patrick.net

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.