Renting or buying has never been more important in making the choice because the great home price collapse of the last few years has brought the two almost to parity. In other words the cost to rent is equal to the cost to buy from a financial point of view. In this case one must weigh the other aspects involved as the financial one is even. We’ll get into those in later blogs. The critical part, and probably the most misunderstood, aspect of making the rent or buy choice a valid one is taxes.
After World War II, the Federal Government decided that they wanted to encourage homeownership. They believed that the stability created by having neighborhoods full of active homeowners was worth promoting and used the tax code to encourage people to choose buying over renting. The concept was simple. All the interest costs associated with a mortgage could be written off. In addition all taxes paid towards the house or property, typically property taxes paid to the County annually, could also be written off. These are no small numbers. Without these tax advantages far fewer people would make the buy decision over renting. The cost difference without the tax advantage is huge. I’ll illustrate.
Let’s say I make $75,000 per year and I choose to rent at $1,600 per month. The math is simple. I will probably pay about 33% of my salary for Federal and State taxes. My after tax income is $50,000 per year ($75,000- taxes of $25,000), or about $4,150 per month. I spend $1,600 per month on rent. That’s 38% of my after tax take home pay. I can spend the other 62%, or $2,550, on bills, entertainment, cars, whatever.
Now let’s say I make $75,000 per year and I choose to buy a $400,000 townhome at $2,400 per month. In the first year, $2,300 of the $2,400 monthly payment is interest. Very little goes to principal until the later years. That means I’ll spend $27,600 in mortgage interest in year one. The IRS says I can write off mortgage interest. That means I pay taxes on only $47,400 of my $75,000 income.
Using the same 33% tax rate, I pay $15,642 in taxes as a homeowner instead of the $25,000 in taxes I pay as a renter [60%+ savings].
The Federal Government says they’d rather see me spend that extra $9,358 per year on a home instead of as taxes. So even though I’m paying $800 more per month buying a home ($2,400) than I did when I rented ($1,600), I’m paying less taxes by almost the same amount ($780). In other words I get to OWN a $2,400 per month townhome for essentially the same amount AFTER TAXES as when I RENT a $1,600 place. I also get to write off the property taxes I pay for the home I own. On a $400,000 townhome it’s about $3,600 per year. That’s another $300 per month I get to write off. The total is about $1,080 per month. When I rent I pay that amount to the IRS. When I buy I can put that amount towards a home. In other words I’m still going to spend 33% of my salary. If I rent I pay it to the IRS. If I buy I can spend it towards a mortgage.
Stop renting and start owning!