Scott Snider
- Jun 28, 2018

Ask an Advisor Series - Homeownership

Updated: Jul 28, 2020

Welcome to the 3rd installment of The Money Blog's Ask An Advisor Series, whereby readers get answers to timely and relevant questions received from clients, prospective clients, and other advisors. The purpose of such a series is to give you, the reader, an actual look into how a financial advisor can better help you evaluate key decisions that greatly impact your future.

Today's focus is on an area that is near and dear to a lot of people - housing. After all owning a home is considered a staple of the American dream. The family memories, the feeling of having a place to call your own, and the ability to do whatever you want behind closed doors are appealing to most of us. At the same time, such a dream comes with great financial responsibility.

Given what's at stake with buying and selling a house, today's Q&A article is certainly worth the read. Here is a quick preview of the topics that we will be diving into:

Are we in a housing bubble?
Why are home prices soaring?
What are the ins and outs of PMI (Private Mortgage Insurance)?
When is it better to choose a higher interest mortgage with no PMI versus a lower interest rate mortgage that includes PMI?
What are the tax consequences of selling a primary residence at a gain?
What kind of taxes are owed when selling a rental property?

Without further ado, let's get started with our first question...

WHEN WILL THE CURRENT HOUSING BUBBLE FINALLY BURST?

The current housing crisis is not a bubble. There is a big difference between the two terms “crisis” and “bubble.” Understanding those differences is key to knowing why housing prices are increasing at a rapid pace.

First, let’s dig into what defines a bubble. An asset bubble occurs during a time of speculative mania whereby the price of the asset far exceeds its intrinsic value. In other words, the growth rate of the asset is rising at an unsustainable rate and once enough investors begin cashing out, the rest of the speculators hit the panic button and the price of the asset rapidly free-falls.

In the case of the housing market, the keyword within the definition of a bubble is “speculative.” Most of us agree that the current growth rate in housing prices is unsustainable and is reaching a crisis level for those who can’t afford to buy an entry-level home. However, this crisis is not due to speculation. It is a result of fundamental economics — the laws of supply and demand.

According to this USA Today article, new housing construction has not yet recovered to the levels it once reached previous to the Great Recession. In fact, new construction is going at a snail's pace, especially in the low-priced and mid-priced markets. Currently, most of the new construction is focused on higher-end homes because builders see that market as a safer investment. Furthermore, commercial lenders are reluctant to take on real estate investment loans. Real estate developers and commercial lenders took a bath during the Great Recession and both are trying to avoid a repeat of “overbuilding” like before. This is largely the cause, whereas the effect is a direct result of intense competition.

One of the main driving forces behind rising prices is that the largest cohort in the US, Millennials, are entering the homebuyer market for the first time. Meaning buying a low-to-mid priced home has become extremely competitive. Therefore, the trendy areas to live, like the Bay Area and Chicago, are seeing home values skyrocket. However, homebuyers shopping in other areas with good school districts are also experiencing similar issues. Consequently, housing demand is far exceeding the level of supply.

To see for yourself, review the following charts created by Dr. Roman Cech. His analysis compares the trend of existing home sales and inventory to the supply of existing homes over the last decade.

The bottom line is that until the pace of new housing construction picks up, we should expect to see the increase in home values to continue along its current trend. Sellers hold all the cards for now. Once the power is back in the hands of the buyer, then the supply-demand equation will come back to Earth, and home prices will begin to fall in line with a more normalized trend. When and how that normalization will occur falls largely on the shoulders of home builders and banks.

I HAVE A QUESTION ABOUT PMI (PRIVATE MORTGAGE INSURANCE).

MY CLIENT HATES PAYING PMI. THEY PUT 10% DOWN WHEN THEY BOUGHT 3.5 YEARS AGO AND PAY ABOUT $125/MONTH IN PMI. THEY ARE AT ABOUT 16% EQUITY IN THE HOME AND THEY JUST SUNK ANOTHER $8,000 INTO A NEW ROOF. IS IT WORTH INVESTIGATING WHETHER OR NOT THEY COULD GET THE PMI LIFTED? HOW WOULD THEY PURSUE DOING THAT IF SO? DOES THIS INVOLVE PAYING SOME PROFESSIONAL FOR AN OFFICIAL APPRAISAL OR ASKING THE LENDER TO DO SOMETHING?

Your clients are not alone. Most people hate paying PMI. I certainly do.

To answer your question, it depends on the loan. A 20% down payment at the time of purchase is the primary way to avoid PMI from the get-go. In the case of your clients they put 10% down, therefore, they will need to have a loan-to-value ratio of 78% in order to waive their PMI without any pushback from the lender.

Just be mindful of the fact that FHA loans do not allow PMI to ever be waived -- the only way to get rid of it is to refinance or sell. However, conventional loans are required to automatically drop PMI once the balance reaches 78% LTV.

