Should you buy or rent?

We’ve been asked numerous times if this is a good time to buy a home. The short answer is ‘Yes!’. Prices continue to steadily increase in most areas of Texas’s four metros; mortgage rates are bouncing off of historic lows and beginning to rise; inventory is diminishing; and home values are rising; and rental prices and occupancy rates are moving up. Currently, in most cases, it is more affordable to buy than to rent. And while all of these are compelling reasons, one of the biggest incentives to buy is the tax benefits to homeownership.

Buying a home is a major life investment and should be taken very seriously. Consideration of your current financial status and your future plans should play a part in when and where to buy and how much to pay. Understanding the tax benefits to buying a home is critical to your decision making process so that you understand the full value of your purchase.

But, let’s back up. Presently if you compare home prices vs. rents in your Texas metros, rents have increased rapidly in some markets such as central and west Austin or Houston’s Woodlands. Most regional rentals have had steady annual increases, sometimes out stripping home value appreciation in the same sub market. That said, homeownership is cheaper than renting by quite a bit in all Texas metros.

If you have not sat down with a mortgage professional to see what you qualify for, now is the time. You may not be able to afford or find where you want exactly, but the forced tax savings and value appreciation over the next 3 to 5 years in Austin, San Antonio, Houston and DFW will help purchase that next property. The other markets should have healthy appreciation over the next 3+ years. Why the difference? The entitlement process in Austin slows down how quickly we can address the need for shelter (housing), so they will play catch up for a while. Also, financing is still a challenge, both from a mortgage side as well as from banks. That said, banks have more capital than they have had in the history of US banking. Mortgage companies are looking to help as many people get into homes as possible. You won’t know unless you start the process.

To determine for yourself whether renting or buying a home costs less, do the following:

• Calculate the average rent and for sale price for an identical set of properties. If you currently lease 1500 sq ft., find something comparable. You want to estimate prices and rents for similar properties in the same neighborhood, to get an ‘apple to apple’ comparison. Even if there is nothing available in the area, you want to know what costs will be. You should not compare the average rent and average price of homes in your submarket, which would be misleading because rental and for sale properties are very different. More importantly, for sale homes are 45+% larger than most rentals in the same submarket.

• Calculate initial total monthly costs of renting and owning, including maintenance, insurance and taxes.

• Calculate what future total costs will be for owning and renting by looking at the history of the submarket. Take into account inflation, price, and rent appreciation.

• Factor onetime costs and proceeds like closing costs, down payments, sales proceeds and security deposits. Factor in the opportunity cost of spending money now (that is, examine where else you could put the money for a better risk/return ratio).

• Presently affordability is the best it has been in the last 60 years. I would not wait for rates to come down, they will continue to increase based on most factors. In addition home values in all Texas metros continue to increase. So waiting to make a decision will cost you.

Now compare the payments; rental and to own. How close are they?

When confirming buying costs know that in most cases, homeowners can take the following tax deductions: (disclaimer; I am not a CPA, Tax lawyer, etc.)

Mortgage interest

The interest you pay on the mortgage you obtain for your primary residence is deductible from the income you report in your Federal Income Tax filing. In many cases, this is a substantial amount and, in the early years of your loan, account for most of the payment you make each month. There are limitations to the amount of interest that can be deducted as well as other important considerations for those who wish to utilize this deduction. Even better, unless changes are made by the IRS, this deduction remains in effect for the life of your loan.

Generally speaking, your mortgage payment will remain relatively steady throughout the time you own your home. As you make payments, the amount of interest you pay goes down while the amount you pay towards the principal goes up. In other words, early in your loan you will pay more in interest (which is deductable) while later in the loan you will pay less interest. Regardless of where you are in the life of your loan, the interest is deductable, meaning your purchase today could benefit you tax-wise for years and years to come. This is one of the key advantages to owning over renting. When you rent, you may not deduct any amount of your payments from the income you report to the IRS. Therefore, every dollar less you pay in taxes due to the mortgage interest deduction is an advantage you would gain from owning instead of renting. The difference is not just between paying rent and buying.

Points and/or origination fees when obtaining a mortgage

When purchasing a home using a mortgage loan, certain fees will be charged for the purchase to be finalized. One is the origination fee, which is the amount charged to the borrower (buyer) to cover the costs of providing the loan including processing the loan application, credit checks, evaluating the loan, and other expenses related to the purchase. Buyers also have an option when applying for their mortgage loan to pay discount points in order to lower the interest rate charged to the balance of the loan. In other words, a buyer can pay extra up front to decrease their monthly payments for the life of the loan by locking in a more advantageous interest rate. In some cases, the seller will pay the discount points as an incentive to the buyer to purchase their property. According to the IRS, origination fees and loan discount points are tax deductible to the buyer, in most cases. Even better, it doesn’t matter who paid the points or fees, the buyer is allowed the deduction. So even if the seller paid the discount points, the buyer gains the tax advantage. What moving costs do you deduct when you rent? Not much!

