Ownership of property is the bastion of capitalism. There is no doubt that owning a home is the goal of the average American today. Why? Is it the ability not to have a landlord? Is it the freedom to stay or move? There are many emotional benefits to homeownership. However, the cornerstones of our capitalistic society are financial in nature. The reason we all aspire to own real estate is simply this: we desire to accumulate wealth. Time and time again, we hear of riches built with a real estate foundation.

Even so, we do not want to play down the importance of the psychological, rather than the economic reasons for owning a home. In 1992, the Federal National Mortgage Association (Fannie Mae) released a survey which indicated that 78 percent of all Americans think that owning a home is a good investment. More than one-third gave security and sense of performance as the reasons for wanting to own.

There are three basic economic reasons for purchasing a home:

1. Real estate is an investment. The concept of leverage explains why real estate constantly outperforms other investment vehicles, even during periods of low inflation.

2. Real estate is a tax deduction. The mortgage interest deduction has suffered nicks and scratches but has emerged as the major survivor in the world of tax strategies.

3. Real estate is an inflation hedge. It has been several years since double digit inflation numbers have raised their ugly heads. Even in times of low inflation, monthly rents move upward more quickly than a mortgage payment.


The concept of rental equivalency

The concept of rental equivalency illustrates one of the three economic factors in favor of owning a home. Recent changes in the tax code leave mortgages as the only major write-off still available to the average citizen. We measure this tax savings by comparing the present rent payment of the purchaser, with the proposed mortgage payment, and then calculating the rental equivalency of the mortgage payment.

The term "rental equivalency" refers to the amount of the mortgage payment after the effect of taxation. A discussion of rental equivalency demonstrates the concept of affordability to a first- time homebuyer. The concept can also be applied to move-up buyers because the increased mortgage payments can also be reduced by the amount of tax savings.

Let us take an example of someone who is paying $1000 each month in rent. Let us also assume that the same home would cost $150,000. Rent $1000

Owing $150,000 Sales price $142,500 Mortgage 9.00% 30 Year

Mortgage Payment (PITI) $1,146.59 Principal & Interest (PI) $150.00 Real estate taxes (T) $30.00 Homeowners insurance (I) $58.19 Private mortgage insurance $1,348.78 PITI

In the example below the mortgage payment is $385 more than the rental payment of $1000 each month. It is natural for a prospective purchaser to say, "I can hardly afford my rent. How can I afford $385 more each month?"

In order to answer this question, we must compare the rent payment with the mortgage payment after the tax benefits have been calculated. In order to do this, we must answer the following:

How much of the mortgage payment (PITI) is tax-deductible?

What tax bracket is the borrower in?

Fortunately, most of the mortgage payment carries tax benefits because the interest and real estate tax portions can be deducted from one's income. The calculation is as follows:

$142,500 mortgage x 9.00% = $12,825 annual interest, or $1,069 monthly.

Therefore, $1,069 out of the total PI payment of $1,147 is interest and is deductible.

Total deductible portion of payment: $1,069 Interest $150 Real Estate Taxes $1,219

$1,219 is 88 percent of the total payment (PITI) of $1,385.

Now that we know the deductible portion of the payment, we can determine the tax bracket of the borrower and calculate the tax savings. Using the Federal Monthly Withholding Tax Charts, we find the following:

Borrower's Income (Single): Annually $60,000 or monthly $5,000 Borrower's present federal tax: $1,061 Borrower's income after deduction: ($5,000 minus $,219) $3,781 Borrower's new federal tax: $699 Tax savings: $362

Rental Equivalent Calculation: Total mortgage payment $1,385 Tax savings: (-) $362 Rental equivalent: $1,023 Actual rent on same property: $1,000

Two things to note on the above calculations:

1. There are also state and local tax savings for most borrowers. They are not shown because many times the borrower will need the deductibility of state taxes paid to exceed the standard deduction given to taxpayers who do not itemize deductions. Those who do not have enough itemized deductions to reach the standard deduction without the mortgage payment with not fully realize the tax savings for mortgage deductibility. Eliminating the analysis of state and local tax savings minimizes this effect.

2. There are additional savings for homeowners. The portion of the principal and interest payment which is not interest ($1,147 PI - $1,069 I) is principal which goes to pay down the loan. This is equity the homeowner is building up even without housing appreciation which is in a sense a forced savings plan. In this case the rental equivalency with the additional factor would be $1,023 minus $78, or $945. Yes, owning can be cheaper than renting!

In order to save you the steps of these complex calculations, the above chart calculates the rental equivalency of mortgage payments. The chart assumes that 85 percent of the typical mortgage payment will be tax deductible. It also assumes the tax bracket of a married couple with no children. The savings for single individuals will be slightly larger. You can use the table to extrapolate to other mortgage payments. For example, the tax savings for a $950 mortgage payment would be one-half the difference between $900 and $1,000.

Written by Dave Hershman, ©2004 All Rights Reserved, The Hershman Group