December 1, 2013

Should You Monetize Your Home Equity?

By Bruce Alan Mann

Your home represents a significant portion of your net worth. Your children have grown, and there are rooms you no longer use. Should you sell and buy or rent a smaller place? Should you stay where you are but take some of the equity out of your home and invest it in other assets? These are questions many lawyers face as they approach retirement.

This article will explore the financial planning issues involved in deciding whether to make a move. But first you need to decide whether physically and psychologically a move is right for you.

From a physical viewpoint, if you have a multistory home, moving to one floor before you are no longer able to make the climb to your bedroom may be prudent. If you are no longer able to handle the gardening, maintenance, and other chores involved in home ownership, it may be time for a move. If you no longer feel up to the long drives involved in visiting your doctor, going to restaurants, or attending arts and entertainment events, a move from the suburbs to an urban environment where public transportation is available may be the right thing for you.

Not all physical considerations are negative. If you are in good health and at a stage in your career where you can take longer vacations, you may want to take an around-the-world cruise, do some adventure travel, or visit new places or distant family members for longer periods than you are comfortable leaving your home empty. Moving to an apartment or retirement community where you can simply lock the door and leave for an extended period can be liberating.

These physical reasons to move need to be balanced against the physical difficulty involved in moving. Make no mistake—moving is not easy. The efforts involved in preparing your home for sale; disposing of possessions you do not plan to take with you; finding another place to live; supervising movers; and dealing with telephone, cable, mail, and other service providers can be daunting and time consuming. Are you physically up to it?

From a psychological viewpoint, are you prepared to be uprooted? A move to a smaller place requires you to let go of part of your past. Do you still want to keep those college textbooks that line your shelves? Are you attached to that comfortable oversized chair you’ve read in for years? Will you miss your neighbors or your chats with the corner grocer? On the other hand, you may be ready for a change. Are the closets filled with an accumulation of objects you no longer need or want? Has your neighborhood changed, and would you rather be in a senior citizens’ community established to address the interests and needs of your contemporaries? Are you looking forward to a fresh start with new friends and a new environment, perhaps even one in some sunny location where you will no longer need to deal with shoveling snow and putting chains on your car?

If you are physically and psychologically ready to make a move, how do you decide whether selling your home and renting or buying an apartment or smaller home is the right decision from a financial viewpoint? There is no easy answer to this question.

Although in many parts of the country renting rather than owning is the right choice from a financial perspective, this is not true in every community. You need to first gather the information necessary to make an informed decision. A realtor can help you determine what your home should sell for. To determine what a satisfactory replacement residence will cost, explore the rental market in the area you want to live in or assess the cost of ownership if you would like to move to a condominium or retirement community. How does the cost of ownership compare to the cost of renting? How stable are rental prices in your area, and how long of a lease are you willing to commit to? Are you prepared to risk rising rental prices if the market becomes stronger or if we enter an inflationary period, or are you satisfied that the return on your investments will provide an adequate hedge against potential rental increases? What about your tolerance for potentially having to move again if you rent a residence that isn’t subject to rent control or if the owner decides not to renew your lease?

It is also important to keep in mind that the cost of ownership includes not only your mortgage interest and the lack of return on your equity, but maintenance, utility, taxes, and other costs that you may not incur in a rental unit. If you take equity out of your home and invest it, what return can you expect your investments to generate? Comparing the cost of home ownership to the cost of renting also involves income tax considerations that need to be taken into account. Home mortgage interest (up to the limits discussed below) and real estate taxes are deductible for income tax purposes; rent, even though it reflects the owner’s interest and tax expense, is not.

There are also tax considerations involved if you sell your home, whether you rent or buy your new residence. The first $250,000 gain on the sale of your home ($500,000 for a married couple) is not subject to federal income tax. The gain above that amount is taxed as a long-term capital gain, with a maximum federal income tax rate (until December 15, 2010) of 15 percent. While this treatment is favorable, it is less favorable than not selling during your lifetime and leaving your home to be sold after it has received a step up in its taxable basis as part of your estate. Even if you need to increase your mortgage or take out a “reverse mortgage” to help pay your living expenses, if you view your remaining home equity as a legacy for your heirs, not selling may be the right decision.

Assume that you are not physically or psychologically prepared to sell your home and move and don’t need to increase your mortgage to meet your current living expenses. There are still financial planning issues you should consider. If you have substantial equity in your home, should you take a portion of it out by refinancing your home mortgage? From a purely financial perspective, this question may be easy to answer. Increasing your home mortgage is not a taxable event. A realtor or mortgage broker can tell you how much equity you can take out of your home and what it will cost to increase your mortgage. Will these funds generate a higher rate of return than the interest rate on your new mortgage? This, of course, depends on how conservative you wish to be in investing, a topic you should be discussing with your investment advisor or financial planner with respect to all of your assets, and not just the amount you may take out of your home equity. Remember that although your home mortgage interest is tax deductible on acquisition indebtedness up to $1 million, if you increase your mortgage debt to make investments, your interest deduction is limited to the interest on $100,000 plus the amount of your tax- able investment income. Thus, if you invest the amount you take out of the equity in your home in tax-exempt securities or assets that do not generate current investment income, the interest you pay on the amount you withdraw in excess of $100,000 will not be deductible. So, when you compare the interest expense on your increased mortgage debt to the return on your new investments, which may be in either taxable or tax-free instruments, you need to compare apples to apples.

Increasing your home mortgage and investing the proceeds have a second effect that is frequently overlooked. It also increases the potential percentage return on your existing equity if housing prices rise and the potential percentage loss on your equity if housing prices decline. Thus, assuming that your new mortgage will not become due during your lifetime, taking equity out of your homeincreases the potential volatility of your home equity as an investment asset and needs to be factored into your other investment decisions.

This brings us to one final point. You may well decide that from a physical or psychological viewpoint your home is your castle and not an investment asset. But if you view your home equity as part of your investment portfolio, you should consider the impact of home ownership on the concentration and diversity of your investments. Many investors seek diversification through investments in real estate without focusing on the fact that their home is a highly illiquid real estate investment in a specific type of real estate in a specific location, and that fact should be considered in determining what types of real estate investments are appropriate for inclusion in your portfolio. Thus, investors with substantial equity in their homes should consider focusing their additional real estate investments on publicly traded real estate investment trusts and other entities invested in nonresidential properties. 

Bruce Alan Mann is chair of the Senior Lawyers Divi- sion Investment Strategies Committee and a senior partner of Morrison & Foerster LLP in San Francisco.