Rent vs. Buy

Over the years I’ve had lots of clients tell me that they’re buying a house, and they’re expecting to save so much money in income taxes. I’ve also had clients who asked me ahead of time to run some numbers, to tell them how much they can really expect to save in income taxes. Similar to the questions I’ve gotten about leasing a car vs. buying, and tax savings for dependents, one of the first replies I give people is “you can’t live your life for tax consequences”. I know, I’m a CPA, taxes are my job, and I’m supposed to help people save taxes, and I do that. But sometimes there are other factors involved that can outweigh income tax savings, and that’s what I want to toss out in this article.

A few months ago I brought up an imaginary couple, Bristol and Levi. I’d like to revisit them, as they’re considering making a major financial decision that could have income tax and other consequences. Between the two of them, they make $100K in wage income, and their investment income (interest and dividends) is negligible, so for tax purposes, their adjusted gross income is $100K. They’re currently renting a 1 bedroom/1 bathroom apartment in Ballston for $2K/month. Since that rent isn’t deductible, their joint federal tax return shows a standard deduction plus two exemptions, their taxable income is about $81K, and the federal tax is about $13K.

Bristol and Levi just found out that they’re going to be parents, and realize that the apartment will be too small for three occupants, so they decide it’s time to buy a house in the burbs. With all the income tax they’re going to save, it’ll be easy to buy all those Pampers, right? Not so fast, folks! They soon discover that things aren’t that cheap in the burbs, plus they realize that they can’t move too far from DC, because the commute will be a killer. They decide to focus on Fairfax, and find a nice place that has four bedrooms and two bathrooms, which sells for $420K. As they move forward with the process, they find out that the real estate taxes are $4K/year, and a 30 year fixed rate mortgage has a 4.5% interest rate. Armed with that information, they soon find out some surprising results.

As homeowners, they’re entitled to itemized deductions for mortgage interest and real estate taxes. Taking a mortgage for 80% of the value ($336K), the total interest they’ll pay in year one will be about $15K, which will be their itemized deduction, along with the $4K of real estate tax. Assuming no other itemized deductions (medical, charity, etc), their projected taxable income will be about $74K, and federal tax will be about $11K, or about $2K less than if they rent. Woohoo, that’s a lot of Pampers…isn’t it?!

O.K., so they save a couple of thousand dollars by renting, but is that really enough financial incentive to buy a house? Let’s look at cash flow, since it’s not just taxes we’re talking about here. Renting is costing them $2K/mo, or $24K/yr. The monthly mortgage payment is about $1700/mo, or just over $20K/yr. The real estate taxes are $4K/yr, so when all’s said and done, the savings in cash flow is pretty much just the $2K saved in federal tax. There are all sorts of other “intangible tangible” things to think of too, including

-they’ll need to accumulate the 20% down payment of $84K, or else the interest rate will probably be higher, or they may not even qualify for a mortgage
-they’ll have to pay homeowner’s insurance
-their monthly utility bills will probably be a lot higher (electric, gas, oil, water)
-they’ll have to pay for lawn care, snow removal, etc
-they’ll have to pay for repairs and maintenance (roof, a/c, etc)
-if the house needs upgrades, they’ll have to pay for those, or take a home equity loan, if they can get it

I’m sure there are other things that I’ve left out of this computation, which are beyond the scope of this discussion (such as time value of money/opportunity costs), but the bottom line here is to remember that tax consequences can’t be the sole basis of a financial decision, in spite of what any CPA might say.

Please leave a comment, and let me know if you have questions, or if I can help you with running some numbers.

2 thoughts on “Rent vs. Buy”

  1. I agree Jay, it’s just not a good enough incentive to buy a house just for tax purposes. As a person who works in financial services, people are surprised when I tell them that renting isn’t bad at all. In fact, for a lot of people, it makes a lot of sense.

