I’ve gotten a number of questions about Capital Gains and Real Estate recently, so I thought it was time for a post. While many home sellers do not have to pay any tax on the sale of their home, for others, capital gains taxes can be significant, even hundreds of thousands of dollars. Here are five ways to reduce capital gains when you sell real estate.
Tax Comparison of 15 and 30 Year Mortgages
I received a tremendous response from readers about last week’s article comparing 15 and 30 year mortgages (read it here). A number of readers astutely asked how the mortgage interest tax deduction would impact the decision of choosing between the 15 and 30 year note. Here is your answer!
For our example, we are looking at buying a $250,000 home, putting 20% down and assuming a mortgage of $200,000. At today’s interest rates, we’d be choosing between a 15 year mortgage at 3.00% or a 30-year at 3.75%. Here are the monthly payments, not including insurance or property taxes.
| 15 Year Mortgage @ 3.00% | 30 Year Mortgage @ 3.75% |
| payment $1381.16 | payment $926.23 |
| difference = $454.93 |
Over the full term of the mortgages, you will pay the following amounts of principal and interest:
| 15 Year Mortgage @ 3.00% | 30 Year Mortgage @ 3.75% |
| principal $200,000.00 | principal $200,000.00 |
| interest $48,609.39 | interest $133,443.23 |
| total payments $248,609.39 | total payments $333,443.23 |
You will pay a significantly higher amount of interest over the life of a 30 year mortgage. The interest payment of $133,443.23 increases your total payments by 67% over the amount you have borrowed. And that’s at today’s rock bottom mortgage rates! I should point out that above 5.325%, the interest portion on a 30 year mortgage exceeds the original principal. In other words, the interest would double your cost from $200,000 to $400,000.
You can deduct the mortgage interest expense from your taxes, but the amount of the benefit you will receive depends on your marginal federal income tax rate. Here is the value of the tax benefit for six tax brackets.
| 15 Year Mortgage @ 3.00% | 30 Year Mortgage @ 3.75% |
| interest $48,609.39 | interest $133,443.23 |
| 15%: $7,291.41 | 15%: $20,016.48 |
| 25%: $12,152.35 | 25%: $33,360.81 |
| 28%: $13,610.63 | 28%: $37,364.10 |
| 33%: $16,041.10 | 33%: $44,036.27 |
| 35%: $17,013.29 | 35%: $46,705.13 |
| 39.6% $19.249.32 | 39.6%: $52,843.52 |
Obviously, the 30 year mortgage provides much higher tax deductions, although they are spread over twice as long as the 15 year mortgage. If we subtract the tax savings from the total payments of the mortgage, we end up with the following costs per tax bracket.
Total Cost, after the tax savings
| 15 Year Mortgage @ 3.00% | 30 Year Mortgage @ 3.75% |
| 15%: $241,317.98 | 15%: $313,426.75 |
| 25%: $236,457.04 | 25%: $300,082.42 |
| 28%: $234,998.76 | 28%: $296,079.13 |
| 33%: $232,568.29 | 33%: $289,406.96 |
| 35%: $231,596.10 | 35%: $286,738.10 |
| 39.6%: $229,360.07 | 39.6%: $280,599.71 |
It should not be a surprise that even though the 30-year mortgage provides higher tax deductions, that it is still more expensive than a 15-year mortgage, even when we consider it on an after-tax basis.
For most Americans, the actual tax benefit they will receive is much, much less than described above. That’s because in order to deduct mortgage interest, taxpayers have to itemize their tax return and forgo the standard deduction. As a reminder, itemized deductions also include state and local taxes, casualty, theft, and gambling losses, health expenses over 10% of AGI, and charitable contributions.
For 2015, the standard deduction is $6,300 for single taxpayers and $12,600 for married couples filing jointly. So, if you are a married couple and your itemized deductions total $13,000, you’re actually only receiving $400 more in deductions than if you had no mortgage at all and claimed the standard deduction. And of course, if your itemized deductions fall below $12,600, you would take the standard deduction and you would not be getting any tax savings from the mortgage whatsoever.
While the mortgage interest deduction is very popular with the public, economists dislike the policy because it is a regressive tax benefit. It largely helps those with a big mortgage and a high income. For many middle class taxpayers, the tax benefits of mortgage interest is a red herring. With our example of 3.75% on a $200,000 mortgage, even in the first year, the interest is only $7,437. That’s well under the standard deduction of $12,600 for a married couple, and the interest expense will drop in each subsequent year.
Compare that to someone who takes out a $1 million mortgage: their first year interest deduction would be $37,186 on a 30 year note. Simply looking at the amount of the mortgage interest will not determine how much tax savings you will actually reap, without looking at your other deductions, and comparing these amounts to the standard deduction.
