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
- down payment 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.
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.
When a buyer puts money into real estate and takes ownership, it changes their financial life. Money for a down payment 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 assume 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.