Mortgage Insurance Premiums (MIP)

Certain mortgage loans require buyers to pay mortgage insurance and is stipulated at the time of purchase. In many cases, borrowers who obtain a mortgage by paying less than 20% of the purchase price as a down payment will be required to pay mortgage insurance premiums. Different loan products have different requirements, so be sure you understand the structure of your mortgage loan by having your lending professional explain the loan terms to you in detail.

Basically, to help buyers purchase homes without having to save 20% of the purchase price for a down payment, they may have the option to pay a smaller down payment along with a Mortgage Insurance premium every month. This helps borrowers purchase their homes sooner. While this deduction may or may not remain in the future, as of today the premiums paid for mortgage insurance are generally tax deductible. In fact, the IRS recently announced that mortgage insurance premiums paid in 2011 will continue to be tax deductible. Some rules and limitations apply, so be sure to check the IRS website or with your tax professional for the details on this deduction or speak with your tax professional for advice.

These three deductions can amount to a significant sum of money that you can deduct from the income you claim in your Federal Tax filing, potentially lowering the amount of tax you are required to pay each year and ultimately the cost of your payment. More importantly, those who choose to rent are not able to enjoy these tax benefits. That’s one of the primary reasons why owning a home is actually more affordable than renting in most cases today. With rental occupancy rates going up, rents are rising. As rents increase, those who are able to buy should be do so.

The tax benefits to owning a home don’t stop there. Barring any changes to the tax code by the IRS, besides the points and origination fees from the issuing of the loan and the mortgage interest and mortgage insurance premiums that can be deducted for the life of the loan, homeowners also have two additional tax benefits they can take advantage later in the life of the loan. Tax benefits that can be enjoyed later in the life of the loan include:

Interest on home equity loans

Over time, as you’ve continued to make your mortgage payments, the principle of your loan will decrease. At the beginning it will drop slowly (since more of the payment goes towards interest), while later in the loan it will begin to drop more rapidly. At the same time, the value of your home will change, hopefully for the better. Generally speaking, over time, a home becomes more valuable. In other words, the amount you could sell it for in the future is usually more than the amount you bought it for, especially when you look at it over a time period of five years or more.

As you owe less principle on your mortgage loan and the home experiences appreciation, the difference between those two amounts is known as ‘equity.’ Many people use the equity in their homes to secure a loan to pay for projects, major upkeep or upgrades, or even paying off balances owed to credit cards, auto loans, or other creditors. Homeowners who consider a home equity loan must understand that they are putting up the equity in the home to act as collateral for the new loan. That means, if/when the home is sold, the home equity loan will need to be paid off in full. Just like the main mortgage loan, interest paid on the home equity loan is also tax deductible. In other words, even while you are decreasing your reported income in your Federal Tax Filing to the IRS for your original mortgage, you can further reduce your taxable income by deducting the interest on your home equity loan. There is nothing like this available to those who rent their homes.

Profits from the sale of your home

If you decide to sell your home, another tax advantage comes into play. Whether you are moving up, downsizing, relocating, or selling for other reasons, the profit on the sale can be exempt from Federal Income Tax. Again, barring any changes to the IRS Tax Code, sellers may be able to avoid paying income tax on up to $500,000 worth of gains made from the sale of their home. Couples can claim up to $500,000 in profits without paying income taxes on the gains while singles can claim up to $250,000 in profits. Currently, it is an IRS requirement that sellers must have lived in the home as their primary residence for at least two of the past five years to qualify for this tax benefit. In other words, if your home goes up in value while you are living in it as your primary residence and you sell it for more than you paid, the IRS will not tax you on the gains up to $500,000 (for couples). If you made gains from nearly any other investment, you would be required to report it as income and pay capital gains taxes. That is one of the main reasons why purchasing a home is a better overall investment than nearly every other option. While there are other tax exempt investments available, few will have the same potential as the purchase of a home.

The tax benefits to owning a home start from the date of the purchase and continue to the date of the sale. Especially right now in Texas the advantages of owning versus renting are becoming more and more important. If you are currently renting and would like more information about preparing for your first home purchase, please contact a financial professional. The first step is gaining the knowledge you need to make the right decision and we highly recommend that you speak with professionals in the industry before moving forward.

Here are some quick summary thoughts on benefits of renting vs. buying.

