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Under the current finance and economic environment, even with fears of a potential real estate bubble, home ownership may be one of the best long-term investment opportunities available today. For most Americans, their homes are their greatest source of net worth and a substantial source of tax savings. This article presents an overview of the tax savings opportunities available to homeowners and analyzes the investment value of home ownership in the current real estate environment using different levels of mortgage financing and costs of renting compared to owning a home over different time horizons. [PUBLICATION ABSTRACT]

Introduction

For many Americans, the purchase of a home is a major step toward the fulfillment of the American dream. It is a very personal and emotional transaction involving a tremendous feeling of pride of ownership and family security. In addition to being a very emotional experience, buying a home is an important financial transaction. For most Americans, die purchase of a home is the largest purchase that they will ever make, their homes are their greatest source of net worth, and the ownership of a home offers tax savings opportunities that are difficult to match. In the year 2004, the percentage of Americans owning homes reached an all-time high. Approximately 70% of the adult population or roughly 120 million people in the United States are currently homeowners.1 The recent upward trend in home ownership has been aided by record low mortgage interest rates, an improving economy, and the many tax savings benefits of home ownership.

This article analyzes the investment value of home ownership in the current real estate environment using different levels of mortgage financing and costs of renting compared to owning a home over different investment time horizons. The after-tax rate of return available to new home buyers is calculated based upon the cash outflow needed to purchase a home, the annual tax savings available, the difference in cash outflows for buying versus renting a home, and the eventual net proceeds from the sale of the home over different time periods.

Tax Deductions Available in the Year of Purchase

The numerous tax benefits available to homeowners can save individuals thousands of dollars in reduced federal and state income taxes over the period of home ownership. When buying a home, most individuals will finance a significant portion of the home's purchase price. In today's real estate mortgage environment, some financial institutions are offering interest-only mortgage loans and even no-down-payment mortgage loans to qualified buyers in order to make home buying more affordable in a rising real estate market. The settlement closing expenses incurred by the homebuyer at the time of purchase will generally range between 3-5% of the amount being financed to purchase a home. The points and loan origination fees paid by the homeowner to the lending institution for obtaining the home mortgage may be deductible by the homebuyer in the tax year of the purchase as an itemized deduction, if the following Internal Revenue Code (IRC) conditions are met:2

* The cost incurred by the homeowner for points and loan origination fees must be listed on the buyer's settlement closing statement.

* The charges for points and loan origination fees must be computed as a percentage of the mortgage loan amount.

* The mortgage loan on which the charges are based must be secured by the taxpayer's residence.

* The fees charged by the lending institution to the homeowner must be typical for the locality of the residence.

* The homeowner must actually pay the points and loan origination fees in the year of purchase. Points are considered paid by the buyer if he or she paid an amount from his or her funds at least equal to the fees charged.

When these conditions are met, the homeowner may receive an immediate tax break in the year of purchase.3

If the IRC conditions are not met, the points and loan origination fees are not deductible in the year of purchase and are instead deductible on a prorated basis over the term of the home mortgage loan. For example, if $4,500 is charged by the lender for points and loan origination fees, but the homeowner does not meet all of the IRC conditions, the $4,500 in loan acquisition costs are prorated over the term of the mortgage. A 15-year mortgage would result in an annual itemized deduction for the homeowner of $300 per year for 15 years ($4,500/15 years = $300). The balance of any prorated closing costs not yet deducted is deductible in the year of sale or in the year in which a homeowner refinances an existing mortgage. However, when refinancing, the points and loan origination fees incurred on the new mortgage loan are not deductible in the year of refinancing. All expenses related to points and loan origination fees associated with refinancing a home are prorated over the term of the new mortgage loan.

In today's real estate mortgage finance environment, the substantial amount paid by a homeowner for home-related tax-deductible expenses in the year of purchase can significantly increase itemized deduction and immediately reduce the homeowner's federal and state income tax bills.

Other tax-deductible items that are not listed on the settlement closing statement may include prorated property taxes paid by the buyer and mortgage interest expense from the date of closing until the first mortgage payment is due. These items are also deductible in the year of purchase as itemized deductions. The settlement fees that are not deductible in the year of purchase include the cost of such items as homeowners' insurance, home inspections, and credit report fees.

Other home acquisition costs that are not tax deductible in the year of purchase, but which may have tax consequences, include closing costs for title search, title examination, title insurance, recording fees, transfer taxes, attorney's fees, and other settlement charges associated with buying the home. These costs are added to the home's basis and may reduce the capital gain realized from the eventual sale of the home if the gain is greater than the amount exempt from capital gains taxation.