Even if you are one of those high earners with a substantial mortgage, you have another problem: your itemized deductions can be reduced under the so-called “Pease limitations”. These limitations were reintroduced in 2013. For 2015, itemized deductions are phased out for tax payers making over $258,250 (single) or $309,900 (married).
Bottom line: If your mortgage is modest, your interest deduction may not be more than your standard deduction. And if you are a high earner, you are likely to have your deductions reduced. All of which means that the tax benefit of real estate is being highly overvalued by most calculations. There is a substantial floor and ceiling on the mortgage interest deduction and it provides no benefit for taxpayers who are below or above those thresholds.
Ceiling: Pease limits on tax payers making over $258,250 (single) or $309,900 (married).
Middle: receive a tax benefit between these two levels.
Floor: no benefit on deductions below the standard deduction of $6,300 (single) or $12,600 (married).
The 15 Year Mortgage: Myth and Reality
Everyone seems to be talking about Real Estate again. This month, I sat with three friends, and remarkably, all three were looking at moving and buying a new house. Real Estate is hot right now in Dallas, and almost everywhere else, too. The losses from 2009 have been erased and prices are making new highs. Even if you aren’t looking to move, chances are good that your property tax assessment has moved up significantly in the past two years.
Major corporate offices are being built in North Dallas, bringing tens of thousands of jobs to the area. And those relatively well-paid corporate employees are going to want to live in close commuting distance to work. Home owners have equity in their property, and interest rates, which have remained low, are expected to start creeping up. Many feel like right now is the perfect time to move up to their dream house. It has been a seller’s market, with many houses being sold quickly and often meeting or exceeding asking prices.
Anyone who has read this blog or my book, knows that I recommend home buyers consider a 15 year rather than a 30 year mortgage. Let’s go through those numbers in detail and consider the myths and reality of your mortgage decision.
For our example, let’s assume you are buying a $250,000 house and putting 20%, or $50,000, down. You will finance $200,000 through a mortgage.
At an average current rate of 3%, your monthly payment on a 15 year mortgage (not including taxes or insurance) is $1381.16. The 30 year mortgage will cost you approximately 3.75%, but your monthly payment will be only $926.23.
| 15 Year Mortgage @ 3.00% | 30 Year Mortgage @ 3.75% |
| payment $1381.16 | payment $926.23 |
| difference = $454.93 |
A lot of people will look at the 30 year mortgage and will say that it “saves” them $454.93 a month. Let’s break that down. On the 15 year mortgage, your first payment consists of $500 interest and $881.16 in principal. On the 30 year note, the first payment includes $625 in interest while only $301.23 is applied towards interest. Most of your payment on the 15 year note is going towards principal, building your equity, where as most of the 30 year payment goes towards interest. So, even though the 15 year note costs $454.93 more, in the first month, it applies $579.93 more towards your principal.
| 15 Year Mortgage | 30 Year Mortgage |
| payment $1381.16 | payment $926.23 |
| principal $881.16 | principal $301.23 |
| difference = $579.93 |
After making 10 years of payments, your remaining balance on the 15 year note would be $76,864.99 and you will have paid $42,604.59 in total interest. On the 30 year, $200,000 mortgage, your balance after 10 years is still $156,223.55, and you will have paid $67,371.29 in total interest. At this point, the person who chose the 15 year note has paid off most of their loan and has the end in sight.
| 15 Year Mortgage @ 10 years | 30 Year Mortgage @ 10 years |
| Balance $76,864.99 | Balance $156,223.55 |
| Interest Paid $42,604.59 | Interest Paid $67,371.29 |
Assuming your home value increases a modest 1% a year, here’s a look at how your home equity would compare after 10 years under both mortgages.
| 15 Year Mortgage @ 10 years | 30 Year Mortgage @ 10 years |
| Home Value $276,156 | Home Value $276,156 |
| Balance $76,865 | Balance $156,224 |
| Equity $199,291 | Equity $119,932 |
| Difference = $79,359 |
The nearly $80,000 difference in equity after 10 years shows how the 15 year mortgage is a really another way of “forced savings”. You would have equity to buy another house if you should want or need to move. Or if you’d like to retire, a 15 year mortgage may enable you to have no house payment when you reach retirement age.
So far this is pretty simple. But you may be wondering, what if I were to choose the 30 year mortgage and invest the difference of $454.93 per month? If you did this for 10 years, and earned 7%, you would have an investment account with $78,740. That’s almost the same as the difference in equity in the chart above.
