Taxes and opportunity costs impact the financial life of owners in ways that have nothing to do with the property. Today we will examine these two features more carefully.
Irvine Home Address … 5 WILDBROOK Irvine, CA 92614
Resale Home Price …… $495,000
{book1}
My strength slips away
Soon I must fall
Victim of fortune
My sources grow small
Life slips away
As demons come forth
Death takes my hand
And captures my soul
Black Magic — Slayer
Today is part 5 finishing the series on Ownership Cost:
Ownership Cost: Income, Payments and House Prices
Ownership Cost: Interest Rates and Downpayment Requirements
Ownership Cost: Property Taxes and Mello Roos
Ownership Cost: Homeowners Associations
Ownership Cost: Taxes and Opportunity Costs
Four Major Variables that Determine Market Price
Over the last four days we looked at the four main variables that determine home price:
- borrower income,
- allowable debt-to-income ratios,
- interest rates, and
- downpayment requirements.
Today we are looking at tax implications and opportunity costs because these number will give you a more accurate measure of the impact home ownership will have on the owner’s financial life.
Taxes
Owning real estate has two significant tax benefits: (1) favorable capital gains tax exemptions and (2) income tax benefit through the home mortgage interest deduction (HMID). Be forewarned that this is not an exhaustive treatise on every permutation in the tax code. I am going to look at the general case the most people will find themselves in.
Capital Gains Taxes
If you own a home more than two years, you can ignore the gains on the first $250,000 or $500,000 if your married. If you don’t make more than $250,000 or $500,000 on the sale — which most people don’t — then you don’t pay any capital gains taxes. It is a tremendous tax advantage that favors capital gains and appreciation.
The reason we have a large deduction or excluded amount is because years ago when there was no exclusion, long-term homeowners would be punished with capital gains taxes when they sold a principal residence when most of that gain was due to inflation. Without a method of adjusting the purchase price basis for inflation (like using the CPI), owners are being taxed on the profits created by inflation. They are getting less than their money back when you consider money’s purchasing power.
Personally, I think it would be a good idea to link the property basis to inflation. An exclusion can be created by linking the basis for the capital gains to the Consumer Price Index, and the tax can be levied on any overage. For instance. If someone purchased a home for $100,000 when the CPI was at 100, then later the property was sold for $300,000 when the CPI was at 200, the tax would be levied on only half the profit:
Adjusted Basis = Original Price times new CPI divided by old CPI
Adjusted Basis = $100,000 * 200 / 100 = $200,000.
$300,000 Resale Price
$200,000 Adjusted Basis
$100,000 Profit subject to Capital gains tax.
This gets around the issue of inflation taxing while taxing irrational exuberance. It will never happen.
The big tax break for capital gains is what makes life as a mid-term flipper possible. There were many people during the bubble who bought with intention of flipping in two years when their gains would not be taxed. Of course, this tax strategy took second place to the pandemonium of the crazy market rally.
Favorable capital gains tax treatment is really a tax-free retirement savings account Uncle Sam worked into the system to benefit homeowners. If you own a property long enough to have capital gains, and the sale of that home represents a significant portion of family savings (which is usually does), the capital gains tax benefit can have significant financial impact on your financial life in retirement.
Income Taxes and the Home Mortgage Interest Deduction
The tax code allows wage earners the ability to give up the Standard Deduction and write off Home Mortgage Interest against their income on Schedule A. If the taxpayer is already itemizing deductions for expenses not related to home mortgage interest, then the taxpayer recieves the full benefit of this deduction.
The deduction is simple. Lenders issue a form 1098 telling a borrower how much interest they paid during the year, and this is put in the tax forms as a deductible interest expense. It does phase out for loans over $1,000,000, and there are exclusions from the deduction, but for most borrowers this is a significant benefit of ownership.
The root of this very popular deduction comes from the need to give owner-occupants the same tax advantages landlords have. Why should landlords get to deduct interest expense and owner-occupants can’t? Whether or not this is justification for the deduction, I don’t know. I do know that it will not be going away any time soon.
Calculating the true tax benefit of owning versus renting
The income tax benefit is calculated in the IHB Fundamental Value Report based on a simple estimation that most buyers will be getting a tax benefit at about 10% lower than their highest marginal tax rate. We base our estimate on two factors: (1) not all of the interest deduction would have been taxed at the highest marginal rate and (2) the loss of the Standard Deduction reduces the value of the home mortgage interest deduction. Anecdotally, when people expert in tax matters have run scenarios with tax software, the 10% reduction in effective tax savings has proven a useful estimate.
