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The principal incentives for home ownership are security - your rent will never go up, the lease will always be renewed and you can draw upon your home equity in emergencies - and the control that ownership provides over your personal living space - you don't need the landlord's OK to paint the bedroom, for example.

The income tax advantages of home ownership are that one may deduct mortgage interest and real estate taxes.  This deduction is of no value to the low wage earner or to the retired individual who pays little or no taxes.

When you have enough money to pay cash for your home, a mortgage makes financial sense if the mortgage rate is less than the pretax rate of return that you earn on your investments.  So, if your money is in a CD earning 6%, it costs you money to have a 7% mortgage.  On the other hand, if you are earning 10% in the stock market, a 7% mortgage is financially profitable.

Residences are unusual investments because there is often no way to spend the gain.   (If you realize $300,000 from the sale of  home that you purchased for $100,000, you have no "profit" if you must reinvest the proceeds in another home.)

If you sell your personal residence, Section 121 allows each owner to exclude up to $250,000 of the gain if they meet the ownership and use tests.  (Own for two of the prior five years and use as the primary personal residence for two of the prior five years.  Ownership and use need no be coincidental.)  There is no longer a requirement that you purchase a new home in order to exclude the gain.

If you die owning a personal residence or other appreciated property, any unrealized gain is forgiven on the portion that you own.  If spouses own property in joint tenancy, for example, one half of the gain would be excluded.  If the property is owned as community property, the entire property receives a stepped up basis upon the death of either spouse and the entire gain is excluded.

Residential Rental

Cash flow from a residential rental is likely to be neutral or even negative since rental income seldom covers current costs plus the opportunity cost of invested capital and the value of the owner's labor (or the cost of professional management.)

Long term real estate appreciation rates are comparable to long term appreciation in the stock market but real estate investment can be more highly leveraged and hence more profitable. Leverage is using someone else's money to buy an appreciating asset. If you put 10% down and the property appreciates 10%, you double your money. Of course, if the property declines in value, you could lose your entire investment. Real estate is also less liquid than are stocks and bonds.

Depreciation is another advantage of real estate ownership. Depreciation is the process whereby part of the cost of a business property is returned each year as an income tax deduction which, with proper planning, can reduce taxable income. For example, if you have $100,000 in depreciable residential rentals, you might get a $3,636 income deduction each year. This is worth $1,273 a year in tax savings, assuming a combined federal and state tax rate of 35%. When the building is sold after ten years, you are taxed on the $36,360 in prior depreciation but at a 32% rate. The net present value of this income/cost stream is about three thousand dollars after tax, assuming 8% after tax return as the reference. A "Starker exchange" allows the tax to be deferred.  The tax is forgiven upon death. In the extreme, the NPV8 benefit could exceed nine thousand dollars.

For more information, consult a text like David Sirota's "Essential of Real Estate Investment."

Before undertaking a real estate investment, be sure to develop a cash flow forecast and to estimate income tax effects.

Assumptions: 27.5 year class life, sale in the tenth year, AGI less than $100,000 and 25% federal tax on the recapture of straight line depreciation of Section 1250 property.

A vacation home is treated much like a personal residence. The owner is entitled to a full income tax deduction for mortgage interest and real estate taxes but the Section 121 forgiveness of $250,000 of gain on sale does not apply.

If you enjoy and also rent a vacation home, the owner may deduct mortgage interest and real estate taxes and a pro rata portion of depreciation and other expenses so long as these costs do not exceed rental income.

For example, assume that you rent your seaside home two months during the summer for $5,000 a month and that you use your vacation home personally one month during the year.   Mortgage interest and real estate taxes are $18,000, utilities and maintenance are   $1,200 and depreciation is $6,000 a year and these costs are apportioned two thirds to the rental activity and one third to personal use.

The rental share of these expenses is $16,800.  Since the rental share of the expenses exceeds the rental income, your tax deductions are limited.  In this example, you are entitled to deduct all of the mortgage interest and all of the real estate taxes but you may not deduct any of the other expenses even though they would probably be deductible if you did not use the property personally.  In general, you are probably not going to be taxed on the income from renting your vacation home but you may not receive a tax deduction for expenses and you are unlikely to receive any benefit from depreciation.

This summary is of a general nature only and may not apply to your situation.   If in doubt, seek competent advice. Posted September 15, 1999.