To Rent or Buy: To Hell with the Landlord or Does He Know Something I Don't?

A friend has asked me to talk about a decision that faces many people, especially in today's economy: renting vs. owning your own home. I'm going to completely ignore the intangible factors, i.e., the psychological satisfaction of being owned by a piece of property (oops, that was a Freudian slip - I swear - and not at all meant to foreshadow my take on the question). Since we have the current home ownership stimulus (TheAmerican Recovery and Reinvestment Act of 2009), I thought I'd use the absolute maximum eligible family (maximum before phase-out of the credit begins) to illustrate the decision-making process . . . at least from a tax/financial planning perspective.
So, let's first assess John and Jane Homebuyer. We will first assume that they have a modified adjusted gross income (MAGI - you just have to love that acronym) of $150,000.00: the precise level where the ARRA credit begins to phase out, and are otherwise qualified for the credit (they haven't owned a home within the last three years, yada, yada, yada). They have a very good income but are prudent about their purchases and willing to live well within their means. They are currently living in a two-bedroom home of some sorts that rents for $900.00. They can buy a comparable home for $150,000.00. Finally, they have the 20% down that is required for the current lending market.
The Homebuyers are going to get a loan at 6% for the balance of the purchase price, or $120,000.00 (we'll ignore closing costs - they complicate matters and ultimately skew the answer further towards the final result - but let's wait and see before we announce that). That $120,000 loan, amortized over thirty years will cost them $719.46 principal and interest per month for the next 360 months. Hey! That looks good, that's a savings of $180.54 per month and we haven't even accounted for the credit and the interest deduction. Oh wait, we forgot about the property taxes. Property taxes on that home in Florida (I'm in Florida so we'll have to use it as an example - I have no idea what property taxes are elsewhere), are likely to run approximately $125 per month (oh boy, most of our savings are already gone - don't worry, though: those real property taxes are tax deductible on your income taxes - whoopee!). You'll also have to have homeowner's insurance (and remember, I'm in Florida). Conservatively, we'll estimate that at $150 per month (this is not tax deductible on your income taxes. So our gross monthly cost for the joy of home ownership is $994.46 ($94.96 more than renting/that's a $1,139.52 annual increase over the cost of renting).
But hey, all that stuff is tax deductible, right? It can't be that bad. Let's add up our "deductions": mortgage interest is$7,159.91 after year one and property taxes are $1,500.00 for the year (I know it is very unlikely you move in on January 1, but bear with me and stop fighting the hypo!), for a grand year one total of $8,659.91. Hey, that's a pretty big deduction, right? There's only one problem. Everyone already gets a standard deduction: and John and Jane Homebuyer's standard deduction for the year will be $11,400 (John and Jane Homebuyer will get an additional standard deduction of $1,000 if they buy the home but don't itemize deductions). John and Jane Homebuyer could add a sales tax deduction of $1,469.00 to their itemized deductions; bringing them up to $10,129.00 in deductions, but that's still short of the standard deduction. It looks like we'll have to compare with the enhanced standard deduction (the extra $1,000 deduction they get for not itemizing if they buy the house).
So, if they buy the house, they incur extra costs in the first year of $1,139.52 but get an extra $1,000 in deductions. Under the 2009 tax brackets, the Homebuyers will pay taxes of $25,337.50 if they buy or $25,587.50 if they rent. Tax are lower with buying! That's good, right? But remember, they spent an extra $1,139.52 per year to own. So with buying the property, they LOST $889.52 on the year. The smart money here says RENT!
But wait, you say. They own the home and it's increasing in value. Let's assume there's a 3% annual increase in value on a home (that is, unless you bought circa 2004 and need to sell now, but let's not even think about that horror). That $150,000 home at the end of year one is now worth $154,500.00. That's worth something, right? You're right, and it's an excellent point. However, in order to recoup that gain, I have to sell, which means paying a real estate commission (probably at around 6% - and again, we'll ignore closing costs - Sellers have to pay them, too). That means I have approximately two years of growth before I can recoup the costs of the real estate agent's services. So, in the long run, the puchase might be a better option. If I have a 3% annual growth, after five years the net value of the home (after the real estate commission to sell it) is approximately $163,500.00. My note balance is approximately $111,500.00, so the net cash I get from the sale of the home is $52,000.00. Assuming the approximately $900 per year LOSS the Homebuyers experience on the purchase (It's $889.52 in Year One but it actually gets worse in subsequent years because mortgage interest, but not mortgage payment, goes down and property taxes go up), the net "gain" on the purchase is $17,500 (remember the Homebuyers already had $30,000 initially). None of this gain is taxable with the primary residential credit.
What happens if the Homebuyers simply put their $30,000 in CDs earning 4% (you can find 12 month CD's paying that with a simple Google search)? They earn $1,200the first year in interest that is taxable at 25%, so they net $900in Year One. By the end of Year Five, they have approximately $34,778.00 in post-tax savings - not exactly retirement-like income generation. They have "gained" $4,778 over the same five year time period. Home ownership wins in this scenario.
Let me introduce a wrinkle though: what if the Homebuyers decide to keep renting AND buy the home but rent it out to someone else? Let's assume they can only rent it for $900 (if I were advising someone, I would advise them to buy where the rent would at least cover the costs, but we'll keep everything equal for this illustration). They will experience that $95 per month "loss", but the great thing is that every expense associated with the property is deductible. Thus, all of the expenses are deductible for a total of $10,460.00. The "income" from the property is $10,800.00 for the year, for a net income of $340 (remember, the actual cashflow on the property is negative in Year One to the tune of approximately $1,140). But this is investment property, and the Homebuyers are required, by law, to depreciate (that's an inartful term, but most people understand it better than "amortize") the property over a 27.5 year period. This means that in addition to their actual expenses on the property, they get to deduct an additional $5,454 per year. This deduction would ultimately show a loss for them of $5,124 for Year One. This loss is going to be limited by certain passive activity rules, but it will be sufficient to zero out the income on the property. Furthermore, the Homebuyers will still get the enhanced standard deduction for the real estate taxes paid. Thus, they will be in exactly the same situation as if they had bought the home for themselves.
This situation improves dramatically if the Homebuyers can find an investment property that will produce a positive cashflow on a monthly basis but still provide no annual tax impact.
Here's the moral of the story: deductions aren't everything, but leverage on an investment is!