The Annual Tax Benefits of Home Ownership

Qualified Residence Interest Deductions

The ability of a homeowner to deduct qualified residence interest expense as an itemized deduction is considered by some tax experts to be the greatest tax break for homeowners. Qualified residence interest is defined as interest on debt secured by a taxpayer's principal or second residence. Interest expense is deductible to the extent the debt does not exceed the lesser of the fair market value of the residence or the taxpayer's basis in the residence adjusted for the costs of any improvements.4

For homes acquired after October 13, 1987, the deduction for home mortgage interest is limited to the interest on $1 million of acquisition debt. (The limit is $500,000 of debt for married individuals who file a separate return and single taxpayers.) Acquisition debt is the debt incurred by a homeowner to buy, construct, or substantially improve a principal or secondary residence. The acquisition debt limit of a homeowner for tax purposes is reduced by the reduction of the debt principal from the mortgage payments. The acquisition debt limit cannot be increased by refinancing, but debt in excess of the acquisition debt limit may qualify as home equity debt.5

Property Tax Deductions

Property taxes and assessments based upon the value of an individual's home are deductible for the tax year of the individual in which the tax is actually paid. Since property taxes are deductible in the year in which they are actually paid, some homeowners may find that it is worthwhile paying taxes in December each year rather then waiting until February or March, when property taxes are usually due in order to take advantage of this deduction one year sooner.

Home Equity Interest Deductions

Homeowners may use the money borrowed from a home equity loan for any purpose and may deduct the interest expense as an itemized deduction, provided the debt limits are not exceeded and the debt is secured by the taxpayer's primary or secondary residence. The tax code allows a deductible limit of up to $ 100,000 for home equity debt ($50,000 for a married individual who files a separate return). Home equity debt includes second mortgages, equity lines of credit, and any other debt of the homeowner, other than the first mortgage, that is secured by a principal or secondary residence. The annual interest paid by the homeowner on the home equity debt may be deducted as an itemized deduction for federal and state income taxes.

Under the right conditions, an equity line can be a very valuable low-cost source of funds and a valuable tax deduction. However, home equity lines should be used very carefully by homeowners. Home equity lines usually have variable interest rates and may change monthly without limits. Also, the repayment schedule for home equity lines is typically set up for homeowners to pay monthly payments that are interest-only payments. Additional payment above the minimum is needed on the part of homeowners to pay off the principal at a reasonable pace. An additional word of caution: similar to a first mortgage, nonpayment of an equity line will result in foreclosure action against the homeowner. As a result, the major advantages of an equity line must be considered in the context of the added risk to the homeowner's greatest asset.

The Sale of a Home

Since individual homes are the greatest source of net worth for most Americans, and the annual appreciation rates have been relatively high for real estate in many geographic areas over the period of a few years, the sale of a home can result in a substantial net gain over and above what was paid for the home. The current tax law provides for a $500,000 exemption from federal income or capital gains taxation on gain realized by a married couple on the sale of their primary residence. The exemption is $250,000 for a single individual.6 If the gain realized is less than the exemption, no tax is due on the sale. The requirements for the homeowner to obtain the exemption are that the home must be the primary residence of the homeowner and the homeowner must have lived in the home for at least two years of the five years prior to the sale.

For individuals who do not meet the two-year occupancy requirement because of a job change, health reasons, or some other unforeseen circumstance, the amount of the exemption is based upon the fraction of the two years they had occupied the home. For example, if a married couple lived in their home for only one year and six months prior to the sale, the amount of the exemption is 1.5 years/2 years = 0.75 x $500,000 = $375,000.

Any realized gain up to the eligible exemption amount is not subject to federal income or capital gains taxation. Any amount over the eligible exemption amount is taxed at the individual's current income or capital gains tax rate. The maximum capital gains tax rate is 15%. Assets, including a home, must be owned for one year or longer to qualify for capital gains. Holding periods less than one year subject the excess gain to ordinary income taxation.

The vast majority of homeowners in the United States will not be subject to tax on the gain realized from the sale of a primary residence. In essence, their greatest asset will increase in value over the period of ownership without being subject to federal income or capital gains taxation. Homeowners with potential taxable gains above the exemption amount should keep good records so they can reduce their gains by the amount of eligible capital improvements. For homeowners who are subject to capital gains taxation, the burden of proof for adjustments to the basis of the home is on the homeowner.