A borrower may initiate a request to have the lender waive PMI once the LTV ratio reaches 80%. Just know that it's not automatic and an appraisal is necessary at the borrower's expense. So if the 16% you referenced did not yet factor in any home value appreciation and it's not an FHA loan, then I would recommend your client request an appraisal.

Also, note that home improvements help. Hopefully, your client kept records of any upgrades to fixtures, roofing, etc. Should your clients elect to move forward, be sure to prep them that an appraisal will cost them somewhere around $400-$600. Meaning they need to be okay with losing out on that money if the appraisal comes in lower than expected.

*Definition: Loan-to-vale (LTV) is a ratio commonly used by banks that takes your total mortgage balance(s) divided by your home's current market value.

I HAVE A HOME BUYING QUESTION. CAN YOU TELL ME WHICH OF THE TWO SCENARIOS IS A BETTER OPTION?

SCENARIO #1 - WELLS FARGO:

PURCHASE PRICE IS $270,000 WITH AN INTEREST RATE OF 4.87% AND 3% DOWN. SO TOTAL FINANCING OF $261,900. THERE IS PMI ON THIS LOAN, HOWEVER, I AM NOT SURE OF THE PERCENTAGE? IT LOOKS LIKE THE STANDARD IS 1% OF THE LOAN.

SCENARIO #2 - NAVY FEDERAL CREDIT UNION:

I GOT ANOTHER QUOTE FOR $270,00 PURCHASE PRICE WITH NO MONEY DOWN AND NO PMI, BUT THE INTEREST RATE IS 5.75%.

Before even running the numbers, I think the best option is the lower rate loan with 3% down because I am a firm believer in having some type of down payment. The reason being is that you never know what direction the housing market will go. Let the housing crash of 2008 be a lesson to us all. In other words, if you have 0% equity from the start, you very well could put yourself in a bind if or when you ever need to sell the house.

However, it's important to cast aside my own personal philosophy and give you the facts. Which is why I ran the numbers anyway.

Regarding the comparison outlined below, I am excluding property taxes and insurance to keep everything focused on what you are truly evaluating. Also, the cost of PMI will range between 0.50%-1% of the loan amount. The percentage that applies is generally tied to the amount of money down, as well as the type of loan. However, I like being as specific as possible. Therefore, I used the following PMI calculator to estimate your monthly cost, which you will find listed in scenario #1.

Without further ado, here is a comparison of the two scenarios you inquired about:

Scenario #1 - 3% Down @ 4.87%

Mortgage Balance = $261,900
Payment = $1,505.20

> Principal & Interest = $1,385.20

> PMI = $120.00

Total Interest = $236,773
5-year PMI Cost = $7,200
Down Payment = $8,100

Scenario #2 - 0% Down @ 5.75%

Mortgage Balance = $270,000
Payment = $1,575.65

> Principal & Interest = $1,575.65

> PMI = $0

Total Interest = $297,233
5-year PMI Cost = $0
Down Payment = $0

My conclusion from the comparison above is that scenario #1 is your best bet. However, let's take a closer look to make sure.

Over the full 30 years of your loan, the interest cost savings in scenario #1 is $60,420. Don't forget we need to account for your PMI cost, which is $7,200. This reduces your overall savings in scenario #1 to $53,220. Furthermore, you reduced your rainy day fund by $8,100 for the down payment. You should also be aware that the PMI cost is assuming you only pay it for 5 years, it could be more or less depending on a number of factors.

The problem with considering the full term of the loans is that most people don't live in the same house for 30 years. According to the NAHB (National Association of Home Builders), the average length of time a house is occupied and owned as a primary residence is about 13 years. This means the current comparison is skewing the numbers and therefore your overall savings in scenario #1 is a bit misleading.

However, it still seems like scenario #1 is the obvious choice because the total payments in scenario #2 are higher by $75 per month. Unfortunately we are not yet at a true apples-to-apples comparison due to the fact we are evaluating two different loan amounts - $270,000 vs. $261,900. Instead we need to apply the 5.75% interest rate being offered at Navy Federal (scenario #2) to a $261,900 loan amount and see if the payment is more or less than $1,505 (scenario #1).

As it turns out, after equalizing the loan amounts, your payments in scenario #2 drop to $1,528, which is still $23 per month higher than the Wells Fargo loan that charges PMI. The other advantage of selecting scenario #1 is that you can eventually get rid of PMI once your loan-to-value (LTV) ratio is 80% or less, which would reduce your payments to $1,385 and provide a monthly savings of $143.

Essentially Navy Federal is sticking you with a "permanent PMI payment" by baking it into the interest rate. The trick is that they stripping away the PMI label that everyone hates. The psychology of offering a "no PMI mortgage" works especially well on buyers who feel like they are being nickel-and-dimed by extra bank fees like PMI.

