patrick.net

theotherside,

you conveniently forgot that by selling Randy's house at $1,500,000, he actually set free his initial down payment, $200,000, and pocketed $500,000 tax free. Taking out the 5% transaction cost of $75K, he now has $425,000 net earnings plus $200,000 dp, a total of 625,000.

So what does Randy do with $625K? Assuming 4% after-tax CD, $625K is yielding $25,000 a year, a total of $125K in 5 years, ignoring compound interest and possible rate hikes. Now he has a total of at least $750K by 2010.

5 years later, buy back the original home of $1M, he puts all the cash accumulated from the previous transaction back into the house. Assuming 2% closing, $20K, he puts altgether $730K down, taking out a mortgage loan of $270K.

Meanwhile, while you do nothing, you still have a loan balance of at least $750K in the same darn house in 5 years. As you said, it is all about the cost basis.

I am not even starting to count Randy's cash flow from rental savings to stay in the same home.

OO,
I'm not talking about parking your cash in a home in a lower appreciation rate location. I'm talking about pocketing the difference and placing it into other investment vehicles. A location arbitrage makes sense to me mainly if for life reasons you want to move anyway. And the way the BA is headed, there are many (nonfinancial) reasons to move away!

Thanks OO. *Not all numbers above are specifically precise; but then I don't really want to publish my tax returns, given I'm not running for office (so far as I'm aware).

But in general, a relatively modest retracement of home prices results in multiplied advantage when buying back in. Because, as you said, it's all about cost basis.

All of 'thefantasyworldside's scenarios are carefully and purposefully dependent upon a very narrow price correction. She also conveniently switches between nominal and real to prove her points.

Nominal to real to unreal...

New thread Mail in the Keys

WHY would he buy back the house? Given the rent being paid, it is only worth 300K. If the spread remained, say both go up at 5% a year, post bubble he still should not buy. Given you scenario, yes, selling and then rebuying is silly, but this scenario I would not buy it back. You get the 4% which would be higher if you are claiming mortgage rates going up in the future. Anyway here are how your numbers spell out.

Net gain on the house $395,000 (1.5 mil x .93 - 1 mil orig cost)
$395,000 + $4700 (mo savings put in savings) per mo at 4% net after tax
at the end of 20 years he has $2,600,000 in the savings account. (You and I both know you can do better, I can get 5.5% right now at WAMU!)

You keeping your 1 million house average 5% appreciation per year for 30 years = $4,321,950 - less the original $1,000,000 is

$3,321,950 Gross profit less:
$354,970 Net prop taxes (1.25% rising 2% per year 507101 * .7)
$770,603 Total interest with tax break (1,100,800 * .7)
$302,536 Selling costs (7% at time of payoff)
$300,000 Maint (10K per year, on a 1 mil house that is cheap!)

Total mo payment is $6737 PIT&maint w tax deduction incl.

Net profit is 1.53 million to buy
or 2.6 million to rent

Renting is clearly the better option under your scenario.

The Other Side

Hey Randy H, my friend, You really don’t get it?

Ok, I will try a very simple example (ignoring principal) for you

1- Let say a builder sold us 2 identical houses in the same subdivision in 2000 for $1,000,000. We both put 20% down and get a 5.75% 30 year fixed mortgage.

2- It cost us $4,000/month { $4668 + $1000 (localtax+insurance+maintenance) }* 0.7 (tax deduction)

3- In 2005, you sell your house for $1,500,000 and I keep my house. You rent the exact same house for $1900/month (5668*0.3) and save $2,100/month.

4- Your monthly savings (assuming a 4% APY after tax on a CD) will yield an average of 12% over the 5 years or $141,120 (2100*60*1.12) out of which you have to pay $125,000 in closing cost (7% of $1,500,000 when you sell and 2% for closing cost when you buy).

5- In 2010 you buy back the same house with a 20 year mortgage at 6.5% (20 year to compare apple to apple, with higher rate to justify such a steep drop in house price due to FB’s unable to refi)

PS, I did this on the fly to respond to otherside so feel free to challenge my numbers, I'm pretty damn good but not perfect, and some people calculate things differently, although my way is normally pretty objective.

Tax break should be 40%, not 30%, imho. Fed + State is much more likely to be 40% for a home buyer. For me it is actually 46%.

Remove transaction costs from selling the house and compare the $2.6M vs. the home, It still favors renting, but only just barely.

The real problem with your analysis is that you compare "risk free gains" with home price gains, which are clearly not risk free. There should be some kind of discount for the risk you are taking in holding the home.

The 20 year average ex ante risk premium is about 3.75%. Ex post is much higher, about 6.0%. But then, I can't accurately predict ex post, ex ante.

But I'd agree that the "present value intangibles" tend to close the gap in favor of ownership, so long as the holding cost to rent ratio returns back to somewhere near it's long run equilibrium of 1.5-1.7. It's more than double that now.

