Author Topic: imputed rent of owning a house you live in - vs marginal tax and benefits  (Read 6040 times)

Mr Mark

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I'm normally a fan of the leverage opportunities having a house provides.

But when FIRE, I realized that the imputed rent you save when living in your own place is effectively tax free income. While not a big deal when in a high tax bracket, at the magic 30-60k income band, this could have an impact on your marginal tax rates and most especially things like access to cheaper healthcare or other government means tested benefits?

Has anyone worked this out?

Ie if my after tax income is $40k, and I own my own $300k house mortgage free, that would normally lease/mortgage for say $1000 a month.

By not paying rent, my effective income goes up by $12k per year, tax free. its as if i earned $52k after tax. If I instead rent/ borrow to buy, I'd need a $45k bigger stash because of tax at the same SWR to get that now $52k of income. . Plus my health care costs would go up, effectively increasing my marginal tax rate still further. Would a change from 40 to 52 in income impact healthcare or other costs significantly?

aj_yooper

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William Bernstein in The Investor's Manifesto, page 37, analyzes the rental dividend of a home this way:

"A good rule of thumb is to never ever, pay more than 15 years fair rental value for any residence.  This computes out to a 6.7 percent (1/15) gross rental dividend, or 3.7% after taxes, insurance, and maintenance, which is about what you might expect from a mixed portfolio of stocks and bonds.  (Imputed rent does have one real advantage over the return from stocks and bond, which is that it is tax free.)"

Your $40 ER income would place you in the 15% marginal tax rate so the imputed rent would be $1,000*12/.85 or about $14,118 that you would have to earn to afford the $12,000 yearly rent, if you were leasing the space.  This would definitely imply a larger stash.  **So to cover that you would need 25*$14,118 or $352,950 more in the stash, which is about your home value.  But you do pay taxes and maintenance on the home so the imputed rent is decreased by those amounts. 

Bernstein, I think, would  do it this way with your numbers:

12*$1,000/$300,000 or 4% dividend.  Then, you would subtract taxes @ 2% and maintenance @1% for a net of 1% tax free return.  However, your numbers may be underestimating the value of the rent for your home and property taxes vary. 

I used Zillow numbers on our home in this way:

12*$1,600/$210,000 or 9.6%, less 3% taxes and 1% maintenance costs or a return of 5.6% tax free on the value of the home.  Or, I would need  about $22,600 in income to pay the rent here.  (12*$1600/.85)

This seems to be a minority thought on the MMM forum, but I am a fan of Bernstein and like this analysis.  A paid for house in retirement is a real plus to me and to MMM. 

The forum members working to build their stash generally scoff at the plan due to an opportunity cost argument and their higher risk/reward AA numbers. 

The imputed rent is real, it just doesn't show up as income and it doesn't get taxed. 

Owning a home outright flies below the tax radar so far.

**edit
« Last Edit: August 05, 2013, 04:23:31 PM by aj_yooper »

Mr Mark

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Thanks for the analysis.

And that is without counting the impact of high effective marginal rates of taxation with means tested benefits. (What used to be called the poverty trap).

I had been attracted to the extreme leverage idea by the rate of return argument, but once in FIRE having a paid off mortgage on your house is a more attractive idea. The place for leverage is in the rental properties. Protected by llc

aj_yooper

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I agree  to the paid for house in retirement, especially if it is sized right.  SOL is up but without the cash going to fund it. 

fiveoclockshadow

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I think the only "gotcha" to this can be getting too big a house. 

In rent vs. buy decisions for the same home one really should consider the imputed rent, tax deductions on property tax and mortgage interest while the mortgage still exists (to the extent above the standard deductible) in the comparison.  As you point out there may be other indirect impacts related to means testing and so forth.

The pitfall of imputed rent is the danger of not being careful in considering this "income" properly.  Really it is an expense one way or another.  Higher imputed rent implies higher housing expense.  Having a high imputed rent is not a mustachian thing to do!  You want a low rent - imputed or real.

This is somewhat related to the pitfall of viewing a house as an "investment".  It isn't, or well it is a really crappy one.  A house, even when owned free and clear, is an expense and one that should be minimized.  And yet it is easy to buy something too large when you think of it as an "investment".

So by all means consider imputed rent when comparing rent vs. buy.  But also be careful to remember it is both an income and an expense!

