Financing Residential Real Estate Lesson 4: Government Policy and Real Estate Finance

Introduction In this lesson, we will cover: federal governments fiscal policy taxation federal governments 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 Governments direct efforts to control the money supply and the cost of money.

Fiscal Policy Set by the governments executive and legislative branches (President and Congress), who establish federal tax laws and federal budget.

Fiscal Policy Set by the governments 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 1 st and 2 nd 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 1 st and 2 nd 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

In early 19 th 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 banks 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 Feds 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 Feds 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 Feds 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, its an indication of the overall view of the economy. Interest rates

Federal Reserve System When the Fed raises or lowers either rate, its 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, its 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) dont respond directly to Feds 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 Feds primary means of controlling the money supply. Open market operations

Federal Reserve System Open market operations are the Feds 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 Feds 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