Large Downpayment make sense

[John Schnyderite]

This is going to be a long one, so prepare yourself =)

My fiancee and I have been house hunting for a personal residence for a few months now. I own a home since '09 that is underwater (stand to lose 18K or so incl. commissions paid, closing, etc).

We want to upgrade to a larger home and planned on putting 20% down. Although we don't like the idea of taking that big of a hit selling my place, we would only be approved for 300K or so while holding my existing mortgage -- which doesn't buy much in NJ.

We recently found out that my fiancee stands to receive an IRA inheritance from her grandmother who passed. Initially, I thought we would distribute 10K or so a year, since from my understanding this would count as income and put us into a new tax bracket if we were to take a lump sum.

I guess my first question would be about the IRA since I don't know much on the topic. Are there any benefits to taking a lump sum?

2nd question is regarding the downpayment and taxes -- Does putting 40% down ever make sense or it better to put 20% down, take our tax benefits from paying property tax/insurance etc over 30 years, and put the remainder of our money into other investments?

And lastly, are there any tax benefits to selling my current home for a loss? It is currently my primary residence. Would renting for a year or two give us an ability to write off as an investment loss? Any recommendations on what I can do here?

Thanks for any input!

[Jon Holdman]

First, I'll start from my fundamental premise that a house you live in is nothing but an expensive doo-dad. No matter how much NAR ads tell you "its the biggest investment of your life", its rarely a good investment. As you've found out. But you have to have some place to live, and there are advantages to owning rather than buying. But as investments houses are mediocre at best. If you add up all the true costs - interest (even when paid pre-tax), insurance, maintenance, upgrades, etc., etc., you almost always come out in the hole. Now, you would if you rented, too, so the comparison is really just what does it costs you to have a roof over your head? And what can you afford? What are your needs? Perhaps staying put is sufficient.

Second, I'll say that paying out $1.00 in interest to save 28 or 33 cents in taxes is crazy. You're still poorer by 72 or 67 cents (or whatever) than if you didn't pay the interest. Where paying interest makes sense financially (and the ONLY case where it does, IMHO) is when you can borrower at one rate and then earn a higher from that money. You're then earning the difference between the two rates. That's exactly the idea of buying leveraged, income-producing properties.

But even in that case, the interest you pay isn't a "tax benefit". Rather, its an expense. So, just like for all the other expenses, it gets subtracted from the income received by the property when computing the net taxable income. Crappy rentals often end up with a negative net income. Depending on your tax situation, you might be able to use this "passive loss" to offset other income. To do that your AGI under $100K for up $25K in "special allowance". Over $100K that $25K allowance phases out by $1 for every $2 in AGI over $100K.

Rental properties do take depreciation. That's subtracted from the income just like any other expenses. On the original purchase, it feels like an unreal expense. However, as you make capital expenditures (e.g., a new roof) you'll find you cannot deduct that cost in the year you spend the money. You have to depreciate it over multiple years. So that sort of deprecation feels just the reverse. You have to spend the money up front but you have to deduct it over multiple years.

Depreciation has an effect when you sell, too. When you sell the gain is the net from the sale less your basis. Initially your basis is the price you paid, plus any purchase costs. But as you take depreciation (or even if you don't but were allowed to) your basis goes down. So your gain on the sale goes up. When you sell, the first part of the gain, up to the depreciation taken or allowed (whichever is more) is subject to the tax on unrecaptured depreciation. That's currently capped at 25%. So, the whole depreciation thing is a lot more like a loan than a real deduction. You get the benefit while you hold the property then pay back the tax savings (well, most of it) when you sell.

Who cares is the income puts you in a new tax bracket? You shouldn't. People sometimes think that means you'll pay more taxes on your existing income if that happens. Not true. You'll pay higher taxes only on the additional income. But you should care in the sense that if you're close to one of the tax bracket limits, you can minimize the taxes on the IRA by keeping your total income under the break point. OTOH, if your boss offered you a raise, would you ever say "no thanks, boss, that'll put me in a higher tax bracket?" Of course not. That money in that IRA is taxable. If you need it, take it and pay the tax. Who knows what will happen to taxes in the future.

As far as renting your existing residence vs. taking the loss now, evaluate the math. To be profitable if you're using a PM the rent you get needs to be double the P&I part of your payment. If you're going to deal with the tenants, about 1.5X the P&I is sufficient. So, is it profitable? Or an ongoing loser?

As far as buying another house, that's your call. Realize you already have one big, expensive toy. You're about to swap it for another, even bigger, more expensive toy. Is that the best thing for you to do, financially? Or, should you take the money you've saved and inherited and invest it rather than spending it? Because buying a residence is "spending it" just like if you were buying cars or vacations.