Reinventing residential real estate in Silicon Valley with $275 million in sales in 2011

By Ken DeLeon ©2011, U.C. Berkeley Law Degree and Real Estate Broker

 

The many tax and financial advantages of home ownership make it your greatest as well as your largest investment.  This article discusses these advantages so you can maximize your investment and also compares investing in your home versus stocks, clearly illustrating that purchasing your home is the better choice.  For any particular tax questions you should consult your accountant.

 

 

A.  $500,000 Capital Gains Exemption - The “Tax reform act of 1997” provides a $500,000 exemption on capital gains tax on your home for married couples and $250,000 for individuals.  With the federal long-term capital gains tax rate at 15% and California capital gains taxed as regular income (generally at 9.3%), this nearly 25% savings can mean a tax savings of just under  $125,000 on a $500,000 gain.

 

This rule only applies for your principal residence and not investment property.  To qualify as a principal residence, you must have lived in the home for at least 2 of the 5 years preceding the sale.  Note that this exemption can be exercised once every 2 years. 

 

B.  Mortgage Interest Deductions - As you may know, the interest you pay on a home mortgage is deductible from your income before taxes.  Given that most home buyers in Silicon Valley are at least in the 28% federal income tax bracket (which starts for singles at $70,000 and at $117,000 for married couples) and the 9.3% state tax bracket (singles at $38,000; married at $78,000), then this means that 37.3% of the interest on your mortgage is indirectly subsidized by the government.  Thus, the after-tax cost of borrowing on a 6% mortgage is actually only 3.76% (taking away the cost of the interest that is subsidized by the government).

 

Tip:  Know this deduction only applies for mortgages up to one million dollars.  For example, only half of the interest paid on a two million dollar mortgage is deductible.  Additional interest on a home equity loan up to $100,000 may be deductible if the money is used for the home purchase or home improvement. 

 

Thus, if you are purchasing a home for $1,400,000, you may want your down payment to be $300,000 and get a one million dollar mortgage and a home equity line for $100,000, that way all of your interest is tax deductible.

 

 

 

Excluding the recent housing downturn, housing is generally a very stable investment that either appreciates or stays constant in value.  In fact, on a nationwide basis there has never been a recorded drop in the median home price.  In California, where home prices have enjoyed greater appreciation but with more volatility than the rest of the country, median prices have risen for 31 of the last 40 years.  Due to this stability, lenders are willing to loan large amounts of money at very low rates.  Generally, buyers today are putting down only 20-30% as a down payment and financing the rest.  Consequently, by leveraging one's money the investment returns are multiplied.  For example, if a buyer made a 20% down payment and her home appreciated 8% in the first year, the 8% return is multiplied by 5 due to leverage and what really occurred was the 20% down payment appreciated by 40%.  

 

Tip:  You always want to avoid paying Private Mortgage Insurance ("PMI"), which is not tax deductible.  Thus, if your mortgage is above 80% of the purchase price, take the first loan up to 80% and borrow the remainder as a home equity line, thereby avoiding the lender's requirement for PMI.

 

 

As mentioned above, mortgages are commonly at very low interest rates given the security offered to banks by generally stable or rising home prices.  At today's low mortgage rates (approximately 5% for a 5 year fixed loan and 6% for a 30 year fixed loan) coupled with the deductibility of the interest, the after tax cost of home ownership is generally at the cost of renting a comparable home.

 

Tip:  Buyers in the past have typically been conservative and get mortgages for longer than they need, resulting in their paying a higher interest rate.  Realistically evaluate how long you intend to be in that home (the average person in California moves every 5 to 7 years), for the interest rate differential between a mortgage fixed for 5 years versus 30 years is generally one point.  Of course, if you realistically expect to be in that home for 20-30 years, you should lock in these great rates for the long term.

 

 

 

This example will illustrate that even when we assign a higher rate of return to stocks versus your home, the advantages discussed above will result in your home being the better investment.     Both investments begin with an initial investment of $200,000. 

 

Generally, stocks have more risk, but also more return than real estate.  Thus, for this example I will assume a 10% appreciation rate for stocks (10% Is very generous based on recent returns).  For your home I will assume an appreciation rate of 6%, which is low on historical standards for Silicon Valley.

 

The $200,000 is used to purchase a stock portfolio, whereas the other $200,000 is used as a 20% down payment on a million dollar home. 

 

The timeline for both investments is 7 years, typically when people move from their home.

 

The value of the stocks after 7 years is:

 

$200,000 x (1.10)7 = $389,744

 

Profit = $189,744

 

Because the $200,000 down payment bought a $1,000,000 home, the value of the home after 7 years is:

 

$1,000,000 x (1.06) = $1,503,630

 

Profit = $503,630

 

The difference in appreciation is further compounded by the fact that the $189,744 profit from stocks triggers capital gains tax at a rate of 24.3% (counting both federal and state taxes), thus the actual after-tax profit is $143,636.  Because the first $500,000 in capital gains are exempt (for primary residences that you own for 2+ years), the after-tax profit of the home is $502,748.  Thus, the after-tax profit of investing in stocks is $143,636 versus $502,748 for your own home.  

 

Thus, even assuming that stocks appreciate at nearly double the rate of local real estate, the benefits of leveraging your money coupled with paying no capital gains on your real estate profits results in real estate providing a profit of over 3.5 times as much as stocks.

 

Because the costs of owning the home, such as mortgage interest and property taxes are generally equivalent to the costs of renting, I do not factor these costs in our comparison of stocks to your home.

 

While the above comparison illustrates why your home makes a great financial investment, there are a multitude of other reasons why you should purchase a home.  These include: 1) fixed housing costs since you can have predictability with your mortgage payment versus the constant uncertainty of variable rental rates; 2) you own the home and have freedom to do whatever you want such as have a dog and paint the rooms any color you choose; 3) you will generally get more space, both indoors and outdoors, with your home versus a rental; 4) there is an indescribable joy and pride of ownership in being a homeowner.

 

View the great financial advantages of home ownership as your incentive to own and no longer rent; the other great perks are the icing on the cake.

 

 

Disclaimer: While all of the above general principles are correct, you should see your legal or tax consultant to determine how they apply to your specific circumstances.