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Sell my House, Really? 3rd edition

You are about to experience what is called a paradigm shift.  This means you are going to change your viewpoint on something because you look at the issue differently.  The classic example is used in Stephen Covey’s book, Seven Habits of Highly Effective People. 

To paraphrase the book, a navy Admiral oversees a night training exercise with several ships while he is on the lead battleship. Radio silence is in effect and the lookout says there is a light bearing 00, which means straight ahead.  The Admiral orders the signal personnel to send a signal to them to change course 30 degrees starboard to avoid the armada.  The signal personnel do so, but then report back the message they received, which says “you should change course 30 degrees.” 

The surprised Admiral orders this message sent. “This is Navy Admiral Jones and you are to change course immediately”.  The message is sent, and the reply is “This is Coast Guard Seaman Smith and you need to change course immediately”.  The now infuriated Admiral instructs a last message be sent “We are the BATTLESHIP USS Enterprise, you must change course now to avoid a collision”.  Back comes the reply, “I am the LIGHTHOUSE Rocky Point and sorry, but I'm not moving”.    

So, what does this have to do with selling my house and renting?  Everything!  Here is the dominate belief about renting versus buying.  The ownership costs are the same and the landlord needs to make a profit, so it MUST cost more to rent.  This sounds so right and there is nothing in that statement that is false.  But, there is a big piece missing.  The TAX treatment of the owner occupier and the landlord are as far apart as the battleship and the lighthouse in the above example. 

Here is a list of some common expenses and the tax treatment of each.  These are per year numbers and reflect the net percentage savings of the expense due to the tax advantages.

Expense Owner Occupied Landlord Tax Treatment Gain for Landlord
reduction to previously identified expenses
Depreciation  none Allowed 2.25%
Repairs & Maint none Allowed 0.60%
Insurance none Allowed 0.30%
Interest Limited Allowed 1.00%
Taxes Limited Allowed 0.50%
Total     4.65%

 

In the Sell my House, Really? first blog, we looked at the average owner probably having about a 5.2% carrying cost or annual expense of ownership, not counting a mortgage.  Because of the favorable tax treatment to rental property, the landlord can offset over 90% of this cost in tax savings versus maybe 10-15% for the owner occupier. This creates a huge economic benefit that is used when rents are considered against the competitive choice of buying.

Add in the ability to defer taxes and pay the capital gains rate and you pick up another 1-2% per year, so we’ll use 1.5% as an average for this benefit.   How about the option to access your gain, by borrowing against the increased value of the property, and not pay any taxes, while being able to completely deduct the interest? This one is tougher to put a percentage on, but let’s just settle at .5% per year.  Add these two nice nuggets to our 4.65% and we are now at an astounding 6.65% return to the landlord from the tax treatment alone!

Now compare the two options, own or rent, from the market perspective.   As an owner, you have 5.2% of ongoing cost plus borrowing cost.   Both should have approximately the same borrowing cost and for this example lets use a 30 year fixed rate of 4.0%, resulting in a 3.0% after tax rate.  This results in our homeowner spending about 8.2% of their property value in providing themselves a house to live in.  The question is how does this 8.7% compare to rental rates? 

Rental rates in the US averaged 9.2% of market value in 2016.  This was obviously higher in some places and lower in others.  This gives us a differential of only 1% between renting and owning, according to the market.  This tiny difference is made possible because of the difference in the TAX TREATMENT of the two types of ownership. 

This opens all kinds of possibilities you might consider with the capital that is freed up by renting.  After all, how hard is it to get a better return than 1% on your money?  Alternatively, is there anywhere you can access funds for only 1%?   You may even want to rent your home from someone and then invest in rental property!   When you consider a 1% rate on capital, many, many options can make you serious returns.

So, the next time someone tells you renting is just like flushing money down the drain, you can just smile and say “True, but only if you don’t know where the lighthouses are!”



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