By Kevin M                                                        

One of the most compelling reasons for owning a home is the heavily touted tax benefit owing to deductions for mortgage interest and property taxes. Real estate agents will play this benefit for all it’s worth in extolling the idea of homeownership for all.

However for three reasons, this benefit is not what it used to be: a generous standard deduction, low mortgage rates and low marginal tax rates.

The tax benefit of homeownership became an entrenched concept back in the 1970s and early 1980s and at that time it had overwhelming merit. Mortgage rates were in double digits most of the time, marginal tax rates ran as high as 70% and standard deductions were down in the low thousands. Owning a home made major sense even for moderate income earners and was an article of faith in the higher income brackets.

None of that is true today, yet the tax savings pitch remains. Standard deductions can exceed $11,000, interest rates are down around 5% and marginal tax rates cap out at 38% (but are substantially lower for the vast majority of households). Yet the notion of major tax savings remains almost unchallenged.

The rules have changed

The tax code as it stands in 2009 is far more taxpayer friendly than it was back when tax benefits had become one of the holy grails of homeownership.

For 2009 the standard deduction is $11,400 for married filing jointly, $8350 for head of household, and $5700 for single.

Marginal tax rates are as follows:

Married filing jointly:
0 – 16,700 10%
16,700 – 67,900 15%
67,900 – 137,050 25%
137,050 – 208,850 28%

Single:
0 – 8,350 10%
8,350 – 33,950 15%
33,950 – 82,250 25%
82,250 – 171,550 28%

The personal exemption is $3650 per person.

Note also, that the deductibility of tax sheltered retirement plans, health insurance premiums, qualified child care expenses and cafeteria benefit plans reduce pre-tax income and can keep a taxpayer in even lower marginal tax brackets. Every situation must be considered based on the facts of one’s own situation and never generalize.

A working example of the diminished tax benefit

A couple with two dependent children, earning $85,000 per year, is considering purchasing a home for $250,000. They have $50,000 for the down payment and plan to take a $200,000 fixed rate mortgage loan at 5% for the balance. First year interest on the loan will be $10,000 and real estate taxes will be $3000, both of which are deductible for tax purposes. So far, so good.

But when they go to file their income taxes after their first full year in the home, the tax benefit windfall they were expecting yields a stark disappointment.

Mortgage interest……………….$10,000
Real estate taxes…………………..3,000
State income taxes………………..5,000
Charitable deductions…………….2,000
Total itemized deductions……$20,000

Deducting $20,000 in itemized deductions and $14,600 in personal exemptions (4 X $3650) yields a taxable gross income of $50,400, which puts the couple in the 15% marginal tax bracket.

$20,000 in itemized deductions looks pretty appealing at tax filing time, but remember, the IRS was giving this couple $11,400 without itemizing. The benefit of owning the home and itemizing will only apply to $8600 in income (20,000 minus 11,400)!

At the 15% marginal tax rate, this translates into a net tax benefit of only $1290 per year! That’s the equivalent of a $107.50 effective reduction in their monthly house payment.

A $200,000 30 year fixed rate loan at 5% interest will have a payment of $1074 per month. Adding $250 for real estate taxes ($3000 divided by 12 months) and a $75 per month estimate for homeowners insurance gives a monthly payment on the home of $1399. If we deduct the $107.50 per month tax benefit, that produces a net payment of $1291.

Certainly this couple will appreciate the tax savings, but the following questions emerge:

1. Will this tax benefit represent a major reason in favor of purchasing this home?
2. Will the benefit outweigh the higher cost of maintenance that comes with owning a home versus renting?
3. Will it offset the opportunity cost of having $50,000 tied up in a down payment rather than earning interest or investment income?

It gets even worse

If the size of that tax benefit seems surprisingly small, consider that as the loan balance declines, the amount of interest paid will decline in step, further eroding the tax advantage of the mortgage interest deduction.

In addition, since the federal tax code adjusts to ever-present inflation, standard deductions are increased over time, while tax bracket thresholds are increased, gradually reducing the tax benefit even more.

Even if there is a modest tax benefit to owning home in the first few years, it will gradually disappear the longer you’re in the home.

None of this is meant to minimize the potential tax savings from homeownership—a single person with a six figure income for example may realize a substantial advantage. However, the benefit of income tax reduction should be carefully examined by anyone wanting to purchase a home to determine if it’s even relevant in their specific circumstances. For many, many households—perhaps even for the majority—it won’t be.

And other questions you should ask before buying a home!

By Kevin M

Many articles have been written on the buy-verses-rent question, but most of the analysis tends to center on the dollars and cents side of the question. We read about tax advantages, investment potential, home buyer tax credits, income ratios—all important considerations, but all essentially monetary in nature.

Rather than crunching numbers, I’d like to consider the question from a mostly non-monetary angle, and discuss factors which are of at least equal importance in making the decision to buy or rent a home. Most have to do with lifestyles, attitudes and future prospects.