You are correct about the tax rates (using his numbers) but thinking about it further a lot of FBs buying a 1 million dollar house are in the lowest tax brackets so 15% fed, and 6% or so state. ha ha ha

Another cost is that your gains free limit is 500K for a married couple (pretty sure) so there is capital gains tax on most of the windfall on that deal.

Transaction costs are a hard cost and do need to be included.

Another point is that house isn't worth 1 million so the assumption of a temporary 20% dip is the biggest flaw in the poposal, since I believe that house is worth less than 300K in present dollars (which does not change when adjusted for inflation in the future).

I am normally a big advocate of home ownership, just not during this inflated bubble. There are many intrinsic qualities of ownership even when the numbers are a push. This is a very severe case where houses were priced 2 and even 3 times what they are logically worth. Come on, 200K mobile home double wides WTF?

Jimbo, for me personally I discount risk from a cash flow, but realistically 5% as an average is pretty fair. You are technically correct.

A simple way to look at it is do you want to pay interest on someone else's million dollars to leverage 1 million in housing, or would you rather earn interest on what you can save each month with zero leverage?

One or the other will be the clear winner depending on the model. Some people go by emotion or rules of thumb, like I can have a dog, or I don't want to make my landlord rich. My rule of thumb is when it is close to a push, just pick the risk free option.

One of the things that people on this site forget is calculating the benefit of owning a house PAST 30 years. Yes, Randy might have more 'net worth' at 30 years investing rather than owning, but at 40 years, big difference. The reason a home is a retirement vehicle is it eventually DRASTICALLY reduces your monthly expenses when you've paid it off entirely.

Additionally, you can 'downsize' and own a smaller home outright as well and have another chunk of cash to live off of.

Unfortunately, many people these days don't treat a house that way. They treat it as an ATM, or when they DO retire, they trade UP houses, and wind up paying a mortgage all through their retirement. (And often use it as an ATM as well.)

SF Bubble, absolutely true. Two points though.

1. Small percentage actually stay for 40 years. Most people will be dead then at present life expectancy.
2. You are living rent free anyway because you can more than easily pay the rent from your interest earnings far sooner than waiting to pay your mortgage off.

The reason I put a liquidation sale at the end is because if there is no harvest at the end what's the point? The buyer saves 4.5million that he never uses? Then the return on equity at that point is 0, that's a bad move. I sold my houses at the peak because renting was a very low return on equity.

Another rule of thumb which worked well for me.

Time to buy = return on investment (fully discounted risk) is greater than other avenues.
** In other words don't buy a rental which doesn't have a cap rate higher than other avenues. Must also generate a monthly cash flow so watch the borrowing costs compared with the cap rate. I will never understand someone buying a rental with a negative income stream, that is subsidizing the tenants's housing.

Time to sell = return on equity (equity in house/income stream) is less than the safe rate. **careful to use this in a flat market because in a normal market your equity does well with leveraged appreciation. Appreciatin does need to be factored as part of the income stream.

Owning a home is a form of savings, technically, to an individual home owner. It is no different than putting money into a money market except for a different risk profile and some different math -- except for the loan. And, the present value of the loan (assuming fixed interest simple term loan with no penalty) is largely computed by 3 factors: leverage, tax shelter, embedded option.

I modeled everything but the PV of the embedded option in my Bubblizer. If you want to model that you can either use some very qualitative inputs into a real-option value, or you can value it like a callable bond.

Sensitivity analysis on present value opportunity costs reveals that two factors comprise nearly 50% of the action: Home Price and Tax Shelter. Mortgage interest rate, contrary to common belief and realtor rhetoric, is merely an average factor mathematically. Of course, things like interest rate have a larger psychological effect than their math would imply, therefore it can affect the macro market despite fundamentals.

Since most people don't understand leverage well, that leaves the tax shelter as the largest input factor which also correlates to its psychological impact on market behavior. I theorize a few things about why this is so: 1) people mistake or don't understand the difference between a tax deduction and a tax credit. 2) people hate taxes and feel any deduction is a greater gain than it is financially. 3) many people over-withhold their taxes causing bigger year end returns, which they are prone to attribute to home ownership even though only a portion may be due to the home mortgage interest deduction.

Also, when talking about long-term ownership to full equity, zero loan, the present value of the tax shelter reduces in sensitivity. That is because the deductible interest portion becomes less over the term, during some period of the term (depending upon one's age) taxable agi is rising for most people, tax rate/bracket adjustments always lag nominal income inflation (witness the current AMT situation).

Finally, once one "owns" their home outright, they are effectively renting to themselves for a discount (cost of taxes, insurance, maintenance and holding costs discount for risk). If we set that portion exactly to rent times a fractional constant, we can determine the value to the owner is only the amount "harvestable" from realizing their savings that sit in the form of a house.