I HAVE A QUESTION REGARDING A PRIMARY RESIDENCE RULE. MY UNDERSTANDING IS THAT GROSS INCOME DOES NOT INCLUDE GAIN FROM THE SALE OR EXCHANGE OF PROPERTY IF, DURING THE FIVE-YEAR PERIOD ENDING ON THE DATE OF THE SALE OR EXCHANGE, THE PROPERTY HAS BEEN OWNED AND USED BY THE TAXPAYER AS THE TAXPAYER’S PRINCIPAL RESIDENCE FOR PERIODS AGGREGATING TWO YEARS OR MORE. BRIEF BACKGROUND: WE INHERITED MY WIFE’S PARENTS PROPERTY 10 YEARS AGO. THE PROPERTY HAD A VALUE OF $270,000 AT THE TIME WE ACQUIRED THE PROPERTY. WE HAVE BEEN RENTING THE INHERITED PROPERTY SINCE ACQUIRING IT. WITHIN THE NEXT 2-4 YEARS WE WOULD LIKE TO SELL IT. WE’RE ESTIMATING THE SALE PRICE WILL BE IN THE $500,000 RANGE. I’M HOPING TO GET YOUR CLARIFICATION ON “….PRINCIPAL RESIDENCE FOR PERIODS AGGREGATING TWO YEARS OR MORE.” BECAUSE WE HAVE OWNED THE PROPERTY FOR 10 YRS CAN WE LIVE IN THE PROPERTY AND MAKE IT OUR PRIMARY RESIDENCE FOR ONLY 2 YEARS AND AVOID CAPITAL GAINS TAX? OR DO WE NEED TO LIVE THERE LONGER THAN 2 YEARS?

The IRS Section 121 exclusion amount is $500,000 for married couples and $250,000 for a single taxpayer. To get the full $500,000 you and your wife must file jointly on your tax returns. At least one spouse must own the property for 2 out of the last 5 years, and both spouses must live in the property as their principle residence for 2 out of the last 5 years. So as long as you live in the property for at least 2 years you can avoid capital gains taxes. There is also a once every 2 year limit to the exclusion that you should be aware of.

The other option, if it is a rental, is to do a 1031 exchange for a like kind property - i.e. residential real estate to residential real estate. Note, the new property must be received within 180 days of selling the old one in order for capital gains taxes to be avoided.

MAY I ASK YOU A FOLLOW UP QUESTION PLEASE?

I CAME ACROSS AN ARTICLE BY MICHAEL KITCES THAT SAYS THERE ARE SOME EXCEPTIONS TO THE CAPITAL GAINS TAX EXCLUSION RULE WHEN SELLING A HOUSE.

THIS IS THE PART OF THE RULE THAT CONFUSED ME:

"'2 OUT OF 5 YEARS' IS ONLY ONE FACTOR IN CALCULATING YOUR TAX LIABILITY WHEN CONVERTING A RENTAL PROPERTY INTO A PRIMARY RESIDENCE."

WHAT AM I MISSING? IS THIS ABOUT A PERSON TRYING TO PUT DOUBT IN MY MIND AS A MEANS TO GAIN A CLIENT? OR PERHAPS THERE HAVE BEEN MORE RECENT CHANGES TO THE TAX CODE?

Michael Kitces is actually an industry guru. His articles are quite detailed and are usually a lot to digest. However, you can rest assured the content is accurate.

At any rate, the following excerpt from Michael's article is where you need to use caution regarding the usage of the 121 exclusion once every 2 years:

"To prevent abuse of this planning scenario, Congress has enacted several changes to IRC Section 121 over the past 15 years, preventing depreciation recapture from being eligible for favorable treatment, requiring a longer holding period for rental property acquired in a 1031 exchange, and more recently forcing gains to be allocated between periods of “qualifying” and “nonqualifying” use. Nonetheless, some opportunities remain for real estate investors who do have the flexibility to change their primary residence in an effort to shelter capital gains on long-standing real estate properties."

Basically, if you are (or were) depreciating the property as a rental, whatever amount that was depreciated will need to be accounted for and recaptured at the time of sale. Your depreciation recapture, which is a form of tax, cannot be avoided with the capital gains exclusion rule. For example, if you depreciated $100,000 over the last 10 years, then that amount is recaptured for tax purposes and is taxed at a rate of 25%. This amounts to $25,000 in depreciation recapture owed. However, the good news is that any gains above what you depreciated still get excluded.

If you never depreciated the property in question, then you should be okay in terms avoiding paying any of type of tax related to the sale of the property. All of this of course assumes the property is occupied as a primary residence for 2 out of the previous 5 years.

One last point to make you aware of is that you can disregard the 1031 exchange part referenced in the excerpt from Kitces, since your property was acquired through inheritance.

Helpful Resources:

Consider This When Buying a Home

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