The Impact of Rising Interest Rates on Current and Future Homeowners’ Taxes

The pandemic sparked more than just a competitive job market and uncertainty surrounding the economy. In fact, one of the greatest impacts all Americans are facing is rising interest rates in the housing market. Whether your clients are looking to buy a home in the near future or sell their existing home, the interest rate hike impacts the decision-making process, making it essential to understand the current situation, how your clients are impacted, and ways to help them navigate the future.

What is the Current Situation?

Back in January of 2021, interest rates saw unprecedented lows with a rate of around 2.75%. However, since then, the rate has gradually increased to near 6% in June of 2022. In March of 2022, the Federal Reserve Chair Jerome Powell announced that with an 8-1 vote, interest rates would begin increasing to slow down inflation.

Interest rates and inflation are inversely related, meaning as one increases, the other one decreases. In 2020, the annual inflation rate was 1.4% while 2021 rose to 7%. The BLS released the Consumer Price Index comparison between May 2021 and May 2022, which detailed an 8.6% price increase in basket goods.

How are Your Tax Clients Impacted?

There’s no doubt that each of your clients is feeling the impact of rising interest rates and high inflation. Not only is it more expensive to buy daily necessities but purchasing a home has become a more challenging goal. Someone who qualified for a $250,000 mortgage in 2020 may only qualify for $225,000 in 2022 because of the rising inflation rates. Despite the decrease in the purchase price, the monthly mortgage payment will stay the same.

Your clients who are current homeowners most likely have fixed interest rates, so they won’t feel the brunt of the hike as individuals needing new mortgages will. Most homeowners refinanced their existing mortgage when rates were low to take advantage of the decrease in monthly payment; however, new homeowners don’t have that luxury. Clients who are purchasing a house in 2022 and even 2023 can expect to pay more interest, as can clients with floating rate mortgages.

There are tax implications of the rising interest rates that may offset the higher mortgage payment. Certain interest expense, such as qualified residence interest or investment interest, is deductible on Schedule A by individuals who itemize. With the rapid increase in interest rates, your clients may be above the standard deduction threshold, allowing them to utilize mortgage interest to reduce their taxable income. However, new buyers won’t have 12 months of payments in 2022, most likely resulting in an interest expense amount below the standard deduction. Their situation could change in 2023 depending on the amount of interest, but new homeowners shouldn’t count on a large refund in the year they purchase a home. For 2022, the standard deduction is $12,950 for single filers and $25,900 for joint filers.

The housing market boom also affects your clients who receive property as an inheritance. Generally, the cost basis of inherited property steps up to the fair market value on the date of the death. This means that your clients might have a high adjusted cost basis. You will need to keep this in mind as your clients sell the property or make transfers to ensure you are minimizing their capital gains tax burden.

What Does the Future Hold?

The Federal Reserve has no plans to halt the interest rate increases as inflation continues to reach all-time highs. As recently as June 15, the Federal Reserve hiked interest rates by 0.75 percentage points, which is the largest hike since 1994 (Blank, PBS). Economists are predicting another interest rate hike as large as 1% by the end of July 2022, highlighting an uncertain future for your current and future homeowner clients.

Homes are becoming more expensive to purchase, reducing competition for your clients looking to purchase a home. However, their purchasing power has decreased and may need to be supplemented with additional cash upfront. When clients ask you about the implications of interest rates on their purchasing power, be sure they adequately plan for infusing additional cash to close the purchase without counting on a large tax refund or extra funds from government relief.

Clients who secured mortgages before the interest rate hike should take into consideration the purchasing power after they sell their home. Selling their home in the housing market boom seems like a great idea; however, if they plan on purchasing an additional home, they will be forced to secure a home with a higher interest rate. On the other hand, clients who are still looking for a home should consider the consequences of rising interest rates and plan accordingly. Interest rates aren’t likely to remain high forever, meaning they can refinance down the road, but they must be able to support the higher monthly mortgage payment in the meantime.

There’s no concrete evidence supporting how long the Federal Reserve Plans to keep interest rates high, especially with the uncertainty surrounding economic and political events. If the pandemic taught the world anything, it’s that unexpected events can occur at any time. As a result, taking a defensive stance is always advised for your clients. The higher cost of living with high inflation rates make purchasing a home a tricky decision with pros and cons on each side.

Summary

The interest rate hike has a direct impact on your tax clients, from lower purchasing power to higher potential tax deductions. The burden of navigating your clients through the tax implications of these uncertain times falls on you as a CPA or Enrolled Agent.

Sources

Attia, Basmalla. “Federal Reserve announces first interest rate hike.” The Ticker, 25 March 2022. Accessed 19 July 2022.

Blank, Brian. “Analysis: What the Fed’s largest interest rate hike in decades means for you.” PBS, 16 June 2022. Accessed 19 July 2022.

Miller, Peter. “Mortgage rates chart: Historical and current rate trends.” The Mortgage Reports, 15 July 2022. Accessed 19 July 2022.

U.S. Bureau of Labor Statistics. “TED: The Economics Daily.” U.S. Bureau of Labor Statistics, 14 June 2022. Accessed 19 July 2022.

By Jerry Brune, CPA, EA
Brune Accounting & Tax Service in Bolingbrook, Illinois
University of Illinois Tax School Instructor