All residential housing is eventually consumed or passed on to other savers through inheritance. There is nothing financially magical about a house. It's just a different kind of savings account with different correlations and risks, and a roughly constant potential long-term discount-to-rent.

God I'm glad I have finally found intelligent people to bounce these concepts around with.

Malcolm,

I still don't think you should add transaction costs at the end for the FB. You could just as logically add a transaction cost for the JRB at the end, which would assume that they would buy a house with their savings.

I don't see why anyone needs to sell their home at the end of analysis. Even in the case of someone dying, their heirs could just chose to hold onto the home, either to live in or rent out.

Which reminds me, does the basis cost for tax purposes of real estate get adjusted up the same way it works for stock? I am hardly in a position to do estate planning yet, but it would be an interesting thing to know.

@ eburbed,

I've come to the conclusion that EVRYTHING goes up and down together in the new economy. There is no benefit from diversification of asset class or international/domestic. It is all about liquidity. Is the spigot on or off? Lately it's off but at anytime the FRB may decide it's time to turn it back on and at that point your tech stocks will be moving up again.

Paul

'Which reminds me, does the basis cost for tax purposes of real estate get adjusted up the same way it works for stock? I am hardly in a position to do estate planning yet, but it would be an interesting thing to know. '

A couple of things since I think I know what you are asking:
Under prop 13 your taxable basis is based on the market value of the house at the time of purchase, and can also be adjusted at a time you add someone to the title or sell to a new buyer. The tax rate is a flat 1% plus local voter approved assesments. The assessed value varies with the market but it basically is irrelevant because the actual tax bill can only go up a maximum of 2% per year. It is capped. So in my case even though my house almost tripled in value, my tax bill is only about 10% higher than when I bought the house. 2% increases in property tax is nothing. It is a genuine perk.

If you are asking about the cost basis for depreciation, or for captial gains, the cost basis is what you paid for it, and you straight line depreciate the improvement portion over a fixed amount of time. I think it is 28.5 years, but I'm not 100% positive of the time period. This applies to investment properties since you have gains exemptions on your primary residence.

Jimbo, even though the transaction costs are significant it doesn't change the outcome. You are correct in your challenge, but again, I would have to say without a harvest there is absolutely no point to paying 3 times the monthly cost to live in the house. Someone would be better off sitting on the sidelines until either it seemed rents were going to skyrocket, or prices plummet to justify the decision.

The percentage of people who stay in the same house for 40 years is minscule. I'd speculate that it is less than 5%. In doing financial modeling you would normally use an average which currently is someone moving after 7 years. In that case, the proposal is ludicrous.

Sorry, I meant to ask if the cost basis got adjusted upward after you die.

If you own stock, when you pass it on to your heirs, they get the basis adjusted upward to the value it was worth when you died, potentially giving them a huge tax break. This is called a "step up in basis."

http://www.pathtoinvesting.org/fyp/cost_basis_stock/cost_basis_041.htm

Does real estate get the same break? Somehow, I doubt it, but I am curious.

Yes, I agree, for the average investor it makes no sense whatsoever.

But in modeling for a person's individual personal case, you can make different assumptions, based on what you plan on doing in your life, and see how the numbers work out with your plans.

If fact, one could argue that this is called "retirement planning" and doing a good job at modeling various scenarios and picking the best one is the key to prosperous and comfortable Golden Age!

Parents can transfer property to their heirs at the same cost basis in California. Also to a grandchild if the parents are deceased. This is up to $1,000,000.

A change in ownership includes almost all transfers of title in real property. Some changes of ownership that are excluded from reappraisal include the following:

The transfer of property between husband and wife;
The transfer of the principal place of residence between parents and children (and the transfer of up to $1 million of any other real property between parents and children) if an application is filed properly (Proposition 58);
Persons over 55 years of age can buy a residence of equal or lesser value than their existing home and transfer the current tax value to the new home within the county (Proposition 60).

Jimbo,

Your heirs get the property at the stepped up basis so there is a huge tax break when they sell (capital gains). Furthermore, because of Prop 58, you can pass on your property at its Prop 13 value. There are some limits which you can read about here:
http://www.boe.ca.gov/proptaxes/faqs/propositions58.htm#4
Overall, strong incentives to never sell a property once you have it. My (free) advice is:
1. Sell half the duplex to your renters (when are you going to see these prices again :-) )
2. Enter the condo lottery (you should win sometime in you lifetime)
3. Pass your condo onto your kids (in the mean time, rent it out or live in it).
Not financial advice.

Yeah EBGuy, I think that is exactly the best course of action, financial-wise. Condo conversion causes a step-up in Prop 13 tax basis, but we didn't buy *that* long ago.

I doubt this is going to happen though, we will probably end up keeping the whole place, but that is not a financial disaster either, just not the fastest way to retirement.

I'll bet a lot of attorneys are hating life since the Internet came on line. All of those links are money out of their pocket for legal advice. Life is good.