Renting vs. Buying a Home

Should you buy or rent your home?  This decision can include financial and non-financial factors.  Even if the non-financial aspects are extremely important, you should not overlook the financial side.

Crucial Ratio

One key to choosing between buying or renting is to determine the annual rent-to-purchase price ratio in the housing market you’re considering.  The higher this ratio, the greater the advantage of buying a home.

Example 1:  Bart Smith is considering the purchase of a home that is priced at $200,000.  He cant rent a comparable property in the same neighborhood for $800 per month, which is $9,600 a year.  The rent-to-purchase ratio is $9,600 to $200,000, or 4.8%.

Example 2:  In a different area of the country, Beth Jones also is eyeing a $200,000 home.  A comparable property would rent for $1,200 per month, or $14,400 annually.  Thus, the rent-to-purchase ratio for Beth is 7.2% ($14,400 to $200,000) a month.

A recent study from Morningstar’s HelloWallet unit indicates that renting might be a better choice when the rent-to-purchase ratio is below 5%, while buying may be preferable if that ratio is above 7%.  That is, the more you’ll have to pay to rent a desirable home, relative to home prices, the greater the chance that the numbers will favor a purchase.

Assuming the rent-to-purchase ratio is favorable, young taxpayers with relatively low early career incomes might do well to rent rather than purchase a home.  The same may be true for relocating retirees who have modest incomes after they exit the workforce.

Conversely, high-income taxpayers might enjoy considerable tax savings from home ownership, assuming they are comfortable with the purchase price.  Today’s low interest rates make financing home ownership appealing, and the leverage can add to any profits from home price appreciation.

Thinking About Taxes

Homeowners may enjoy multiple tax benefits that are not available to renters.  Mortgage interest and property tax payments may be tax-deductible (as itemized deductions) in 2018, as follows:

Mortgage Interest & Property Tax Deductions

Moreover, profits on a sale of your home are often tax-free due to an exemption from capital gains tax.  Assuming the home was owned and occupied at least two (2) of the preceding five (5) years, up to $250,000 of gains are untaxed ($500,000 for married couples filing a joint tax return).

Of course, there is no way for a home buyer to know if a home will eventually be sold at a profit.  What’s more, the deductions for mortgage interest and property taxes may not generate any actual tax savings.  That’s because those savings are only available to taxpayers who itemize deductions.  Homeowners taking the standard deduction get no tax benefit from their mortgage interest or property tax payments.

Example 3:  Craig and Diane Emerson bought a house for $200,000, taking out a $160,000 mortgage.  At a 4% interest rate on their mortgage, their interest payments this year are $6,400 (4% of $160,000).  The Emersons also pay $7,500 in state and local taxes ($3,500 in state income taxes plus $4,000 in property taxes) and make $9,000 in charitable donations, for a total of $22,900 in possible itemized deductions.

In 2018, the standard deduction is $12,000 for single filers and $24,000 for married couples filing jointly.  Thus, the Emersons will choose the standard deduction and get no tax benefit from paying mortgage interest and property taxes.

Tax Bracket Truths

Now, what happens if the Emersons had $29,200 in itemized deductions instead of $22,900?  If so, they would itemize and deduct their mortgage interest and property tax payments.  In this scenario, $29,200 of itemized deductions is $5,200 greater than the standard deduction for a married couple filing jointly, so the Emersons’ net tax deduction from home ownership would be $5,200.  Assuming an effective marginal tax rate of 20%, that $5,200 in additional deductions would save them $1,040 in tax this year.

Example 4:  Assume the same financial information as in example 3, but assume the Emersons have a higher income and, thus, have an effective marginal tax rate of 30%.  In this case, the same $5,200 in net tax deductions from home ownership would save the Emersons $1,560 in tax.  With a higher income, owning a home saves more tax.

Other Issues

The decision about whether to rent or buy a home involves more than the purchase price, rental rates, and tax savings.  Buying a house means saving up a great deal of cash for a down payment and putting that cash into an illiquid asset.  Renting may leave you with more easily accessible cash, but will that cash be invested wisely or spent imprudently?  It’s also important to decide if the responsibility of home ownership is for you.  Either way, financial concerns are vital to residential decisions.

Additional Resources

IRS okays home equity deductions by Dillon Wright


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