Wednesday, March 30, 2005

Cash in on Your Home?

by Kristin W. Davis Kiplinger, April issue

Many 21st-century homeowners are feeling as if they've won the real estate lottery. Especially on the East and West coasts, they have seen their home values double, or even triple, over the past five years. There's just one problem: It's all on paper. You can't reap the benefit of all that wild appreciation, or protect it from a blowup in your local housing market, unless you somehow cash out.

A small but growing number of homeowners are doing just that. Karen Davidson Seward took advantage of New York City's soaring real estate market to make a move last year to her "dream retreat," a house and barn on nine acres in Lake Placid, N.Y. She paid $250,000 in 1987 to buy a loft in a Tribeca warehouse that had been used to refrigerate cheese. In 2004, after many improvements, it was worth $1.6 million.

The Lake Placid property was a fixer-upper, too, purchased for $65,000. Karen says she has spent another $185,000 to turn the open barn into a winterized living space, complete with plumbing. (Along with her husband, Peter Seward, she did the woodworking herself -- a talent she's proud to say she learned from her father.)

"I had spent nearly 20 years paying off the debts associated with getting the loft -- I didn't save any money," she says. "It became very clear to me after 9/11 that all my eggs were in one basket, and suddenly that investment did not feel secure." Living seven blocks from Ground Zero, Karen had grown weary of the heavy security in her neighborhood. She also felt that there would be no better time than the sizzling market of 2004 to take her profits.

Taxes and real estate commissions took a healthy bite from the proceeds. But for the first time, 50-year-old Karen has a retirement account, invested mostly in stocks and bonds. She's put some of her profits aside to invest in more real estate.

Karen, a graphic designer, primarily works from her Lake Placid home (as does Peter, an illustrator), although she makes occasional trips to New York City to meet with clients. "That's a wonderful balance to being in the wilderness," she says.

For Karen and Peter, who were psychologically ready to pull up stakes, the madcap run-up in housing prices was a golden opportunity to act on an idea that had been simmering for years. And if you live in New York, Southern California or one of the other hyper-inflated housing markets that trigger nightmares of bursting bubbles, bailing out soon could prove to be a shrewd financial move, too.

We know that for every homeowner who fantasizes about semi-retiring on real estate profits and living the simple life in a bucolic locale, few are truly willing to leave behind friends, extended families, schools and communities. But there's no denying that many harbor fears and worry over how can they protect the home equity that makes up a large part of their wealth.

There's no perfect solution. Empty-nesters can cash out and downsize--and tuck their profits someplace safe -- but they may run into tax snags. Risk-takers can refinance to cash out profits and invest them in the stock market or more real estate. But if your house does fall in value, you could end up with more debt than the place is worth--and investment losses to boot. "I'd think twice before I had someone dump their home simply for financial reasons," says Gary Schatsky, an Albany, N.Y., financial planner.
The sky is falling?

Every client who comes into my office asks about buying a condo on spec -- every one," says Benjamin Tobias, a Plantation, Fla., financial planner. "It's reminiscent of the stock-market bubble in 1999, when every client came in wanting tech stocks." The indicators of a market top are easy to find, from "get-rich-quick in real estate" seminars filling church basements and hotel conference rooms to a soon-to-debut reality-TV series called Property Ladder. The show will start out chronicling the efforts of Southern Californians to buy, remodel and flip properties for profit. But for the record, we don't think the national housing market is headed for a crash. A breather, yes, but not a crash.

Rising interest rates will undoubtedly dampen demand. But even if short-term rates rise substantially, mortgage-rate increases (which tend to rise in step with longer-term bonds) will probably be modest. David Berson, chief economist for Fannie Mae, predicts that mortgage rates will rise only one-half to three-fourths of a percentage point this year. And in many markets, recent immigrants, new job seekers and baby-boomers looking to buy homes in warmer climates will continue to drive demand. David Lereah, chief economist for the National Association of Realtors (NAR), predicts a 5.3% increase nationwide in the median price of a house in 2005.

But real estate is local, and in some markets, returns have been breathtaking. Since 1997, the median price of a house has risen 212% in San Diego (from $185,000 to $578,000) and 157% in New York's Nassau and Suffolk counties (from $164,000 to $422,000), according to the NAR. Such markets are the most vulnerable to a slump, especially if mortgage rates go up more sharply than anticipated or unemployment rises.

A nose dive in prices would not be unprecedented. In the late 1980s and early '90s, the median price of a house in Los Angeles dropped 20%, and some homeowners in Southern California and the New York metro area saw 30% slips. It took five to seven years for prices to recover. "My older clients who went through that period have a much different view of real estate than my young clients who bought at the bottom and have experienced phenomenal growth," says Scott Leonard, a financial planner in Redondo Beach, Cal. So if you're afraid your winning lottery ticket may soon expire, you might be looking for a way to cash in.
Sell high, buy low

Cheryl and Mark Shirey were sitting on a $1-million profit in their 1942 Craftsman-style home in Newport Beach, Cal. They purchased it in 1985 for "a couple hundred thousand" and renovated several times. "The stock market crashed so bad, and we went through that," says Cheryl. "We knew it would happen sooner or later with real estate in California." In August, the Shireys sold for $1.2 million and moved to Boise, Idaho, where $500,000 bought a similar Craftsman-style home.

