Reason #1 Imputed Rent
We hear it all the time, especially now, “real estate is a good investment.” Buying a house is a good investment, just not in the way you think.
It is easy to oversimplify and only think about the increase in home prices (called appreciation). For some markets, like Denver, where the cost of living is low and the population is rapidly growing, appreciation certainly is the leading driver of return on investment.
However, there are many reasons, not just appreciation, that buying a house can be a great investment. This article will tackle the first of these: imputed rent. Imputed rent is, for most people, the reason that real estate is a great investment:
A mortgage is a rent payment, to yourself. It’s called imputed rent.
Most Americans have most of their wealth in their homes. It’s their “equity,” and a good way to think about it is as a forced savings account.
Imputed rent has all sorts of advantages. It’s like dollar-cost averaging into stocks. Amidst the rising cost of rents, mortgage rates, and inflation, a 30 year fixed rate locks in lower monthly payments. As the saying goes, the best hedge against inflation is a 30-year fixed rate and a Costco card.
Furthermore, US homeowners get a huge tax break almost nobody knows about, and it’s even part of GDP (gross domestic product – the way economists measure the growth of the economy). In other words, everyone knows, even and especially the government, that people are gaining wealth, and yet the government does not tax it. In a life where the only certainty is death and taxes. How does this work?
Let’s say you’re renting an apartment for $2,000 a month. To your landlord, your rent checks are considered income, and they pay tax on it. Then, you decide to buy a home of your own. Turns out it’s pretty similar to the one you were renting, but it’s all yours. Imputed rent is based on the logic that instead of paying your landlord, you’re now paying yourself that $24,000 a year.
In other countries that effective income is taxable; in the US it is not. It is considered effective income because you are “effectively” paying yourself, even though you’re actually paying down the mortgage loan.
PITI payments
An important note: Not all of that monthly payment is debt paydown. Each month’s payment is called a PITI payment. PITI stands for principal, interest, taxes, and insurance. In addition to paying down the mortgage, called the principal, part of each payment also contributes to interest, taxes and insurance. Private mortgage insurance, HOA fees, and other escrow payments can also be tacked onto this monthly cost of home ownership. This is why it is so important to work with a realtor that educates about the real costs of home ownership, not to mention repairs and maintenance that are not included in regular monthly payments.
Now back to the effective income of imputed rent….
Imputed Rent is not taxed
US lawmakers decided long ago that landlords pay income tax, but not homeowners who live in their own homes. The US government taxes the income from stocks, savings-account interest, and rent received as a landlord. But if you own an asset like a house and live in it, that generates an implicit income that’s free from tax. You can think of the “return” on this investment as the value of paying yourself, rather than a landlord, even if it’s not paying dividends or increasing in value.
There’s a huge tax benefit to housing which comes from the hidden “dividend” it pays. You don’t have to pay taxes on the implicit rent you earn on your house since it is paid to yourself. A house generates enormous rental value each month — like a dividend. If you rent it to yourself, you take the money out of one pocket and pay it to the other one, and the IRS doesn’t tax that. In contrast, if you earn money some other way and then use that money to pay rent, you probably also have to pay taxes. That can add up.
Clearly, you can see the huge advantages of owning a home. Here’s the challenge: All that equity is locked up in a house. It is illiquid. This is why Robert Kaplan (noted author of the popular book Rich Dad, Poor Dad) argues that real estate is not actually an asset. The home that people live in does not pay people money. Most people’s homes are actually a liability. The PITI payment, not to mention maintenance and repairs, must be paid every month.
Work with an expert you trust
So, yes a home is a great investment. Yes, appreciation gains can be substantial. However, most of those gains are locked up in the equity of your house, which is only realized when you sell. So, you want to find a house you love, that is not just a good investment, but also a holder of memories and a place to call home. Buying a home is also the biggest expense of people’s lives. Work with a realtor who can help educate you to reach your goals, for investment and life.