Persfi

How would you like a comfortable, low-risk investment that can provide a 12 percent return, absolutely tax-free? You may already own it. It’s your house or condo. All you need to do is work on paying off the mortgage and the return will be yours. How do I come up with that 12 percent figure? Listen up. The “return” we enjoy on our home comes from two sources, shelter services and appreciation. While everyone talks about appreciation, most people don’t understand the “shelter services” part. In fact, the best part of debt-free ownership is that we get to enjoy what economists call “imputed income” benefits that are not received in cash but have a cash value. Because these benefits aren’t received in cash, they are not taxable. How much are they worth? It depends on all kinds of factors, but we can get an idea by using a rough rule of thumb. One of the longstanding rules in real estate is that a house should rent for about 1 percent of its market value per month, or 12 percent a year. The same house will also have ongoing expenses real estate taxes, insurance and maintenance that may cost about 4 percent a year, leaving 8 percent as a net return to the investor. If you rent the house to a tenant, your 8 percent return will be taxable income. But if you live in the house, you will receive your return in shelter services the “imputed income” mentioned earlier. Suppose, for instance, your house is worth $150,000 and has annual expenses of $6,000 for taxes, insurance and maintenance. If you rented it for $1,500 a month and owned it mortgage-free, it would net you shelter services worth $1,000 a month, tax-free. (The same house, mortgaged at 7 percent with a 5 percent down payment, would cost $948 a month for the mortgage plus private mortgage insurance. As long as it is mortgaged, as the saying goes, “you’re renting it from the bank.”) The remainder of the return comes from price appreciation. Even before the recent changes in tax law allowing $500,000 of tax-free capital gain to be realized from the sale of a personal residence, the rollover and exemption for those over 55 meant that home appreciation was tax-free for the vast majority of Americans. According to the National Association of Realtors, the median sale price for existing homes was $70,300 in 1983 and $130,600 at the end of 1998. That computes to an annual compound appreciation rate of 4.2 percent, well ahead of the 3.3 percent rate of inflation during the same period. Add the service return and the appreciation rate, and you get a total return of 12.2 percent, tax-free. To do as well in a taxable investment, it would have to provide a pretax return of 16.94 percent for an investor in the 28 percent tax bracket. During the same period, the best performing asset we could own was large-company common stocks an annualized return of 18.2 percent before taxes. Most equity mutual funds, however, returned nearly 3 percent less, before taxes. In other words, the return on debt-free homeownership was on par with the ownership of equity mutual funds during the greatest bull market of the century. Caveats? Of course. A rule of thumb is only an approximation. There are many real estate markets where houses and condos are valued at such high levels that they could never be rented for 1 percent of their market value per month. Those markets, however, tend to be rapidly appreciating markets where the annual appreciation rate is likely to be higher than the 4.2 percent average. Is it possible to lose? Of course. But most people, in most areas, don’t. The bottom line: The next time you think you shouldn’t pay off your 7 percent mortgage because you can earn so much more in the stock market, just remember that the long-term return on a debt-free home is just as good and a whole lot more certain. Questions and answers Q: My husband and I are 67 and 65, respectively, and both came out of long marriages with our possessions “in a shoebox.” At the age of 50, we had to start over. Our current monthly income is $4,085. Our credit card indebtedness is $18,000, which we repay at the rate of $1,300 per month. Our household expenses including mortgage, utilities, auto expenses, insurance and medical expenses are $2,372. Our assets include: our home, with an equity of $30,000 and a mortgage balance of $97,000; another home that we sold with owner financing, which brings $250 a month for nine more years; two mutual funds worth a total of $84,600; a small savings account with $3,000; and a number of “DRIP” stocks worth $11,800. Our 1994 Taurus is paid for. My husband would like to retire, which will reduce our income to $2,885 per month. Our household expenses will remain at $2,372, and we would like to sell our 1994 auto and lease a new one for $250 a month. This would bring our expenses up to $2,662 a month. To do this, we need to rid ourselves of the $18,000 in credit card debt. What do you suggest? We could take the money from one of our mutual funds, but what would the repercussions be as far as Social Security and our tax liability? C.R., Plano, Texas A: Paying off your credit cards will have no ramifications for your tax liability and no impact on your Social Security benefits. You will have some tax liability related to redeeming mutual fund shares to raise the cash. How large the liability is depends very much on how much you realize in capital gains when you redeem the shares. With $89,400 in financial assets, you’ll probably be OK if you reduce them to $71,000 to pay off the credit card debt. What worries me is that your expected income is so close to your expected expenses. While it’s just a back-of-the-envelope estimate, you’ve probably got a federal income tax bill, in retirement, of about $250 a month. As a result, your after-tax income will be about $2,635, just $263 a month greater than your basic expenses. Before adding a $250 a month auto lease. That’s pretty tight. So I have two suggestions. First, work a little longer and reduce the credit card debt as much as possible before retiring. Second, unless you have specific plans that require a new car, consider keeping your current car or replacing it with a recent model used car purchased for cash. Syndicated columnist Scott Burns can be reached by fax at (214) 977-8776 or by e-mail at [email protected].