Let’s take this further and assume that you invest the $454.93 for the full 30 years. How would this compare to paying the 15 year mortgage and then investing $1381.16 for the following 15 years?
| 15 Year Mortgage | 30 Year Mortgage |
| Pay mortgage for 15 years, then invest $1381.16
for the next 15 years, at 7% |
Invest the difference of $454.93 for 30 years, at 7% |
| Investment Value $437,760 | Investment Value $554,959 |
This shows that choosing the 30 year mortgage and investing the difference versus a 15 year mortgage could generate a better outcome over 30 years. So then why would I suggest that home buyers choose the 15 year product instead? Here are two reasons:
1) If you go to a bank, mortgage broker, or realtor and say that you can afford a $1381 per month payment, they are not likely to help you decide between a 15 or 30 year mortgage. Rather, they will assume you will choose the 30 year note and then tell you how much house you can “afford”.
Instead of looking at the $250,000 house in our example, you could afford a $370,000 house with a 30 year note. And you will not be investing the $454 per month difference as in the theoretical example. With the more expensive house comes more expensive costs, including taxes, insurance, utilities, and maintenance.
People who become wealthy look at their housing as a cost, not as an investment. While you can afford a more expensive house under a 30 year mortgage, that doesn’t mean that it is in your best interest to do so, if you have other financial goals such as retirement.
It is vitally important to remember that there is a conflict of interest throughout most the real estate industry. People who are paid commissions have an incentive to put you in the most expensive house and mortgage that the bank will allow them to sell. They do not get paid to help you retire, save in your 401(k), or send your kids to college. It’s remarkable to me that six years after the sub-prime crisis that there has been so little change to the fundamental conflicts of interest in the real estate industry.
2) I don’t know very many people who actually have the discipline to invest the $454.93 a month they would “save” with a 30 year mortgage. More likely, they will increase their other discretionary spending (cars, vacations, furnishings, etc.) that accompany “keeping up with the Joneses” in a nice neighborhood.
The only way someone would be able to make it work would be automate the process and establish a recurring monthly deposit of $454 into a mutual fund or IRA. By the way, the 30 year example above only showed a good outcome because I assumed the investment was made into stocks and earn 7% for 30 years. If you put that money in cash and only earn 3%, the 15 year mortgage produces the superior outcome. The 30 year mortgage only produces a better outcome if you can greatly exceed the cost of borrowing (3.75% in our example). Here’s what it looks like if returns are only 3% over 30 years:
| 15 Year Mortgage | 30 Year Mortgage |
| Pay mortgage for 15 years, then invest $1381.16
for the next 15 years, at 3% |
Invest the difference of $454.93 for 30 years, at 3% |
| Investment Value $313,486 | Investment Value $265,105 |
My fear of the 30 year mortgage is that it is not used by consumers or real estate professionals to maximize saving and growth investing. If it was, it would be a good tool for increasing your net worth. Rather it is used to maximize the amount of home you can purchase today.
For professions where career income is expected to rise only at the rate of inflation (such as teachers and musicians), your income is not going to increase fast enough to enable future saving when you take on a jumbo-sized mortgage. The result is that all your disposable income will go towards the house, with very little towards retirement, saving, or investment.
If today’s real estate market has you excited, be careful. It’s great that your home value has shot up 20% or more in the past couple of years. That makes it a great time to downsize, but actually an expensive time to buy a bigger house. We are lucky in Dallas that Real Estate prices have remained affordable; in many cities on the coasts, home buyers have no choice but to use the 30 year mortgage because prices are so high. If you start with the 15 year mortgage in mind when you are considering how much house you can afford, it can help you increase your net worth faster.
Should You Invest in Real Estate?
Almost everyone has wondered at sometime: should we invest in real estate? Perhaps it sounds appealing compared to the intangibility and lack of control in the stock market. However, for 90% of the people I meet, I think the answer is a definite no. I’m going to tell you why, and for the 10% of you who might still want to invest in real estate, I’m going to tell you how.
First, let’s get this on the table. Most financial advisors make their living from recommending or managing stocks and bonds, so yes, we have a conflict of interest. Unlike many advisors though, I have some first hand knowledge of real estate. Growing up, my parents purchased, managed, and sold 10 apartments, which in retrospect, was no small feat on teachers’ salaries. The proceeds from selling one property (which contained four apartments) comprised their entire contribution to my college education. Â It didn’t cover everything (the rest came from student loans, work study, and graduate assistantships), but I know that real estate investing does work and can be a wealth generator. I’m not fundamentally opposed to the idea of real estate investing for the right person who does it wisely.
During my childhood, we spent many weekends mowing lawns, doing maintenance, and interviewing prospective tenants. We cleaned, painted, did plumbing work, and whatever else was needed. The first thing that any potential investor needs to understand is that real estate is not a passive investment; it is a business which makes demands on your time, resources, and patience. Being a landlord is not about bricks and mortar, it’s a people business. Your job is to find, manage, and retain good tenants. Inevitably, you will still encounter the Tenant from Hell who doesn’t pay the rent, steals, vandalizes, and then moves out in the middle of the night owing you thousands. It can be frustrating, time consuming, and at times incredibly stressful.
