Question: Given tax reform does it still make sense to buy a home when you can get a rental in many markets for the same money or less?
Answer: The tax reform legislation passed in December changes the real estate game. Let’s look at the changes and their impact.
The December legislation does much to reduce or eliminate the tax advantages we traditionally associate with homeownership. Mortgage interest and property taxes remain deductible in theory but in practice that will not be the case for many taxpayers. The legislation itself says tax reform will raise an additional $668.4 billion from the “repeal of itemized deductions for taxes not paid or accrued in a trade or business (except for up to $10,000 in state and local taxes), interest on mortgage debt in excess of $750K, interest on home equity debt, non-disaster casualty losses, and certain miscellaneous expenses.”
That $668.4 billion is coming from property owners. It is a transfer of wealth to the Treasury.
“Under current law,” says Zillow, “roughly 44 percent of U.S. homes are worth enough for it to make sense for a homeowner to itemize their deductions and take advantage of the mortgage interest deduction. Under a reconciled House and Senate tax reform plan that proportion of homes drops to 14.4 percent.”
The Tax Policy Center estimates that only 4 percent of all taxpayers will itemize deductions versus 21 percent under the old rules.
Tax Reform Real Estate Deductions
Huh? How is possible that homeownership deductions remain but fewer people will use them?
In a large number of cases, homeowners will do better taking the new standard deduction rather than taking itemized deductions. This is because the standard deduction has been increased from $12,700 in 2017 to $24,000 in 2018 for a married couple filing jointly. At the same time, itemized deductions have been limited. As an example, the amount that could be deducted under the old rules for property taxes and state and local income taxes was unlimited. Under tax reform, there is a $10,000 cap.
Ownership Advantages Remain
Since both renters and homeowners will be able to take the standard deduction it may seem as though renters have caught up, that tax incentives for homeownership are now less important. However, the advantages of homeownership have never been limited to tax deductions. There are a number of reasons why ownership remains a very attractive housing choice.
First, buy a home with a fixed-rate mortgage and you have locked-in your shelter costs. The expense of principal and interest cannot go up. Alternatively, if you’re a tenant the landlord will always be there to raise the rent.
Second, you have greater control over your lifestyle as a fee-simple property owner. You can have a pet. You can paint the front door any color. Within the bounds of zoning, you can expand the home. You may be able to have a short-term rental business. Think of Airbnb.
Third, if you stick with it you can enjoy a mortgage-free home as you pay down the debt. As a tenant, you will continue to pay rent even if the landlord pays off the mortgage.
Real Estate Profits Sheltered Under Tax Reform
Fourth, under tax reform, there is still a huge benefit when you sell a prime residence. If you have lived in the property for two of the past five years then as much as $500,000 in profits is sheltered from federal taxes. Speak with a tax professional for details.
Fifth, as a property owner you get the benefit of any price increases. As a renter, you get nothing if the value of the property goes up.
Of course, property values can also fall. We saw that most dramatically in the mortgage meltdown. There is no doubt that buying a home – just like buying stocks and bonds – includes an element of risk. Alternatively, with a fixed-rate mortgage if the value of real estate goes down and you don’t sell what you have is shelter with a set cost.
There is also risk in renting. Figures from the Federal Reserve Bank of St. Louis show that rental rates have risen with great consistency since the 1940s. During the mortgage meltdown, rental rates were fairly level in 2009 and 2010 and then once-again went up.
Past performance does not guarantee future results. That’s the usual guidance from Wall Street. So far, at least, ownership is ahead. According to the Federal Reserve’s 2016 Survey of Consumer Finances homeowners have a typical net worth of $231,400 versus $5,200 for renters.