from going into effect that will add to the nation's long-term debt. From what I have researched, Trump and the GOP would have to offset their various tax cuts with other sources of revenue (other tax hikes? budget cuts?) in order to comply with the Byrd Rule in the eyes of a non-partisan reviewer. Economic growth assumptions cannot be used as rationale to pacify the Byrd Rule. But we know darn well Trump will try to argue that, for better or worse.
So will tax reform happen? There is a legitimate chance it will, though like many people I am notoriously cynical and critical of Congress. This particular type of bill would only need a simple majority of 51 votes in the Senate rather than the normal two-thirds majority (60 votes). This has to do with the "reconciliation" clause that allows bills involving revenue, spending or the debt limit to pass with just 51 votes. This is a big deal because it simply means that a tax bill passes so long as all Republican senators approve it, rather than needing all GOP senators plus 8 Democrats to pass the bill. Republicans already control the House of Representatives, so any bill originating in the Senate would likely breeze through the House and quickly become law.
As for ensuring that any tax plan satisfies the Byrd Rule and does not add to the federal deficit 10 years down the road, it appears there are workarounds Republicans can employ. One option would be to sunset certain tax provisions as the 10-year mark approaches. Politically that would give the appearance of the "biggest tax cuts in history" while quietly allowing them to fizzle over time. Apparently this sun-setting technique was used 3 different times to implement tax laws under the most recent Bush administration.
A more likely scenario may be that there are, in fact, massive federal spending cuts or offsetting tax increases coming and Trump would rather let the air out of that balloon much more slowly.
So isn't tax reform a slam-dunk then? Like everything Congress does, it's complicated. Earlier this year Republicans applied reconciliation rules to the health care repeal/replacement. It seems because of that, some Republicans don't want to move forward with taxes until health care is completed. This led to the fumbled health care replacement vote back in July when the GOP could not muster 51 votes because a few Republicans (including AZ Senator John McCain) opposed it. Health care reform is priority to some Senate Republicans, who would prefer addressing that first before turning to tax reform.
(You might wondering... How did the health care bill qualify as a simple majority vote? Aren't the "reconciliation" vote rules reserved for budget-related bills only?
Great question. This is where I found myself digging way too deep into Congressional protocol. The best answer I have is that there is a disconnect between the spirit of the reconciliation rule and how it is used. Although the simple majority vote is technically reserved for budget legislation, many bills - including health care - can be argued to have budgetary consequence. If this is true, it seems like a slippery slope where more and more bills will avoid the normal two-thirds vote requirement over time because, well, what bill does not have budgetary consequences? This is a massive development considering Republicans could effectively pass any bill in the Senate if every one of the 52 GOP Senators are unified in their vote.)
One more roadblock: Additionally, a 2018 fiscal budget is necessary before tax reform can go to vote. While that should be easier since it will only need 51 Senate votes, we know it won't be. Similar to the failed health care vote, there is no guarantee that every Senate Republican will vote for whatever budget or tax plan is proposed. The longer this goes, the more fatigued Congress becomes and the longer everything drags on with little-or-no action. A movie we have seen before...
(Feel free to correct me on any of the above. Some of these procedures were news to me when I researched them this past week.)
In The Market...
The S&P 500 rose +0.7% this past week. Let's look under the hood:
STOCKS: The S&P 500 ended the third quarter with a bang, closing the week, month and quarter at a new all-time high of 2,519. For the week, 9-of-10 sectors were higher, which continues to be bullish entering what is seasonally the best quarter of the year. Our Utilities position was unfortunately the lone loser last week, but only down -0.3%. Our positions in Financials and Technology both outperformed the broad market on the week by a nice margin.
BONDS: Long-term interest rates rose for the third-straight week. As such, conservative bonds slid while high-yield bonds and investment-grade corporate bonds were up mildly. We continue to own investment-grade corporate bonds in most accounts.
We invested the cash we had been previously holding by repurchasing bond funds. One of those, long-term Treasuries (TLT), is one we sold a few weeks back. At that time I posted the following chart here:
The first two notes on the above chart are what I wrote back in late-August. The shaded area highlights the weeks since then, showing how the price has fallen since we sold. We did so believing that Treasury bonds still posed a nice long-term opportunity. With the recent pullback I think bonds could be due to rally again. So we bought them again.
In Our Opinion...
Home prices appreciated +0.7% in July. Here are the notable price changes over the past year:
San Francisco: +6.7%
National average: +5.9%
Seattle continues its reign as the hottest housing market, going on nearly a year now. Portland clings to its spot at #2, just ahead of a slew of major cities. This shows just how wide the gap is behind Seattle and everywhere else.
I often hear people say they will buy in the greater Seattle area when prices come back down. What they need to understand is that not everything that rises quickly in price is a bubble due to burst. I do think Seattle price gains will slow in the next 6-12 months, but prices slowing is far different from prices falling. I think San Francisco is a good reflection of this. Price growth in San Francisco ranks 9th among the 20 major cities in this latest S&P/Case-Shiller Home Price Index, whereas San Francisco was #1 for a very long time and was well ahead of the next-best city much like Seattle is now. I would suspect that Seattle will experience a similar arc.
But even if homes in Seattle appreciate at just 7% or 5% or even 3%, the point is they ARE rising. If you think timing the stock market is tough, good luck with real estate. Housing recessions do not come along often. In fact, 2009 is the only time over the past 60 years where prices definitively dropped. There were instances in the late-60's and early-90's where prices plateaued, but again, we're talking flattened prices not falling prices. I will side with history and say that, if anything, a price plateau is more realistic than a precipitous drop.
Here is a complete look at the monthly housing numbers by market:
In Our Portfolios...
Quick comment in light of potential tax reform coming. If it looks likely that tax reform will happen and that new laws will dramatically impact how your investments are taxed (good or bad), we will work to make any necessary decisions before year-end.
I have not received any questions for a couple weeks. If you have any questions as it relates to financial planning, investing or our process, feel free to ask!
What's New With Us?
I will be trying to stay dry this weekend, with the exception of going to the Seahawks game this Sunday night.
Have a great weekend,
Brian E Betz, CFP®