The title might take many of you by surprise and this topic is not to discourage homeownership but is more geared to explaining why your home (and possibly other properties) may not be the best investment or why your home should not be viewed as an investment.
The primary focus of this article will be on your primary residence and not on rental properties. We are also going to assume that this is just an average community without any additional factors such as a gold rush, or a green rush, or an establishment as the next Silicon Valley. In those circumstances, real estate can outpace the national average. Do not forget the three things that matter in real estate is location, location, location!
The ability to use leverage (borrow money from the bank) is what attracts people to invest in real estate. When you buy the home you only have to put down 20% or less in some cases and the bank gives you a loan to pay on over the next 30 years (or whatever term you select). For example, purchasing a home for $500,000 in a traditional scenario requires 20% down ($100,000) and the bank provides a loan over 30 years for $400,000. With rates near historic lows (2.75%) the payment for this 30-year loan is about $2,041 per month.
The downside to using leverage is that it has a cost. Looking at the loan above ($400,000 loan at 2.75% interest for 30 years) you would pay over $187,000 in interest over the life of the loan! To put this another way, instead of buying the home at $500,000 you are paying $687,000 for the home ($500k purchase price + $187k interest paid). Owning a home is expensive and has many additional costs besides the loan. With a home, you have to pay property taxes, homeowner insurance, repairs, and potentially other costs like homeowner’s association (HOA) or mortgage insurance if your down payment is less than 20%. Below are the estimated costs for a $500,000 home in Orange County:
What we see is that the true cost of homeownership is much higher than we realize. The example above does not take into account any upgrades or repairs and maintenance the home may need as well. With the costs for owning a home so high, this lowers the actual investment return of the home.
We all know that home prices go up over time, but many people are not aware that the primary driver for the increase in home prices has been inflation. If you look at the chart below, it shows since March 1999 until now real estate home prices (1) have grown 131.37% and stocks (2) have grown 342.27%.
Another factor that needs to be considered when looking into real estate as an investment is liquidity. Other investments like the equity and bond markets provide liquidity and you can have access to your money quickly. For real estate, this is not necessarily the case and it can be difficult to get your money back. If major employers move out of the area, you cannot quickly sell your home before home prices drastically shift downward.
Please understand we are not telling you to not buy a home. Homeownership is one of the biggest accomplishments one can achieve and provides security and stability for you and your family. We just caution against considering your primary residence to be considered an investment like many people recommend. Real estate is good as part of an overall portfolio but can be done in many ways in a more liquid manner. Please feel free to contact us to discuss how this article impacts your circumstances.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Benefit Financial Services Group (“BFSG”), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from BFSG. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. BFSG is neither a law firm, nor a certified public accounting firm, and no portion of the newsletter content should be construed as legal or accounting advice. A copy of BFSG’s current written disclosure Brochure discussing our advisory services and fees is available upon request
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California is about to go through a dramatic change to real estate and property tax assessments with Proposition 19 (Prop 19) going into effect on February 16, 2021. Prop 19 replaces Proposition 58 (Prop 58), which has provided a favorable transfer of real estate from parent to child. It is important to understand these changes to see if you need to make any immediate changes to your real estate holdings before Prop 19 takes effect.
How do current laws work?
Currently, real estate with a low tax basis can be transferred during the parent’s lifetime or at death to a child and the child keeps the low basis and it does not trigger a tax reassessment. This rule applies to both primary residences and rental properties. The kids can live in the home or turn it into a rental and maintain the same low taxes the parents enjoyed. This transfer has unlimited value for a primary residence and “non-principal residence” (rentals or other homes) is limited to $1 million of assessed value per person. A married couple can transfer $2 million in assessed value. This means a property worth $3 million but a tax assessed value of $750,000 can be transferred to the children.
What changes with Prop 19?
Under Prop 19 any primary residence gifted to children will require the children to maintain that as their primary residence for the remainder of their life. If they turn the property into a rental or live in another home, that will trigger a tax reassessment on the property creating larger property taxes. The exemption amount is lowered to $1 million and applies ONLY to primary residences. The non-primary residence home exclusion is eliminated and will trigger a tax reassessment.
1. Primary Residence
Assume you bought a home twenty-five years ago and today it is worth $2.4 million but has a tax assessed value of $400,000. Under current law, the home can be transferred to your children during your life or at death and they will maintain the tax basis of $400,000 and can live in the home or turn it into a rental.
Under Prop 19, once the home is transferred to your children, one of them must live in the home immediately and maintain it as a primary residence indefinitely to avoid a tax reassessment. Since the home is worth more than the $1 million new exemption, it would trigger a new tax assessed value. The new tax assessed value would be $1.4 million ($2.4 million value – $1 million exemption) instead of $400,000.
2. Rental Property
Assume you bought a rental property twenty-five years ago and today it is worth $2.4 million but has a tax assessed value of $400,000. Under current law, the home can be transferred to the kids and they maintain the $400,000 tax assessed value since a couple can use exemptions up to $2 million in tax assessed value.
Under Prop 19, the “non-principal value” exemption is eliminated so it would trigger a large tax assessment and the kids do not retain the $400,000 tax assessed value.
What should you do?
If you own a home in California with a low tax basis and would like to keep the property in the family, talk with us and your estate planning attorney today to explore if you should consider gifting the property before the February 16th deadline when Prop 19 takes effect. If you would like to contact us, please speak with your advisor or you can reach us at email@example.com.