    Just like anything that effects your wallet, you should always have a real idea of your personal cash flow. Sure buying a space locks in your “core” living expense (the cost of the home), but so many other external factors come into play when you are the owner of your space. Taxes will only go up, if you are living in a development or condo, your HOA expenses will only go up as well. Do you have a budget for repairing/ replacing major appliances? And don’t forget that periodic maintenance on a house can be very expensive and the most costly repairs always seem to hit on months that savings are low. As your living space ages, your utilities will increase due to some inefficiencies in the living space. And all the while, your monthly mortgage payment will not drop just because you are paying down principal on the loan unless your refinance your loan, which will cause you to incur further expenses. And I should also mention that in light of current and future fuel prices, moving further out of town to save money on housing costs could really hurt in the long run. High fuel prices and vehicle depreciation are a “silent killer” in most homeowner’s personal budgets.

    And please don’t tell me buying is a great investment. Ah, that feverish year of 2006. A house isn’t an investment, it’s a living space! A stock can be sold in ten minutes to a broker for whatever amount they traded for on Wall Street that day. If you bought a stock and saw that it was dropping in value, within 24 hours you could sell it off and be done with it. If you bought a house as an investment, by the time you realize the market is tanking, everybody else who has been doing their homework on buying a home has realized that it’s now a buyer’s market and unless you drop the price significantly, they can wait you out. Then your house not only stopped appreciating, but also begun to lose value. When will it stop losing value? When it’s sold to a buyer and not a second before. And, in selling your home in a down market, you are in competition with every other seller in town.

    Not only should cash flow play a big part in your decision to buy versus rent, but your time at the address should also be the other half of the equation. I don’t know why, but the residence time of a typical Washingtonian is only a few years, something I don’t understand because this town is great! If the value appreciation of the home won’t offset the amount that you paid in closing costs and every single monthly mortgage payment you have made, then you have just rented a house from the bank. AND you essentially kept the house up for them at your own expense. Think about that when you are mowing your lawn in 105 degree heat.

    So you have read all of this and have decided that you still might want to be a homeowner. Sit down and add up everything that you currently pay as a renter and then come up with a final dollar amount. Let’s call that total “A”. Then on the other side of the paper, write down everything that you will have to pay to own a home and label that “B”. If B comes out cheaper than A, with some adjustment for future expenses, then consider buying. If A comes out on top, stay in your rental. It it better to go to sleep in your rental than to be losing sleep trying to figure out how to stave off foreclosure.

  2. Jay,

    I appreciate and wholeheartedly agree with your perspective on home ownership. Home ownership is not for everyone. When deciding to buy a property and put down roots, one really needs to weigh both the financial side AND the emotional side.Tax implications, maintenance costs and budget savings are important to calculate. Other factors are job security, opportunity costs, emotional commitment and desire for control of your environment.

    In this economy, I don’t need to say much about job security. However, we live in a large enough metro area that some of my clients are secure in the idea that the type of work they do would mean their next job would be in this area even if they lose their current job. They just focus on building up that 3 to 6 month reserve in case they do lose their job. Isn’t that what we should be doing anyway?

    Opportunity costs may mean that you need to replace your roof instead of going to Venezuela for 10 days. Or, maybe you need to mow your lawn on Thursday night so that you can go camping for the weekend. The trade-offs that home ownership requires can sometimes be a drag. But if ownership is right for you, these “cons” are offset by “pros” that allow you to put down roots. Many renters I encounter are tired of moving every 12 months. Or they’re tired of living out of boxes. They are annoyed that they have to move out when their landlord decides to move back in or to sell. They are frustrated by the amount of money they’re paying to keep some bigger pieces of furniture in storage. Or, they want to open up the kitchen to make their space more entertainment-worthy. Renting doesn’t allow them the long-term control that they want over their living environment. And that long-term control often outweighs some of these shorter term opportunity costs.

    Home ownership is not for everyone. I spend a lot of time with my buyer clients trying to make sure that their expectations of the market are appropriate and that their goals are achievable. Without this consultation, buyers might still think that their homes can work as ATM machines!

    Chris Fischer
    McEnearney Associates Inc

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