A lot of people dream about the day they finally finish paying off the mortgage. Free and clear, baby!
What might you be willing to pay to live in this house you already own? Economists refer to this concept of a mortgage-free living space having market value as “imputed rent.” Some countries even tax it.
Beyond being a fun topic at cocktail parties, for most people imputed rent has few real-world considerations… you pay off the house and you have more $$$ every month. Good times.
But for an early retiree with a tax-minimization hobby, the choice to pay rent or imputed rent has some interesting implications.
Rent vs Imputed Rent
Sometime in the future, we may find ourselves living the good life in sunny California… swimming pools, movie stars…
Despite being in the triple crosshairs of the California, United States, and ACA tax systems, we would likely find ourselves with nearly free health insurance and a low/zero tax burden. (So… about the same as now.)
However, this situation is far from robust – despite my best efforts, over time the percentage of our annual income from capital gains would grow, resulting in higher tax bills. (Several thousand dollars more.)
So what could we do to harden our low tax position? Of all crazy things… buy a house.
Choosing Imputed Rent
In my theoretical budget for life in California (~$70k/year), I had assumed rent of $2,500/month. In the Sacramento region (amongst others), houses that rent at this rate sell for $500k – $750k+.
This photo is a random example I found on Redfin… 4 bedroom, 2.5 bath, 2000 sq ft, 2 car garage, good schools, decent bike score (but still “car dependent”…)
Let’s say I traded $500,000 worth of stock for one of these houses.
Now, instead of receiving $10,000/year in dividends (2% of $500k) I get zero/nada/zilch. My taxable income has gone down significantly.
Additionally, instead of paying $30,000/year in rent, I pay $12,000/year in property taxes, maintenance, HOA dues, insurance, etc… that is $18,000/year of cash flow improvement. As such, my income needs have also gone down significantly, so I need to sell less stock / realize fewer capital gains.
With much lower income and expenses for the same quality of life, imputed rent makes our low tax lifestyle extremely solid. Total taxable income of less than 200% FPL (~$41k for family of 3) means nearly free health insurance and health care, and a total tax burden of zero or less than zero.
Here is a nice summary in table form:
|Cost of Living||$70k||$50k|
(200% - 266% FPL)
(150% - 200% FPL)
($0 - $15k)
($0 - $10k)
|Taxes & ACA premiums||$0-$3k||$2k refund - $1k|
Lower cost of living, lower income, lower taxes, lower health insurance premiums… same quality of life…
But… is this actually a good idea?
Cost / Benefit
“Wow, that sounds really compelling. Buying a house sounds like a great idea!”
Naturally… Anything sounds good when the author is writing what you want to hear.
But let’s look at a few other numbers…
The 1% Rule of real estate investing is a good metric for assessing a property’s potential. Roughly, the monthly rent should meet or exceed 1% of the purchase price of a property, including upfront repairs. For a $500,000 property, rent should be $5,000+/month. Clearly, this property doesn’t pass the smell test, but people love being landlords. (See how to never pay taxes again with real estate.)
But this isn’t an investment property, this is our home, dammit! You can’t put a price on that.
Or can you? With a mortgage, the property would be cash flow negative relative to renting. Even with 20% down, mortgage payments and taxes exceed rental income. Now add maintenance, repairs, etc….
We would need more income as “owners.” Which kind of defeats the purpose of buying, no?
Or, maybe we’ll make it up on appreciation.
Paying cash for the house means no mortgage payment and the double benefit of fewer dividends / capital gains to support our cost of living. We’d have no income taxes and essentially free health insurance and care, saving us $2,000 per year plus or minus.
On the flip side, we would be trading $500k of growth on the stock market for possible price change in a property.
What does that look like for a K-12 time period?
Not so good, according to the NY Times rent vs buy calculator:
Maybe paying a thousand or two per year in taxes and health insurance premiums is not such a bad deal after all.
(Due to leverage, the calculator gives a slight buy recommendation for the 20% down option at current market rents… assuming getting $500k in cash for the upfront purchase is a zero tax event.)
In any progressive tax system such as the US Federal, California State, and ACA health insurance subsidy systems, lower incomes will result in lower taxes and lower health insurance premiums.
One option to have the same quality of life with much lower income/expenses is to have a fully paid for (mortgage free) home. Money invested in a house would mean fewer dividends and (potentially) reduced monthly cash flow. As one example, our annual cost of living could be lower by $20,000 per year, which would reduce our annual tax and health insurance premium bill by about $2,000.
However, this is not without cost – purchasing a $500k property instead of renting it at $2,500/month would INCREASE long-term costs by $1,000/month.
Math over emotions. In this round of rent vs imputed rent, the winner is…. rent.
Related: Renters For Life.