Let’s look in more detail as to why this effect happens. Assume a borrower has $50,000 in mortgage interest during a tax year, and this borrower makes about $150,000. For this borrower, the portion over $137,050 is taxed at 28%, and the amount between $67,900 and $137,050 is taxed at 25%, the gross tax savings would be about $12,888 for an effective marginal tax rate of 25.5%. This is the impact of crossing marginal tax rate lines.
Also, to be more accurate, we must subtract the negative impact of giving up the Standard Deduction of $11,400 for a family. If borrowers have $50,000 in deductible interest, but they have to give up $11,400 in tax benefit to get it, the net tax write off is $38,600. Crunching the numbers shows the tax savings is $10,038 instead of the $12,888 people thought they are getting. This reduction in tax benefit due to giving up the Standard Deduction.
When you combine these two effects, a good guide is to take 10% off the borrower’s highest marginal tax rate.
Opportunity Cost
When a buyer puts money into real estate and takes ownership, it changes their financial life. Money for a downpayment had to come out of some other asset even if this is only a savings account or CDs. The place where the money used to be parked either paid interest or provided some return. The interest, dividends or positive change in value of the competing asset is an opportunity cost the buyer must consider.
For instance, a buyer could choose to rent and park their money in a 2-year CD and earn about 2.25%. When someone goes to buy a house, they will take money out of CDs and put it into real estate where it earns nothing — unless prices appreciate. However, when considering the purchase from a cashflow basis, owning the asset can provide a cash return if your cost ownership is less than the cost of renting the same unit. This return is independent of appreciation and provides the only reasonable financial reason to own when prices are flat or declining.
Calculating Opportunity Cost
Projecting future costs is more an art than a science. Trying to estimate the opportunity costs of an average investor over the life of a 30-year mortgage is a guess at best. However, since this opportunity cost is real, there are useful theoretical models for providing an estimate to use in decision making.
Interest rates on savings are tethered to mortgage interest rates as all debt and deposit instruments are tied together in the web of risk and return in the debt market. The loosely correlated relationship between mortgage debt and reliable savings returns like medium-term Certificates of Deposit is the basis for estimating opportunity cost.
When mortgage interest rates are very high, the demand for money is high, and lenders will be paying high CD rates to try to supply the demand for money through loans. The inverse is also true. When lenders do not need money to loan, interest rates fall, and lenders do not need to pay borrowers much for money. Plus, in a deflationary environment the lender has no reliable customers to loan the money to anyway.
This direct relationship between mortgage interest rates and CD rates — irrespective of how loosely correlated they may be — is the basis of my calculation. I make the following assumptions:
- CD Rates will never fall below 1%.
- As mortgage rates go up, CD rates will go up 66% as fast.
When I put in different test numbers, the stretching spreads this formula creates does re-create the same phenomenon that happens in the real world when inflation expectation is added into the market’s thinking.
We have the ability to override our default settings and put in whatever inputs you believe most accurately reflects your financial situation in our reports.
Irvine Home Address … 5 WILDBROOK Irvine, CA 92614
Resale Home Price … $495,000 
Income Requirement ……. $92,146
Downpayment Needed … $99,000
Home Purchase Price … $555,500
Home Purchase Date …. 12/9/2004
Net Gain (Loss) ………. $(90,200)
Percent Change ………. -10.9%
Annual Appreciation … -2.3%
Monthly Mortgage Payment … $2,150
Monthly Cash Outlays ………… $2,820
Monthly Cost of Ownership … $2,130
Redfin Property Details for 5 WILDBROOK Irvine, CA 92614
Beds 3
Baths 2 baths
Size 1,816 sq ft
($273 / sq ft)
Lot Size n/a
Year Built 1980
Days on Market 84
Listing Updated 10/11/2009
MLS Number S584100
Property Type Condominium, Residential
Community Woodbridge
Tract We
According to the listing agent, this listing may be a pre-foreclosure or short sale.
Spacious single level home with formal dining and living room. Open kitchen with a large breakfast nook. Great private yard. Two car garage with indoor laundry. Located in the heart of Irvine in the woodlbridge village that offers, two lakes, pools, and tennis courts.
This short sale was purchased on 12/9/2004 for $555,500. The speculator used a $400,000 first mortgage, a $125,000 second mortgage, and a $30,500 downpayment. On 12/30/2005 he opened a HELOC for $208,000. Total property debt is $608,000. Total mortgage equity withdrawal is $$83,000 including his downpayment.
