financing residential real estate lesson 4: government policy and real estate finance
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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
The resulting shortfall when the government spends more money than it takes in.
Treasury covers the shortfall by issuing interest-bearing securities.
Spending and debt financing
Fiscal Policy
Federal deficit
The resulting shortfall when the government spends more money than it takes in.
Treasury covers the shortfall by issuing interest-bearing securities.
This borrows money from private sector, leaving less available for private borrowers.
Spending and debt financing
Fiscal Policy
Some economists believe federal deficit has little effect on interest rates.
Others believe federal borrowing pushes interest rates up.
Spending and debt financing
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
Taxpayers allowed to deduct (from taxable income) interest paid on mortgage of home.
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).
Deduction of mortgage interest
Fiscal Policy
Taxpayers allowed to deduct (from taxable income) interest paid on mortgage of home.
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.
Deduction of mortgage interest
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
Homeowners allowed to exclude from taxation a gain or profit on the sale of a principal residence.
May exclude a gain of up to $250,000 (or $500,000 if married and filing jointly).
Gain on sale of a home
Fiscal Policy
Homeowners allowed to exclude from taxation a gain or profit on the sale of a principal residence.
May exclude a gain of up to $250,000 (or $500,000 is married and filing jointly).
Excess is taxed at capital gains rate.
Gain on sale of a home
Fiscal Policy
To qualify, the taxpayer must have owned and used property as principal residence for at least two of the last five years.
Gain on sale of a home
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).
Gain on sale of a home
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.
Gain on sale of a home
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
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
Federal Reserve System
In 1863, Congress passed the National Bank Act.
Established basic banking regulations and procedures for supervising commercial banks.
Historical background
Federal Reserve System
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.
Historical background
Federal Reserve System
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.
Historical background
Federal Reserve System
Federal Reserve Acts of 1913 and 1916 created the Federal Reserve System and established the modern banking system.
Historical background
Federal Reserve 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.
Historical background
Federal Reserve System
The Fed is “lender of last resort,” providing short-term backup loans to banks that run low on funds.
Historical background
Federal Reserve System
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.
Historical background
Federal Reserve System
Federal Reserve System is made up of:
12 regional Federal Reserve Banks in 12 Federal Reserve Districts,
Organization
Federal Reserve System
Federal Reserve System is made up of:
12 regional Federal Reserve Banks in 12 Federal Reserve Districts,
Federal Reserve Board,
Organization
Federal Reserve System
Federal Reserve System is made up of:
12 regional Federal Reserve Banks in 12 Federal Reserve Districts,
Federal Reserve Board,
Federal Open Market Committee,
Organization
Federal Reserve System
Federal Reserve System is made up of:
12 regional Federal Reserve Banks in 12 Federal Reserve Districts,
Federal Reserve Board,
Federal Open Market Committee,
Federal Advisory Council,
Organization
Federal Reserve System
Federal Reserve System is made up of:
12 regional Federal Reserve Banks in 12 Federal Reserve Districts,
Federal Reserve Board,
Federal Open Market Committee,
Federal Advisory Council, and
over 5,000 member banks.
Organization
Federal Reserve System
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
Federal Reserve System
Board of Governors
Governors set reserve requirements for commercial banks and control the discount rate set by the Federal Reserve Banks.
Organization
Federal Reserve System
Federal Reserve Banks
Each district has one main Federal Reserve Bank. Some districts also have branch banks.
Organization
Federal Reserve System
Federal Reserve Banks
Each district has one main Federal Reserve Bank. Some districts also have branch banks.
Owned by member banks.
Organization
Federal Reserve System
Federal Reserve Banks
Each district has one main Federal Reserve Bank. Some districts also have branch banks.
Owned by member banks.
Make discount loans.
Organization
Federal Reserve System
Federal Reserve Banks
Each district has one main Federal Reserve Bank. Some districts also have branch banks.
Owned by member banks.
Make discount loans.
Set discount rates with Board approval.