"For the first time in my life, I am not working," says Cheryl, who gave up her sales job with a commercial printing business and now spends more time with the couple's three teenage children, Kayla, Scott and Eric. Mark returns to California every other week to help run a pest-control business he owns there. Together, the family has more time to enjoy Boise's outdoorsy lifestyle, including mountain biking, trout fishing and skiing. "I have no stress anymore," says Cheryl. "I'm not driving on the freeway in bumper-to-bumper traffic."

Jim and Jen Compher made a similar transition. Their Fairfax, Va., townhouse, bought in 2000 for $176,000, had nearly doubled in value when Jen, a special-ed teacher in the Fairfax County school system, decided to stay home with their twins, Owen and Ainsley, born in 2003. To make it work financially, they refinanced with a low-rate 3/1 adjustable-rate mortgage to hold down their monthly out-of-pocket costs. But that was a "ticking time bomb," says Jim. After three years, the rate was sure to go up and no doubt bust their one-income budget.

A move to Florida solved the dilemma. Jim, a Web-site designer, found a new job with Northrop Grumman in Orlando. The Comphers promptly sold their townhouse this past December -- the value had jumped to $377,000 -- and moved to Oviedo, 15 miles outside of Orlando. Their new home is bigger, sits on a kid-friendly cul-de-sac, has a big backyard with a pool -- and cost just $299,000. "It's the Leave It to Beaver experience," Jim says. Their $1,700 mortgage payment is about the same as it was in Virginia, but with a 30-year fixed-rate mortgage, there's no hurry for Jen to return to the workforce. A bonus: Jim traded an hour-plus slog to work in Virginia for a 15-minute commute.

Homeowners in pricey markets are sometimes stunned by what their money will buy elsewhere. Linda Sherrer, a Jacksonville, Fla., real estate agent, recently helped dozens of homeowners relocate from Santa Barbara, Cal. The $650,000-to-$700,000 homes her clients sold "are our $110,000 homes here, with linoleum floors in the kitchen," Sherrer says. "When they saw our $650,000 homes, they couldn't believe the granite and marble."

The only wrinkle: When you're used to expensive real estate, it's easy to pay too much in another market. "Everything looks so cheap that you're not as careful as you ought to be," says Al Stinson, chief financial officer of Fidelity National Financial, in Jacksonville. He says that he probably overpaid when he traded a 3,400-square-foot house in Santa Barbara for a similar-size house in Jacksonville that cost about one-third as much. (But not to worry: He still sold it for a profit when he traded up a year later.)
Cash out and downsize

Who else might want to seize the opportunity to take profits? Anyone with more house than they really need. Warren and Rebecca Boroson bought their Glen Rock, N.J., home 29 years ago for $69,900 and raised their two sons there. But now, says Warren, "our children are grown and out of the house. We had four bedrooms, which is three more to mess up than we needed." Last year the Borosons sold for $579,000 and moved to a high-rise apartment in Hackensack, N.J., with a doorman and a swimming pool.

"We sold mainly to lock in the profit," Warren says. "It was a little faster than we'd planned. But if you're planning to sell in a few years, you might as well do it now while you're sure the market is still good." Warren writes a financial column for the Morris County, N.J., Daily Record that is syndicated nationwide. With an eye on retirement (he's 69), he invested his cashed-out home equity in a laddered portfolio of bonds.

Dave Moran, a financial planner with Evensky and Katz, in Coral Gables, Fla., says some of his clients who are in or near retirement are taking real estate gains off the table. One is a doctor who traded down from a 10,000-square-foot house to one half the size, cashing out $1 million in profit. After he bought a new fishing boat, he invested the rest.

But there is a tax snag in some areas, including Florida and California, that can undermine the benefits of downsizing. State laws sometimes hold down property-tax increases to no more than 2%, say, or the rate of inflation. So if you've owned a property for a long time, your tax bill is likely to be based on an assessment that's far lower than the home's actual value. Once you buy a new property, however, the tax bill on your new home will be based on the current value. Thus, your taxes could go up dramatically even if you buy less house. For example, the Florida doctor's tax bill has tripled, says Moran. And if your profits exceed $500,000 for a married couple or $250,000 for a single taxpayer, you'll have to cough up capital-gains taxes, too.

On the other hand, if you have profits that large, selling now could save you on taxes down the road. When you sell, you can take your tax-free profits -- assuming you've owned the house for at least two years -- and then reset the tax clock. "I know of two families that are selling or seriously considering selling homes that they love to lock in the $500,000 capital-gains exclusion," says Cheryl Costa, a financial planner who lives in Sudbury, Mass. "They are buying homes in a similar price range in the same town to start with a clean slate -- another $500,000 exclusion -- in a new home." There's no limit to the number of times you can claim tax-free profit, as long as you don't sell a home more often than once every two years.