I don’t know what hoops people are being asked to jump through to get loan modifications, but this owner has dutifully stopped making payments and listed the property for sale.
Foreclosure Record
Recording Date: 07/15/2009
Document Type: Notice of Default
Document #: 2009000378012
I hope you have enjoyed the week of analysis posts here at the IHB. I may not be so ambitious next week. I over did it.
Thank you for reading the Irvine Housing Blog: astutely observing
the Irvine home market and combating California Kool-Aid since
September 2006.
Have a great weekend,
Irvine Renter
😉
Slayer rocks! (even at 5AM)
I wouldn’t place too much faith in the CPI as a true measure of inflation. IMO it is skewed to understate inflation, which of course helps limit entitlement programs like social security.
In fact, I can’t say I agree with capital gains on a sale of a home at all for the average Joe, in light that Joe has been paying property taxes every year while owning said property. Seems like double taxation to me (just like paying sales tax with money that has already been through the income tax machine).
The capital gains tax break is not really all that great for retirement – it depends on you selling your dwelling, for heaven’s sake. THen you get a cap. gains tax break but you’re homeless. It’s only good for feeding the real estate churn.
This place looks nice – what makes it a condo? Is it attached to another similar unit (hence the “1 common wall” in the listing?). With these common walls, can you still crank your stereo/home theater and not disturb the neighbors?
Redfin shows the list price as $565K, where did the $495K price tag come from?
I actually like this (except for the cabinets). I still think there’s a ways to go however; price is high for a condo, and ~$400 for HOA fees are no fun… we’re getting closer to normal. We’re not there yet, but we’re getting there!
Maybe the nice exterior is proof that the $400 HOA fees are well spent.
One more thing I just noticed from the sale history – this sale appears to coincide perfectly with a 5/1 Option ARM. Purchased 12/04… five years later it’s time to get out while you can!
I thought about riding that train when seemingly everyone I knew was doing it (even going back to 2003 when I first started paying attention to what was going on), but the thing that held me back was the thought of “What am I going to do in five years when everyone else doing this decides to sell their homes because they can’t afford the fully-amortizing payment? Won’t that mean lots of homes coming on the market all at once? What will that big inventory of homes on the market do to asking prices?”
It’s annoying to watch banks that would have collapsed a year ago now minting money at taxpayer expense. But that’s the way monetary stimulus always works. Obama knew it as an exchange to get Wall St’s support for running next election.
Also as the price for a relatively gentle deflation. Think what would have happened if not for gov’t intervention – failed banks across the board, mark-to-market, price declines of about 80% in one year in Irvine.
Do you prefer to work the band-aid loose gradually or yank it off?
Yank it! Why prolong the pain? Besides, how is bank failure a bad thing? Banks fail all the time, even in a good economy. The only difference now is that we have zombie institutions (Freddie, Fannie, Ginnie, AIP, CIT, GM, etc etc) pretending to be solvent, propped up with printed paper. All is well! Pay no attention to the man behind the curtain!
Correction…AIP=AIG That’s what I get for posting before my morning coffee. 😉
My fellow Patriots – it is time to shop!
http://www.crackthecode.us/images/I_Want_You_To_Piss_Away_Money.jpg
Love it.
Perhaps the carrot can be replaced with the ever popular KFC bucket?
Popeye’s!
When you click on the address the price is now $565,000. It looks like they raised it from $495 to $565 on October 26. Wow, that’ a big jump. Being a long time Woodbridge resident, the $495 seemed like a good deal to me for that place.
It’s weird how that place is listed as a condo.
It looks like a SFH.
Any reason why it’s listed as a condo?
Has more to do with the legal way of owning then the property.
You own the `air space` of the property and an undivided interest in the land of the community instead of the land and structure outright.
They took that picture at an angle where you don’t see the other condo(s) attached to it. Those condos go up and down W and E Yale Loop, some older, some newer. This one looks very nice on the outside.
They also have a few 2 story models which are quite large.
Absolutely excellent work IR!
How can this be a pre-foreclosure. From the pictures, looks like the property is empty. The owners seems to have left their old CRT TV in the living room though. Free disposal I guess…
Whether or not somebody lives in a property has little to do with it’s foreclosure status.
The govts artificial economy is losing steam. And it’s starting to show in the stock market.
