On April 1st, 2023, Los Angeles enacted a new voter-backed measure that effectively increased transfer taxes on property sales in excess of $5 million. The measure, officially known as Measure ULA but more widely referred to as the “mansion tax,” imposes a 4% tax on property sales valued between $5 and $10 million; and a 5.5% tax on sales valued above $10 million. The proceeds generated from this tax are earmarked for affordable housing and the prevention of homelessness in the city (the population experiencing homelessness has increased by 45% since 2016). The proliferation of taxes based on the value of a home can increase the cost of living across the country, affecting all homeowners (current and future). Understanding how transfer taxes can affect your clients and how best to guide your clients through the blind spots that can occur in response to changes in tax laws can help set you apart as a Financial Professional (FP).
Los Angeles is not the first major metropolitan area to amend transfer tax laws to put more of a tax burden on higher-valued property sales. Both San Francisco and New York City have enacted transfer taxes ranging from 2.25% to 6%. So, while many property owners are not affected by so-called mansion taxes currently, there is reason to believe such tax legislation could be adopted in other areas as the cost-of-living throughout the country increases.
Most of the news around LA’s mansion tax has focused on individuals scrambling to offload their homes before April 1st in order to avoid the new taxes. However, solely focusing on the tax costs ignores the fact that real estate holdings are part of a well-rounded portfolio, and the costs and benefits of ownership or liquidation must be carefully considered by an individual and their FP. While the news headlines focus on a rush to sell, that does not mean this is the best choice for every homeowner. In fact, there are very few people for whom selling because of the tax makes sense.
The costs and benefits of ownership or liquidation must be carefully considered by an individual and their Financial Professional.
A mansion tax can trigger many potential irrationalities in sellers. These can result in sellers selling too quickly or holding onto a property too long—both actions having the potential to negatively impact their long-term financial well-being. So, why might sellers behave this way? And, more importantly, what can FPs do to help their clients avoid an irrational decision that can devalue a client’s entire portfolio? We discuss three common blind spots (and how to help your clients navigate them) below. loss aversion, mental accounting, and time inconsistency.
People hate losses. Psychologically, losses hurt twice as much as gains. For this reason, individuals looking to sell their property would be willing to sell their home for up to 2x less than the possible transfer tax to avoid the associated loss altogether. In other words, they might list a home valued at $5 million for as low $4.6 million just to avoid a perceived loss (if they continued to list at $5 million, they would get $4.8 million net the 4% transfer tax).
What’s worse is this avoidance amount only increases as the value of the property increases. This foregone money is money that could be invested now and converted into large gains in the future, meaning the true cost of loss aversion is even greater than the immediate loss and has long-term negative implications for the individual.
FPs can help clients deal with loss aversion in this arena by pointing out exactly how much they are losing to avoid the transfer tax. Simulations showing the future cost of such a decision can also be helpful to make the future implications of the decision more concrete.
Mental accounting is a descriptive framework for how individuals track their money. This finding was established by Richard Thaler, who won the Nobel Prize in Economics in 2017. Thaler found that individuals partition their monetary inflows (and outflows) into categories, or accounts, and determine whether an investment is good or bad depending on the account’s balance—even though individuals should be considering their wealth and investment decisions more holistically.
An aspect of mental accounting that may be most important here has to with how individuals treat the transfer tax—do they integrate it with the proceeds of the sale, or do they separate it into its own account? Most individuals will separate the tax debt from the gains of the home sale. This is because the tax is seen as something added onto the price after the fact, not as an expected transaction cost, like closing costs. This segregation of the loss creates a large amount of loss aversion. To illustrate, imagine an individual sells their house for $5 million. They now owe $200,000 in transfer taxes and they’ve gained $5 million in their “home account.” If the individual segregates the loss, they see just the large $200,000 debt—the $5 million is separate and already considered part of their overall wealth (or their status quo). Conversely, if the seller integrates the loss into the “home account” and sees the outcome as a $4.8 million gain there is no loss aversion to feel.
As an FP, if selling is right for your client, help them to integrate the transfer tax into proceeds from the sale. Refer to the amount gained inclusive of the transfer tax and reframe the tax as the cost of doing business, rather than an additional charge on top of the normal costs of selling. If holding is right for your client, segregate the loss for them. Separate out the cost of the transfer tax above and beyond other costs so that they do not incorporate it with any potential proceeds from selling. This will focus them on the large immediate loss of selling (in the form of the transfer tax) and make holding more desirable.
Most people value today more than any time in the future. As a result, their present self takes priority over any future version of themselves. This explains why people often fail to stop smoking, go to bed early, or save—all these entail costs now for benefits later, which means the present self’s desires are more important than what the future self may want. This is called time inconsistency because we plan to do things in the future (go to bed early, save for retirement), but then when the time arrives to do those things, we don’t do them (even though we want to!). In the face of a mansion tax, some individuals may be willing to sell at a significantly lower price because less money today is worth more to them, psychologically, than more money later. In other words, $4.6 million before April 1st is more valuable than $4.8 million after April 1st. For many sellers in L.A., before and after was mere days.
If other local governments follow suit with LA, SF, or NYC, FPs will want to help their clients avoid this line of thinking before the taxes go into effect. Remind time-inconsistent clients of their long-term goals and highlight the returns several years from now—longer timelines induce less emotion and diminish the future less (i.e., $200,000 today vs. $500,000 in ten years).
As an FP, it is important to be aware of potential irrationalities your clients may have in times of change and external shocks. Many of these irrationalities are caused by emotions and blind spots, but they also provide an opportunity to have deeper conversations with your clients and help them maximize their financial well-being.