Employment mobility

How stable is your job? That’s a question that probably didn’t need to be asked a decade or more ago, but it’s crucial now. It isn’t just that jobs have become less certain, but also because the ability to profitably flip a house every 3-5 years to follow a new job isn’t an option any more.

People who work in healthcare, education, local government, or who are self-employed in established local businesses have the kind stability that support long term home ownership. Almost ironically, having a successful portable business—one that isn’t dependent on location—can also provide stability.

However, if you’ve found yourself experiencing regular job transfers, extended periods of unemployment or if you work in a location where parallel opportunities in your line of work are rare, renting may be the better option.

Do you have, or plan to have a family?

A family is a major reason to own a home. Room to grow and a sense of permanence can’t be measured in money alone. Even more compelling: if you have—or expect to have—an aging family member to care for in your home, owning will be the better choice.

Activities, hobbies and trades

From a pure financial standpoint, it may be cheaper to rent, but what if you like to work out and have a lot of exercise equipment? You probably won’t be able to store it—let alone use it—if you live in an apartment.

Likewise, you probably will be unable to create a garden, keep more than a single pet or run a plumbing business out of a house that you rent. If you have activities that are an integral part of your life or livelihood, you’re probably better off owning your home, even if it costs more money to do so.

Dead equity

It’s gotten much more difficult to qualify for a mortgage to purchase a home with a minimal down payment. The most basic alternative is a larger down payment, typically at least 20% of the purchase price.

We’re talking $100,000 on a $500,000 house, and that will be dead equity. You won’t be able to tap it for emergencies, investments, to buy a car or to help a sick or struggling relative. (Note: home equity lines are no longer easy to get!)

Do you have sufficient funds available for these contingencies over and above your down payment? Are you OK having most or all of your money tied up in a single asset? If not, renting may be the better option.

Would you buy a house if it didn’t rise in value?

The house price spiral of recent decades has fostered a sense of necessity: buy now or it will cost more later. Simply put, higher prices drove higher prices. Real estate turned into a tangible get-rich-quick scheme forcing us to buy in as early as possible. A house was no longer a home, but an investment, and like all investments, it succumbed to the boom/bust cycle.

If a house won’t be an investment—meaning it won’t be worth substantially more in X number of years—would you still want to buy it?

Life in transition

During my many years in the mortgage business I’d often wonder why a person coming fresh out of college, a divorce or a financial catastrophe would feel compelled to buy a home. I’ve always suspected it had to do with that price spiral discussed above.

Is an immediate home purchase is the right course for newlyweds? I’ve seen a sufficient number of recent marriages break up within the first two or three years, complicated by a house that needed to be disposed of. In today’s market, selling that soon will most likely require the seller to write a check at the closing table.

If you’re in a period of natural transition, such as those listed above, would you not be better off renting until your life becomes more settled?

Repairs, maintenance and remodeling

These are the great variables that most would-be homeowners ignore. Fact: even if your projected mortgage payment is no higher than your current rent payment, it will still cost you more to own a house than to rent. In a typical house, repairs and maintenance can average several thousand dollars per year; periodic remodeling can run in the tens of thousands. Are you prepared for this?

How much do you like your free time?

Repairs and maintenance will cost not only money, but also time. As an owner, you’ll need to maintain your lawn, fix what breaks, shovel snow and handle any chore your landlord is probably doing for you now. Generally speaking, owning means less free time.

If you have a job or business that takes up most of your time, owning your own home could compete with that. Are you a fitness buff? Owning may compete with that as well.

Alternatively, if you have a family, taking care of the home together can be a shared experience, as you maintain and improve the home as a joint venture.

Buy with the intent of paying off your mortgage

The concept is virtually old fashioned, but how many people buy a house with not only the intention, but also a plan for paying off the mortgage ahead of schedule? If your house doesn’t rise in value over the next 10-20 years, the primary investment value of owning will be paying it off to own it free and clear as soon as possible.

Are you committed to doing this?

Buying beneath your means

The real estate industry has done a superb job of convincing home buyers to purchase at the maximum of their ability, or even higher. More than a few homeowners are now facing the fallout of that choice. Alas, deep recessions and house price declines are not only possible but here we are.

When you buy at the maximum of your affordability you deny yourself any flexibility in the event that perfect world assumptions don’t pan out. If possible, purchase a house that’s about 1/3 below your maximum; if you lose your job, you probably will be able to get one that pays 1/3 less than you now make in a relatively short period of time.

In the meantime, you’ll be able to save some money in case that rainy day comes. If it never comes, you may be in a position to accumulate some real wealth, a little at a time!

Are you ready to buy beneath your means? If you aren’t, then ego may be driving your purchase decision more than logic or good sense.

 
Neither owning nor renting is the right choice for everyone, but owning clearly carries greater risks. Have you considered or prepared for those risks?

Can you think of any other non-monetary factors that should be considered in deciding to buy or rent a home?