You’ll never get a call in the middle of the night from your mutual fund because the hot water heater blew up. So trying to compare a real estate business to a passive investment program is apples and oranges. Don’t expect real estate to be easy, regardless of what “reality” program you saw on HGTV. For most people, you are already stretched too thin juggling your career, family, and other interests to want to tackle being a direct investor in real estate. It can detract from your quality of life, and there’s no guarantee of success.
As a stock investor, you can own the whole market with an index ETF and be very diversified. You can buy the same stocks as Warren Buffet, if you want, and get the same return. A person with $10,000 in a fund will receive the same return as someone with $10 million. Fund investing is liquid, requires no effort, and is very democratic, if you will. Real estate, on the other hand, is completely idiosyncratic. Every deal is different. Your neighbor might do well, and you could do poorly. A house in one city might appreciate significantly, but might depreciate in another city. Thinking that you have control over real estate, because it is a tangible item, is an illusion. Buying a house in 2005 could have created a substantial loss, while buying the same house in 2010 may have created a large gain. You have no control over the underlying economic factors which drive real estate prices, just like we have no control over the factors which drive stocks and bonds.
In the last downturn, I know several smart, hard-working people who went into personal bankruptcy because of their real estate investing. It can be risky. If you still want to own real estate, I suggest having it be only a portion of your portfolio, and keep your retirement accounts invested in stocks and bonds. Here are seven tips to keep your investment safe:
1) Get rich slow. Forget about flipping houses. Buy residential properties to rent and plan to hold them for years or decades. Make sure you are investing and not speculating. Buy a house that has good ratio of rent compared to its costs. A $100,000 house that generates $1000 a month in rent is obviously better than a $200,000 house that rents for $1600. The property is an investment, and not for your personal taste, so it does not have to be a luxury home. Wealthy people are not your target tenants. Look for clean, well-maintained properties with access to good schools.
2) Focus on building equity. Use your tenant’s money to pay down the mortgage – that’s how you create wealth in real estate. Get a short note (15 or 20 years) rather than a long mortgage, an interest-only loan, or balloon. Each year, your equity in the property will increase and the amount of interest you pay will decrease. Eventually, you can sell the house for a large gain, or you will pay off the note and then you can bank the rent each month. Don’t make it your goal to have high cash flow from the property for your own income. Invest that cash flow into the equity. And whatever you do, don’t quit your job thinking you will live off your real estate investing – that’s often a disastrous idea. Inflation (rising home prices) should be the icing on the cake; your primary objective is to build equity by paying down debt.
3) Do it yourself. Profit margins are razor thin in real estate. After you pay property taxes, insurance, the mortgage, and maintenance, there is almost nothing leftover. If you plan to hire a handyman every time you need to change a light bulb, you can easily slip into a negative cash flow situation. You have to save money where ever you can, so be prepared to be hands-on. No one will care more about your property than you. Don’t be a long-distance landlord; aim to buy properties within a 10-mile radius of your home. If the idea of sweat equity is a turn-off, real estate is probably not for you.
4) Use leverage wisely. If you have $100,000 to invest in real estate, you could pay cash for one $100,000 house. Or, you could make $20,000 down payments on five houses. Owning five houses will give you better diversification and a much better long-term return because of the leverage. It really is smarter to use the bank’s money for real estate, especially with today’s low interest rates.
5) Keep a strong cash reserve. You will have unexpected expenses, and they can be large. Real estate investors must have a sizable cash position and cannot be living from month to month. Budget for maintenance and vacancy. Will you be okay if you have to spend $10,000 on a new roof or HVAC system? Can you survive if the property is vacant two or four months a year? Know the occupancy rates and market rent rates in your area.
6) Be super organized. Everything needs to be in writing, including applications and lease agreements. Check references for prospective tenants. Keep all receipts and work with a good accountant to track your deductions, depreciation, cost basis, and other tax benefits. This is a business, not a hobby. Treat it seriously.
7) Appreciate your good tenants. They make your life easy, take care of your property, and keep your account in the black. Do nice things for your good tenants and make them want to stay. Their money is building your wealth.
As for me, I spent enough time with apartments to know I’d rather stick with stocks and bonds. It’s a better fit for my schedule and I know myself well enough to know that my efforts are better directed elsewhere. And over the previous 30 years, the nominal return of residential real estate was 4.38% versus 11.09% for large cap stocks. When we include taxes, inflation, and expenses, single family homes returned only 0.80% over those 30 years, compared to 5.97% for large cap stocks. So real estate is often not the home run that people believe it will be.
If you’re thinking about real estate investing, let’s get together and discuss what it entails before you get started.
