Should You Buy a Home?

The desire to join the nearly 70% of Americans who are homeowners entails various intangibles: pride of ownership and becoming a part of a neighborhood. Home ownership also has a direct impact on your pocketbook now and for years to come. Can you afford it? Does it make financial sense?

Affordability. As a rule of thumb, experts suggest that a prospective homeowner can afford to carry a mortgage on property that costs roughly 2 to 2.5 times the homeowner’s annual income (before tax). Someone with a salary of $75,000 (and no other income) could afford a residence costing $150,000 to $187,500. With a 20% down payment, this means having a mortgage of $120,000 on a $150,000 home. A 30-year fixed mortgage at 6% interest results in monthly payments to cover interest and principal of $719.47, or $8,633.64 annually.

Another cost for homeowners is property taxes, which local governments assess to cover school costs, police, and other municipal services. Another rule of thumb pegs the affordability of property taxes at 3.1% of annual pretax income, so the person earning $75,000 could afford a home with annual property taxes of $2,325.

Expect annual maintenance costs to average between 1% and 1.5% of the residence’s value, or about $1,500 a year for a $150,000 home. Thus, total costs for buying a $150,000 home run about $12,000 annually.

After-tax cost. Being a homeowner and paying these expenses does not mean you are out-of-pocket $12,000. The reason: A portion of this amount is tax deductible. Homeowners who pay mortgage interest and property taxes can deduct these costs as itemized deductions. In effect, your Uncle Sam pays part of the cost by way of reducing the taxes you owe. Say of the $8,633.64 mortgage payments, $8,400 represents deductible interest. Add to this fully deductible property taxes of $2,325, for total deductions of $10,725. For someone in the 25% tax bracket, it means a savings of $2,681 (or $1,607 in the 15% tax bracket). Tax savings increase when state income taxes are factored in.

Tip: You don’t have to wait until you file your return to reap these tax savings. You can receive them throughout the year by decreasing tax withholding from your pay. You do this by filing a new W-4 form with your employer and increase the number of wage withholding exemptions

Potential tax-free gain. Current tax savings aren’t the only thing to consider. Historically, homes appreciate in value and can be sold for tax-free gain if certain conditions are met. The tax law has a home sale exclusion of up to $250,000 ($500,000 on a joint return), which transforms capital gains on the sale of a residence into tax-free income. Say your $150,000 triples over the years to $450,000. Your gain of $300,000 (the difference between what you paid and what you received on the sale) is not taxed to the extent of this exclusion.

Renters who invest what would otherwise be a down payment on a home can also build up funds. However, they do not enjoy any current tax breaks for paying their rent (except those who run a business from home and claim a home office deduction). Assume an after-tax return on this investment of 6% annually, after 10 years, the initial $30,000 investment will grow to nearly $54,000. In addition, renters can invest what they are not paying toward home ownership (the difference between (1) annual rent and utilities, and (2) mortgage payments, property taxes, maintenance, utilities and other home ownership costs).

In the end, owners and renters may not fare too differently, from a financial perspective. However, variables, such as interest rates and property appreciation-things that can’t be known in advance, will have a great impact on which choice proves to be the better one.

Qualifying for special tax breaks. Certain homeowners may be eligible for tax breaks that reduce federal income tax and, thus, enable them to keep more money in their pockets.

• D.C. first-time home buyer credit. First-time home buyers in the District of Columbia, but nowhere else, may be eligible for a one-time tax credit for buying a home there. The credit is up to $5,000, or $2,500 for those who are married and file separate returns. The credit is phased out for those with modified adjusted gross income over $70,000 if single, or $110,000 on a joint return. No credit may be claimed for singles with MAGI over $90,000, or married couples filing jointly with MAGI over $130,000.
• Mortgage interest credit for low-income home buyers. Regardless of where you live, if you meet certain income standards, you can receive a mortgage credit certificate (MCC) from the state or local government showing the credit rate used to figure the credit. This entitles you to a credit each year for the amount of indebtedness listed on the certificate. The certificate must be obtained before the home is purchased.