The Alternative Minimum Tax

High-income homeowners need to be aware of the alternative minimum tax (AMT). Certain itemized deductions that are allowed for regular income tax purposes may not be allowed when calculating the AMT.7 For tax planning purposes, an important consideration is that the mortgage interest deduction for taxpayers subject to the AMT is limited to qualified housing interest rather than qualified residence interest. Qualified housing interest includes only interest incurred to acquire, construct, or substantially improve the taxpayer's principal residence or second home. When additional mortgage interest is incurred (such as a mortgage refinancing, second mortgage, or equity line), interest paid is deductible as qualified housing interest for AMT purposes only if

* the proceeds are used to acquire or substantially improve a qualified residence

* interest on the prior loan was qualified housing interest

* the amount of the loan was not increased

Another tax planning consideration is that property taxes, which are deductible as an itemized deduction by homeowners for regular income tax purposes, are not deductible in computing the AMT. As a result, homeowners with high incomes who are within the AMT income and expense limitations will not be allowed to take the full tax advantages of home ownership on a primary or secondary residence.

An Analysis of the Investment Returns of Home Ownership

Homes and real estate in general have been considered good investments for many years but especially since the stock market decline that began in early 2000. According to the National Association of Realtors, median home prices have risen 39% over the past five years ending September 30, 2004. This compares very favorably to the 13% loss experienced by the Standard and Poor's 500 stock index during this same five-year time period.8 Even though home ownership may be a good investment, individuals need to be cautious not to overextend in the purchase of a home. Money spent on housing costs reduces the money available for other financial goals. All personal financial goals must be considered and priorities established when deciding if and when to purchase a home and how much to spend.

Investment Parameters Used

In order to examine the investment returns available from home ownership, the annual after-tax rates of return to a new homeowner were calculated using multiple investment assumptions. The first analysis examines the return on investment for a buyer who purchases a home for $187,500, finances 80% of the purchase price at a mortgage interest rate of 5% for a 15-year conventional mortgage, and incurs 4% ($6,000) total settlement closing costs with 3% ($4,500) tax deductible in the year of purchase. The analysis assumes a 5% annual appreciation rate for the home and that the annual interest expense on the mortgage is fully deductible as an itemized deduction for the homeowner. Annual property taxes are assumed to be 1% of the property's current value. The selling expenses to the homeowner in the year of sale are assumed to be 7% of the home's selling price. Since the cost of buying a home may be more expensive from an annual cash outflow standpoint than the cost of renting, three different cost assumptions are used to explore the different results. The actual difference between the annual before-tax cash flow required to buy a home and the annual cost of renting may be determined by many factors including the local real estate market, amount financed by the buyer, type of financing, mortgage term, current interest rate, property taxes, insurance costs, and other factors.

The first analysis (Table 1) assumes that the cost of renting is equal to the annual before-tax cash flow required to buy the home. The second analysis (Table 2) assumes that the cost of renting is 75% of the annual before-tax cost of buying. The third analysis (Table 3) assumes the annual cost of renting to be 50% of the before-tax cost of buying.

For the investment value analysis, the rate of return on investment is calculated using the total cash outlay required for the purchase of the home. This includes the down payment required and the settlement closing costs. The rate of return on investment listed by year in each table is the annual return the home buyer earns on the required cash outlay for purchasing the home compared to the annual tax savings and net cash flow from the eventual sale of the home calculated as if the sale were to take place at the end of each year for years 1 to 15.

To better understand the calculation of the total rate of return on investment for a home buyer based upon the cash outflow required to purchase a home, the following simple model may be used.

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As can be seen in Table 1, the annual returns differ each year depending upon how long the buyer owns the home. Using the stated investment parameters, the rate of return on investment for homeowners whose annual cost of renting is equal to the before-tax cost of buying a home after the first year ranges from 18.05% to 26.17%, over the 15-year period of analysis. The rate of return to the home buyer if the home is sold after 7 years, which is a common holding period for many homeowners, is 23.87%. The rate of return at the end of 15 years is 18.05%.

Table 2 provides analysis similar to Table 1 with all the investment parameters remaining the same except one important critical assumption. Table 2 assumes that the cost of renting (cash outflow per year) is only 75% of the annual before-tax cash outflow required to buy the home. The cost of renting is assumed to increase by 5% per year over a 15-year period. The annual property taxes are assumed to increase 5% per year.

