One of the costs of living in the Bay Area, and California for that matter, is that you are much more likely to owe AMT (Alternative Minimum Tax) when you file your personal Federal Tax Returns. Other than an act of congress to change the tax law, there’s not much you can do about it. The silver lining on this cloud has to do with… your mortgage.

The original AMT established in 1970 targeted tax shelters used by a few wealthy households and was greatly expanded in 1986 to aim at a different set of deductions that most Americans receive. The AMT sets a minimum tax rate of either 26% or 28% on some taxpayers so that they cannot use certain types of deductions to lower their income tax obligation. Sounds reasonable, right? I mean, why should people who are making millions of dollars be able escape paying their fair share of income tax!? Well, because of the way the AMT is structured, welcome to the life of the rich and famous!

According to the Congressional Budget Office, “Over the coming decade, a growing number of taxpayers will become liable for the AMT. In 2010, if nothing is changed, one in five taxpayers will have AMT liability and nearly every married taxpayer with income between $100,000 and $500,000 will owe the alternative tax.” That will be over 30 million household.

But why are we Californians affected more than the rest of the population? First, incomes in the Bay Area are statistically higher than the rest of the country. But here is the more specific reason: two of the disallowed deductions through the AMT schedule are state income tax and real estate tax.

As of 2007, the highest rate of state income tax is that of California, with a maximum rate of 10.3%. Under the standard 1040 tax schedule, if you itemize your deductions, you are allowed to deduct what you pay in state income tax. Not so under the AMT schedule. Despite the real estate downturn over the past year, values in many places in the Bay Area have remained stable and are still one of the highest priced areas in the US. Property taxes are often a significant part of one’s housing expense, to the tune of 1.25% per year of the assessed value of your home. This too is excluded under the AMT. So what’s a newly rich & famous person to do?

Generally speaking, the interest that you pay on your mortgage for your home remains deductable under AMT. That’s a bit of a blanket statement, so don’t take it as gospel. I’ve discussed this with the brightest of CPAs and they still will say “well… there may be some other issues”. The point being talk with your CPA or Tax Advisor. Nonetheless, let’s go through an example of how this can remain a tax benefit of having deductable mortgage interest on the AMT.

Let’s say you have a $500,000 qualified mortgage and pay 6% interest (and for simplicity let’s say your mortgage payment is interest only). You would have paid $30,000 of interest over the course of the year. If you are subject to the 26% AMT rate and approximately 10% California tax rate, that $30,000 would give you an approximate $10,800 reduction in your tax liability. This basically means that because of the deduction (even under the AMT), that 6% interest rate is costing you about 3.8% on an after-tax basis. Not bad.

What the moral of the story? Tax Efficiency. In the words of Ben Franklin… “In this world nothing can be said to be certain, except death and taxes.” If you accept that premise, then it would be wise structure your mortgage and money to be tax efficient. It’s not too complicated but it can be complex. For the do-it-yourselfers, run through pro formas on your Turbo Tax or other income tax preparation programs. For the rest of us, get good help from a skilled CPA or tax advisor. You need to do this whenever you are buying, refinancing or messing with your mortgage. You could inadvertently make a move that would eliminate your tax benefits.

Fannie Mae and Freddie Mac were taken over by the US government on September 7th, 2008. This is result of the unprecedented changes that are occurring in the US financial and real estate markets. And there is no doubt at this point that the effects of our liquidity crisis will be felt worldwide. Yet, what does it mean for top 1% income earners that are also consumers of US mortgages? (If you’re wondering, you are in the 90th percentile of income earners if your annual household income is over $150,000; top 1% is above $250,000.) It has been almost two decades since the recession and real estate downturn of the early 1990s brought on by, among other things, the Savings & Loan crises. As we learned back then, top 1% income earners are not immune. I’d like to offer my speculation about the risks and opportunities available in the current volatile marketplace.

In the short term, I believe we will see falling interest rates as the US government touts increased liquidity and the international markets cheer the savior of their large investments in the US mortgage markets. This drop has already occurred as rates fell more than 1/2% in the last couple of days in treasury yields and certain conforming and so-called conforming-jumbo mortgages. This could be positive for a large group people currently holding US properties encumbered with interim fixed period ARM loans that are due to reset in 2009. I believe we are going to see a massive refinancing movement while these rates are low and this may act to lessen the blow of the second wave of foreclosures due to hit the US next year. Rates on many 30 year mortgage products are now at or below 6% which is extremely low in terms of historical averages at 9%. Note that many property owners will still not be able to refinance due to the drop in property values and the lack of their ability to get a satisfactory appraisal, as well as stricter underwriting guidelines. Yet, I think it is safe to say that this second wave of foreclosures is going to be less dramatic than the first wave that was primarily attributed to defaults of sub-prime mortgages. The first crippling wave of foreclosures during 2007 and 2008 was a product of highly risky sub-prime loans done in mass and then abruptly stopped as the markets collapsed.

Yet, it is my belief that unabashed glee is short sided. The takeover will shift Fannie Mae and Freddie Mac’s losses to US tax payers. If you are a taxpaying US citizen who does not own real property, then you are exposed to the financial burden without any of the benefits of owning real estate. Someone will eventually have to pay the piper for these losses and it now appears that this burden will be heaped on top of the US’s national debt that is already staggeringly high. Just like individuals cannot expect to heavily leverage themselves without consequence, neither can governments. Thus I speculate that in order for our government to strengthen its position in the global economy we will need to drastically cut debt and this translates into increased taxes and slashed government programs. We are already experiencing this issue of increasing taxes and reducing government programs at the state level as California once again struggles to pass a balanced budget. An increase in taxes means additional financial pressure that will have to be levied on US citizens at some point in time. This will be a destructive consequence to the US economy.

Now more than ever top 1% income earners who endeavor to capitalize on their existing assets and/or enter the real property markets need superior help. Questions such as whether or not to refinance existing debt, if to sell and/or buy now, trade up, what financial structures are most tax efficient, and so forth, are vital to answer in order to preserve and increase their wealth. The answers to these questions will significantly impact the profitability or loss in your real property transactions, whether for investment or for your personal residence. It is critical that your financial, real estate and tax advisors are able to make powerful interpretations of your current and future situation. When there is a disruption in the marketplace, such as our current economic situation, there is heightened risk and also amplified opportunity. Make sure that your advisors are capable of handling all of your concerns during this turbulent time. If you are looking for financial, mortgage or real estate assistance feel free to contact us for a free initial consultation so we can adequately assess your needs.