Yesterday’s News:
Dow’s Gain: 199.89 as GDP Wows Wall Street. NEW YORK (TheStreet) — A better-than-expected pop in third-quarter GDP pumped stocks Thursday, making up for losses earlier in the week, while oil marched ahead. <-Bullshit! Today's news: NEW YORK (TheStreet) — A strengthening dollar compounded on earlier profit-taking and a soft consumer spending report, pushing stocks further to the downside. The Dow Jones Industrial Average lost 203 points, to 9760, while the S&P 500 fell 24 points, to 1042. The Nasdaq trailed 42 points, at 2056.
The govts actions of bullshitting the American people is ending. We cannot spend ourselves out of this debacle.
I think equities will lead the next step down in real estate.
IR,
I just wanted to thank you for this week posts. They were extremely informative, and goes deep into the details of home ownership costs. A lot of my friends are now beginning to look for their first home. I am definitely recommended everyone of them to come to this week’s post… its time to see exactly what they would be paying for.
I agree the post was very informative.
However, I felt like I was left hanging waiting for the analysis of lost opportunity money over time. IR mentions being tied to mortgage rates, but other than that how can one determine the value of their money vs. sinking it into home ownership? I guess I was looking for an example to provide some idea as to the magnitude of the lost opportunity.
Thanks!
The lost opportunity is whatever you feel you can make in a competing investment.
I find it interesting that some people believe they should max out their home loan to “free up” investment capital as if they can consistently achieve a higher rate of return than their home mortgage. These are people that would put in an opportunity cost rate higher than the interest rate. Under those circumstances, the cost of your equity is so high that you would rather have a loan. In the real world, people put money into all kinds of investments, but for the sake of comparison, I chose the very conservative return of CDs.
In today’s market, you can tie your money up in real estate, or you can tie it up in 2-year CDs at 2.25%. I suppose you could have put it in the stockmarket in March and had a 66% rate of return, too. I wouldn’t count on that continuing forever.
To be even more accurate, one needs to add the property tax paid as an itemized deduction when comparing to standard deduction. For properties priced low (around $200K or less), it may not been very advantageous to itemize if buyers are a married couple since they already get the higher standard deduction. Disclaimer: Always consult your tax consultant or your trusted tax software 🙂
I stopped reading when you wrote 50K of mortage interest in a year.
Damn, my wife and I make damn good money together, we don’t pay half of that and we’re like scratching our heads trying to figure out how to pay for our kids’s college tuition.
We don’t have fancy cars either.
Sorry, maybe I’ll finish reading this one later…. I just can’t wrap my head about paying so much interest on your mortgage.
Love the Dali though. Salvador was always a shrewd businessman, did you know that? Ever been to Cadaques?
“…we don’t pay half of that and we’re like scratching our heads trying to figure out how to pay for our kids’s college tuition.”
Everybody should be scratching their heads thinking about how they would pay for their kids’ college. Turns out tuition fees are bubble-ized too, thanks, again, to our government. Here’s an excellent article courtesy of Mish:
http://globaleconomicanalysis.blogspot.com/2009/10/remarkable-comparison-affordable.html
I hope our generation really rallies to prevent the credit bubble scamsters from ever operating in our lifetime again.
I recall being told that I was not “smart enough” to understand the value of 125% home loans. Only 60% of my income to mortgage servicing.
The extra 25% was to be used for extra goodies and to pay for monthly mortgage payments until the money ran out or one sold their house a profit. Too bad the “smart” people got trapped with a house under water.
For many, it was best to buy a second house in the down market with the extra money and walk away from the first house.
Only us dumb people are still renting, didn’t party on the loans and are left to pay for the bailouts of the toxic loans.
I think you should talk about transaction costs if you are going to talk about cap gains.
I am looking at my closing statement now on a house I owned for 10 years. Besides the usual relator fees (which total 5%, which is lower off the older 6%) there are escrow fees, title charges, counter transfer taxes, processing fees, etc., etc. THOUSANDS of dollars in transaction fees come off the gain – or add to your loss.
Good point. Do these fees count against capital gains? Say for example if I buy a house for $300,000 and have 2% or $6,000 in transaction fees. When I go to sell my house for $400,000 in ten years, is the capital gain $100,000 or $94,000?
Just to clarify, total cash outflow of the home for the buyer my example would be $306,000. Sale value would be $400,000.
Of course, there are also transaction fees with selling a home, such as commissions. How would this effect the gain figures?