Some recent responses to my blog posts have questioned whether 2008 is a good time to buy real estate. One person pointed out that people said it was a good time to buy in 2006, and prices have gone down since then. So that buyer made a bad investment?
Not necessarily. People focus too much on appreciation as a basis for evaluating the value of real estate, without thinking of the much more significant tax benefits of home ownership. Let me go over a rough example:
Let's say Bob the Buyer bought a house in 2006 for $500,000, roughly the regional average. He put down $50,000, and took out a 6% mortgage to finance the rest. Let's also say the house has annual taxes of about $12,000.For two years, Bob has made monthly mortgage payments of $2,697, and monthly tax payments of $1,000. You can do your own mortgage calculations here. Each year, those payments total $44,364 ($32,364 for his mortgage, $12,000 for his taxes).
A small part of his mortgage payment goes to pay for the principal, about $5,500 each year in principal, the rest goes to interest. (You can check that here). The fact that the bank loads the interest in the first two years of the payments, though, works in Bob’s favor, because the interest on his home mortgage, and his property taxes, are all tax deductible against his yearly federal and state income taxes. We figure that Bob has to make at least $100,000 to qualify for that loan that he bought, so he has lots of income at the top federal and state rates, blending at about 40%.
What does that mean? Because Bob gets to deduct the interest on his mortgage, and the property taxes on his primary residence, he was able to deduct $38,849 against his income taxes in his first year of ownership. That saves him about $15,539 a year in taxes that he would otherwise have had to pay on that $38,849 in income. He also built about $5,500 in equity in his home.
And he owned that property for two years. So in two years he's now amassed over $32,000 in tax savings as a benefit of home ownership, and about $11,000 in equity. And this year he's going to get another $16,000 or so against his taxes, so he's going to at that point have amassed almost $50,000 in tax savings just from property tax deductions, and another $16,000 in equity. So although his property might have declined in value by $50,000, he's now ahead of the game because of his equity and his tax savings. And his property will eventually start appreciating again, but all the while he's getting these tax advantages.
On top of that, he’s had a place to live for two years. Hopefully, he likes his house, likes his neighbors, his kids are going to a school that he believes in, and he’s got all those other benefits of home ownership.
And, by the way, Bob’s friend Alan decided to rent for the last two years, because he was worried the real estate market was going to go down. So he put that $50,000 in the stock market. He’s got $27,000 left. And he's still renting. How’d that work out for him?
P.S. A couple of clarifications on the above analysis, for nitpickers:
· I rounded some of the numbers, just for ease of use.
· The home interest deduction only applies to mortgage debt of up to $1,000,000, so if Bob was buying a much grander house with a much larger income, he might at some point lose the deductibility of his home mortgage interest.
· I realize that Bob might lose his ability to deduct his home mortgage interest and property taxes if he falls victim to the Alternative Minimum Tax, and all this depends on his other exemptions.
· And I realize that there are other housing-related deductions that I ignored, because they’re much more boring and I didn’t want this to become a treatise.