Organization
Federal Reserve System
Federal Reserve Banks
Each district has one main Federal Reserve Bank. Some districts also have branch banks.
Owned by member banks.
Make discount loans.
Set discount rates with Board approval.
Appoint bankers to Federal Advisory Council.
Organization
Federal Reserve System
Federal Reserve Banks
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
Federal Reserve System
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
Federal Reserve System
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
Federal Reserve System
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
Federal Reserve System
Banks required to maintain percentage of deposits on reserve in own vaults or at the district Federal Reserve Bank.
Reserve requirements
Federal Reserve System
Banks required to maintain percentage of deposits on reserve in own vaults or at the district Federal Reserve Bank.
Varies from 3% to 12%.
Reserve requirements
Federal Reserve System
Depository Institutions Deregulation and Monetary Control Act of 1980 subjected all commercial banks to same reserve requirements as Federal Reserve members.
Reserve requirements
Federal Reserve System
Increase in reserve requirements = decrease in funds available for investment and increase in interest rates.
Reserve requirements
Federal Reserve System
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.
Reserve requirements
Federal Reserve System
The Fed has control over two key interest rates:
federal discount rate, and
federal funds rate.
Interest rates
Federal Reserve System
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 Reserve System
Federal funds rate
Interest rate banks charge each other for overnight, unsecured loans.
Interest rates
Federal Reserve System
Federal funds rate
Interest rate banks charge each other for overnight, unsecured loans.
Banks can borrow funds from other banks to meet reserve requirements.
Interest rates
Federal Reserve System
Federal funds rate
Interest rate banks charge each other for overnight, unsecured loans.
Banks can borrow funds from other banks to meet reserve requirements.
Rate set by banks.
Interest rates
Federal Reserve System
Federal funds rate
Interest rate banks charge each other for overnight, unsecured loans.
Banks can borrow funds from other banks to meet reserve requirements.
Rate set by banks.
Federal Open Market Committee sets target for federal funds rate.
Interest rates
Federal Reserve System
When the Fed raises or lowers either rate, it’s an indication of the overall view of the economy.
Interest rates
Federal Reserve System
When the Fed raises or lowers either rate, it’s an indication of the overall view of the economy.
Lenders often make corresponding changes to the interest rates they charge customers.
Interest rates
Federal Reserve System
When the Fed raises or lowers either rate, it’s an indication of the overall view of the economy.
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
Federal Reserve System
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
Federal Reserve System
The Fed also buys and sells government securities. in transactions called open market operations.
Open market operations
Federal Reserve System
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.
Open market operations
Federal Reserve System
FOMC is the most important policy-making organization in the Fed.
Open market operations
Federal Reserve System
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
Federal Reserve System
Open market operations are the Fed’s primary means of controlling the money supply.
Open market operations
Federal Reserve System
Open market operations are the Fed’s primary means of controlling the money supply.
The money supply:
increases when Fed buys government securities,
Open market operations
Federal Reserve System
Open market operations are the Fed’s primary means of controlling the money supply.
The money supply:
increases when Fed buys government securities, and
decreases when Fed sells government securities.
Open market operations
Federal Reserve System
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.
Open market operations
Federal Reserve System
Monetary policy is experimental, and the Fed changes strategies from time to time.
Changes in monetary policy
Federal Reserve System
Monetary policy is experimental, and the Fed changes strategies from time to time.
During 1970s, the Fed moderated interest rates by increasing money supply when interest rates rose.
Changes in monetary policy
Federal Reserve System
Monetary policy is experimental, and the Fed changes strategies from time to time.
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.
Changes in monetary policy
Federal Reserve System
In 1982, the Fed once again focused on preventing large fluctuations in interest rates.
Changes in monetary policy
Federal Reserve System
In 1982, the Fed once again focused on preventing large fluctuations in interest rates.
Since then, inflation has been moderate.
Changes in monetary policy
Summary
Implementing Monetary Policy
Interest rates Discount rate Federal funds rate Federal Open Market Committee Open market operations Inflation
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