Jamesqf

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One of the benefits of not thinking of your house as an investment is that it frees you from worrying about market values.  If I own my house free & clear, I don't have to worry about what the market is doing to the part of my 'stash that would go towards paying for housing - barring a small bit for taxes & insurance, of course.   Long as I can come up with the tax money, I don't have to worry about being tossed out on the street because I can't pay rent, or am getting foreclosed on.

dragoncar

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One of the benefits of not thinking of your house as an investment is that it frees you from worrying about market values.  If I own my house free & clear, I don't have to worry about what the market is doing to the part of my 'stash that would go towards paying for housing - barring a small bit for taxes & insurance, of course.   Long as I can come up with the tax money, I don't have to worry about being tossed out on the street because I can't pay rent, or am getting foreclosed on.

Taxes can have a huge impact.  In CA they run around 1.2%.  If you want a stache to cover that, you need 30% of the purchase price.  Maintenance can be another 1%.  So if you wanted to build a housing trust for yourself, you would need to tack on around 55% to the purchase price to really "own" your home forever (ignoring tax changes and beneficial deductions).  Of course if you have HOA dues its even more.  That's a spicy meatball.

aj_yooper

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I think of a paid off house as a prepaid expense that may deliver a 1% real return.

Jamesqf

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But my point was that (other than HOA dues, which I hope any sane person would avoid by choosing not to live in such a place), the taxes &c aren't subject to large changes.  Think of it as equivalent to buying an inflation-protected annuity.

aj_yooper

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But my point was that (other than HOA dues, which I hope any sane person would avoid by choosing not to live in such a place), the taxes &c aren't subject to large changes.  Think of it as equivalent to buying an inflation-protected annuity.

I like that!  Bernstein says it might even have a possible real annualized return of 1% plus the inflation-protection you note.  It does come with the pesky maintenance issues, but then, renting space, has issues too and ownership means more control of one's living environment. 

I think MMM is on to something with his paid up housing idea in retirement.

dragoncar

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But my point was that (other than HOA dues, which I hope any sane person would avoid by choosing not to live in such a place), the taxes &c aren't subject to large changes.  Think of it as equivalent to buying an inflation-protected annuity.

Yeah, an annuity that costs 55% of the purchase price.

aj_yooper

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I would guess that housing is about 15-25% of the average budget for most people so that translates into a mighty bite on the stash for paid for houses and not.

Unrelated post:

I saw this post on the pros/cons of owning a home outright:

http://affordanything.com/2013/03/22/pay-off-your-mortgage-or-invest-in-the-stock-market/

Mr Mark

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I support the comments on the danger of overspending on your retirement house. The house you live in is an expense, mainly.

And there are two distinct phases. In full accumulation mode, years from FIRE, I still think a 30 yr fixed mortgage invested in the market is better under current US conditions. YMMV

But post FIRE I will be paying of my mortgage, maybe arrange a HELOC, and then maximising leverage (at least at these rates)  on a few rentals. I'm even thinking multiple LLCs.

And yes, allow a % of your 'stash's portfolio at 4%swr to cover all reasonable forward cashflow on the property. Yes, this adds a huge % to the effective cost of your house, but it forces you to properly consider post tax cashflow. And encourages a cheaper house.

But given the increasing impact of healthcare costs and other government benefits that require (or may require)  means testing against declared income, that hidden income is worth a lot more that the sticker rental equiv. Add the many other benefits emotionally of knowing you own freehold a piece of the planet.... priceless.
« Last Edit: August 10, 2013, 12:43:09 AM by Mr Mark »

Crash87

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I didn't do a ton of math on my apartment. I figured I don't need a lot of space so I rented a 550 sqft apartment, but I would never buy a house so small.

Maybe this link will help:

http://www.nytimes.com/interactive/business/buy-rent-calculator.html?_r=0

Jamesqf

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There are a couple of other financial benefits to paying off a mortgage.  One is that I have to pay something over $1K/yr for flood insurance, even though my house is situated in a place that won't be flooded.  Another is that because a lot of the value of my place is in land rather than the house structure, I continually have to fight the insurance companies to get a policy based on a realistic replacement cost rather than total property value.  Getting free of those mortgage-related obligations would save me about $100/month.  (Or alternatively, I'd have to add an extra $30K to my retirement stash to cover them.)

Mr Mark

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There are a couple of other financial benefits to paying off a mortgage.  One is that I have to pay something over $1K/yr for flood insurance, even though my house is situated in a place that won't be flooded.  Another is that because a lot of the value of my place is in land rather than the house structure, I continually have to fight the insurance companies to get a policy based on a realistic replacement cost rather than total property value.  Getting free of those mortgage-related obligations would save me about $100/month.  (Or alternatively, I'd have to add an extra $30K to my retirement stash to cover them.)

Nice one. Hadn't thought of that saving either.