As can be seen in the analysis in Table 2, when the annual cost of renting is 75% of the annual before-tax cost of buying a home, after the first year, the annual after-tax rate of return ranges from 12.9% to 20.2% depending upon the eventual year of sale over the 15year period of analysis. The rate of return to the home buyer if the home is sold after 7 years is 19.6%. The rate of return after 15 years is 16.37%.

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Table 3 uses the same financial assumptions as Tables 1 and 2 except that the cost of renting is now assumed to be only 50% of the before-tax annual cash flow required for buying. As can be seen in Table 3, when the annual cost of renting is assumed to be only 50% of the beforetax annual cash flow of buying, the homeowner's rate of return on investment after the second year ranges from 10.2% to 13.4% depending upon the eventual year of sale. As illustrated in Table 3, even when the befo re-tax annual cash flow required for buying a home is twice the annual cost of renting, the rate of return to the home buyer is 13.3% if sold after 7 years.

Figure 1 is a summary of the potential investment returns available to new homeowners under the current real estate finance and investment environment using different costs of renting compared to the cost of buying. The analysis indicates that home ownership has the potential to be an extremely competitive long-term investment when the homebuyer places a 20% down payment to purchase a home. The 20% down payment is a usual requirement in order to obtain the most competitive interest rate and avoid the added costs of mortgage insurance premiums. Recognizing that many homebuyers today are opting for lower down payments, the next section examines the rate of return available when more money is borrowed. Purchasing a home with less than a 20% down payment allows for the greater use of positive financial leverage in an appreciating real estate market. However, purchasing a home with less than a 20% down payment may require a higher mortgage interest rate, more closing costs, and mortgage insurance premiums which are added to the monthly mortgage payment.

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The Impact of Financial Leverage on Return

In order to examine the impact of financial leverage on the returns available to new homeowners, analysis was conducted using the same investment parameters used in the previous analysis except the amount of financing was changed. Separate analysis was performed for homebuyers financing 95%, 90%, 85%, 80% and 75% of the purchase price. The interest-only mortgage loan was not used in the analysis since many financial planners advise against an interest-only mortgage as being too risky. The mortgage interest rate used in the analysis was 5% for the 75% and 80% loans, 5.25% for the 85% loan, 5.5% for the 90% loan, and 5.75% for the 95% loan. All other parameters and assumptions used in the analysis were the same.

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The potential annual rates of return available to new home owners were computed using different degrees of financial leverage assuming the cost of renting equals (1) the cost of buying, (2) 75% of the cost of buying, and (3) 50% of the cost of buying. As can be seen in Figure 2, the annual rate of return on investment increases with the increasing use of financial leverage.

Figure 3 shows the potential annual rates of return available to new home buyers assuming that the cost of renting is 75% of the annual cash outflow required to buy a home. The return on investment is lower when the cost of renting is only 75% of the annual cash outflow required to buy a home; however, the return on investment is still very high. Using more debt increases the return on investment when buying a home.

Figure 4 examines the rate of return assuming that the annual cost of renting is only 50% of the annual before-tax cash flow of buying. As can be seen, when the cost of renting is only 50% of the annual before-tax cash flow required to purchase a home, the annual rates of return available to a new homebuyer comparing different degrees of financial leverage is still quite attractive as an investment. Even in real estate markets where the cost of renting is low compared to the cost of buying a home, the use of financial leverage and the available tax deductions provide very attractive returns to homebuyers.

Summary

Even with the illustrated 4% closing costs in the year of purchase and the 7% selling expenses in the year of sale, the annual rate of return on investment for homeowners compares favorably with any reasonable investment opportunity available today. While there is no guarantee that home values will continue to increase at the appreciation rates experienced in recent years, home ownership appears to be a very favorable long-term investment opportunity. The 5% annual appreciation rate used in this analysis is very modest compared to the rates experienced in many real estate markets. The homebuyer's rate of return on investment is calculated in each example assuming that the eventual sale of the home takes place at the end of each stated year. However, a homeowner who never intends to sell his or her dream home may still benefit from the investment value of home ownership. For example, in retirement, the equity or net worth in a home may be utilized in the form of a reverse mortgage or reverse annuity mortgage. Also, if adequate other sources of retirement income are available to the homeowner, the equity may be used as an emergency fund. Or, even if a retired homeowner never sells or uses the home equity, a paid-for home is a major source of financial security and reduces the required monthly costs in retirement. The options are numerous.

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