Downsizing can also be a smart move for the house rich and cash poor. In many hot markets, families have stretched to the limit to afford homes bigger than they really need. Those who relied on interest-only or variable-rate loans to qualify for big mortgages may be in for a rude shock when rates rise and payments adjust accordingly. If such a scenario could force you to sell, now is the time to unload, before any potential price drop.
Strip the equity?

Short of selling, can you put any of your home's paper gain to good use? Some risk-takers say you should. "There's no reason to have 50% equity in your house," says Scott Leonard, who is advising many of his clients to strip excess equity and invest it in stocks or more real estate. (He defines "excess" as more than 20% of the home's value.) Those investing in real estate are "buying houses in areas they feel are going to be more stable, as a diversifier away from the Southern California market," where Leonard works. Those buying stocks or tax-efficient mutual funds are seeking at least an 8% return, most of it in appreciation that won't be taxed until the investment is sold. With the after-tax cost of borrowing at about 3.25%, Leonard estimates, "8% tax-deferred for 20 years is phenomenal." He pursues this strategy only with clients in their thirties and forties who have the time to weather any down markets and incomes high enough to easily afford the payments that come with a bigger mortgage.

"It's unbelievable how cheap it is to borrow money on your home," Leonard says. "But people don't take advantage of it as they should." A homeowner with $400,000 of equity in a $750,000 home, for instance, could borrow $250,000 and, invested over 20 years at 8%, turn it into about $1.2 million. The extra mortgage payment, at 5%, would be about $1,300 a month. If you were to simply invest that $1,300 every month, you'd end the 20 years with about $770,000, assuming the same 8% return. (In both cases, any income tax paid along the way is ignored.)

Leonard is in the minority in recommending such an aggressive strategy. And Gary Schatsky wonders how it could make sense for people who are worried about a housing bubble. "Now you have more debt on a property that you're anticipating is going to drop in value," he says. "You don't want to find yourself in the same situation that people did in the late '80s, with more debt on your house than your house is worth." Some people were compelled to file for bankruptcy or, if they sold, had to lick their wounds and come up with the shortfall, Schatsky recalls.

"Expected rates of return greater than the consumer's current borrowing rate come with a high level of volatility and uncertainty," adds Mark Joseph, a financial planner in Reston, Va. If the $250,000 investment in Leonard's example lost 20% over five years and then you were forced to sell your home, you'd have magnified your losses. Not only would you be down $50,000 on your investment but you'd also be out some $78,000 in mortgage payments.

"I'm very cautious" about borrowing against paper gains, says Terry Gustafson, a planner in Carlsbad, Cal. "If someone has significant emergency funds, can tolerate risk and is moving into an investment that is tax-free, that's the only scenario where I'd recommend it."

There's one other hitch. Although you can claim a tax deduction for interest paid on up to $1 million in mortgage debt used to buy or improve a home, only the interest on up to $100,000 in mortgage debt is deductible when the money is used for other purposes. Interest on additional debt could be deductible as investment interest, but only to the extent you report taxable investment income that does not qualify for the special 15% rate for capital gains and dividends. And if you borrow to buy tax-free bonds, interest on the loan is never deductible.
Just let it ride

I am seeing a small percentage of clients taking the money and running," says Gustafson, "but the majority of people are standing pat, sitting on the equity they have accumulated." Whether it's family ties, jobs, schools or community you love, there's usually a reason you live where you do. To take the money and run, you have to have somewhere you want to run to. "It's crowded here," in Southern California, says Leonard, "because it's a great place to live."

So although the shrewdest financial move may be to take some home equity off the table, lifestyle will trump profit-taking for most homeowners. Nonetheless, you can protect your equity in small ways, especially by keeping an eye on minimizing taxable profits when you do sell someday.

Keep the paperwork. When the law changed to allow home sellers to claim up to $500,000 in profits tax-free, financial experts declared an end to the tyranny of keeping receipts for home improvements. (Before that, everyone was told to keep the records to show additions to a home's basis, which reduce the taxable profit on a sale.) Pack rats who ignored the "toss 'em" advice and saved receipts anyway were smart. "I have had clients bumping up against the $500,000 limitation," says Gustafson. If you do keep your receipts (at least from this point forward), you'll save yourself capital-gains taxes if your profits someday exceed the threshold. Additions, landscaping and upgrading the kitchen and bathrooms all count as basis-boosting improvements (but ordinary maintenance, such as fixing a broken window, doesn't count).

Prepare for the worst. Don't quite have enough cash in your emergency fund to weather six months of unemployment? Now is the time to make your home equity accessible should you need to tap it later. Set up a home-equity line of credit while home values are high, rates are low, and banks are lending freely. Should a crisis strike, it could keep you from being forced to sell in a down market.

In the end, don't sweat it. Keep in mind why you bought your house in the first place: It was probably for the property's location, size, style and amenities, not its prospects for appreciation. No matter what happens to its value, you still live in the home you bought because it was just right for your family. So although a paper gain may not be as much fun as winning cash, a paper loss isn't all that painful. In a lot of markets, says Schatsky, "if prices drop 20% or 30%, you've lost maybe a year and half's worth of appreciation." Presuming you've owned the house longer than that, you're still ahead.


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