• Easier to Relocate
• Limited cost & responsibility for repairs
• You can split rent with roommates
• Renters insurance is cheaper than homeowners insurance.
• No property tax payments
• No equity lost to foreclosure

• Homes builds equity
• Buy low, sell high. There has never been a better time to buy
• No rent hikes
• Low interest rates for a while
• No land lord
• Christmas time every April, when you get money back.
• Numerous tax benefits.
• The pride of ownership

Texas vs. California (Part 3)

This is our third installment in a series discussing Texas and California. We have written about why businesses and individuals seem to be leaving CA for TX. One in five Americans calls California or Texas home. The two most populous states have a lot in common: a long coast, a sunny climate, a diverse population, plenty of oil in the ground, and Mexico to the south. Where the states really diverge is in their governance.

Let’s look at population, GDP, and the states’ respective budgets. We will use budget data from the Census Annual Survey of State Government Finances and job and per capita income data from the Bureau of Economic Analysis.

Last year (2012), California had a population about 30% larger than Texas, a deficit 210% higher, and state debt 380% higher. It’s safe to say that low-tax Texas appears to be in a better fiscal shape.

California earned the name “The Golden State” and adopted the motto in 1968. The nickname’s origins are from the discovery of gold in 1848, and the expansive fields of poppies and many opportunities present in the state. In 1950 the Golden State had 40% higher per capita income than Texas. In 1970, the advantage was still over 30%. By 2009, the difference had shrunk to only 10%, without taking into account the higher cost of living in California.

As we have discussed the last couple of weeks, it appears that Texas is doing better than California not only fiscally, but also in terms of aggregate job and income growth.

One thing I would warn about is exaggerating California’s debt problem. It’s true that they have mismanaged their finances, and expanded government seemingly beyond what they can afford. However, California is still extremely wealthy, with a total GDP of about $1.8 trillion dollars in 2011. This is bigger than Brazil and Russia ($1.6 trillion) and almost as large as Italy ($2.3 trillion). Texas is $1.2 trillion in comparison. So while their tax base may appear narrow, their entire economic base is very wide. The debt to GDP ratio for California alone is still below 10% (or 80%, if you add the national debt).

Also, let’s not make too strong policy-inference from the short-term (less than ten years) mortgage-bubble that is currently distressing California. Policy should be based on evaluations of long term performance. We would argue above that the long term trend also favors Texas.

There are many other reasons why Texas is thriving while other states flail.

Rising oil prices

A boon for Texas, California not so much.

In 2012, the Brent crude oil spot price averaged $112 per barrel, and rose to $119 a barrel in early February. Even though we have seen an unexplained surge at the pumps lately, the Energy Information Administration is projecting an average price of $109 a barrel. Crude prices peaked at $134.02 per barrel in June 2008. Those rising oil prices may have been bad news for drivers, but they helped out the Texas and California economy, which rank #1 and 3 respectively in oil output.

When oil prices are high, job growth in Texas historically has exceeded that of the nation. Texas entered the recession late and came out early, mirroring trends in oil prices, which rose towards the beginning of the recession, fell in 2009, but have been steadily rising since.

The states that are expanding economically are almost all energy states. Based on Dallas Federal Reserve research, a 10 percent increase in oil prices leads to a 0.3 percent rise in employment and a 0.5 percent rise in GDP for the state of Texas.

One of the big differences between the two states has been the introduction of fracking. New recovery techniques, such as steam injection and later hydraulic fracturing (fracking), changed the industry and lessened our reliance on other countries oil production. A decade ago, Texas oil engineers decided to combine horizontal drilling with a process called hydraulic fracturing, which injects chemical-laced water into the shale to push out the minerals. The system has been effective in releasing previously untapped pockets of natural gas in shale formations, such as the Eagle Ford shale formation in South Texas. In 2000, 1 percent of the U.S. gas supplies were from shale, but now the figure is 25 percent. And as a result of the new technology, Texas is home to some of the most prosperous new oil fields in the country.

Fracking has opened up the Eagle Ford formation to tremendous economic opportunity. This region of south Texas was a sparsely populated area that has not historically been very economically strong. Fracking has breathed new life into the area and has not only brought jobs but has also created a new set of millionaires whose land has sky rocketed in value.

In California, fracking has kept older fields open, particularly those in Kern County, and has preserved CA’s place as the nation’s third largest petroleum producer. But to this point, fracking has not been used for new fields due to environmental and regulatory concerns. Meanwhile, oil production is booming in other states, principally North Dakota and Texas, due to extensive use of fracking to tap into deposits in shale — so much so that the U.S. may soon become an exporter again.

But what about California? It’s been estimated that deep shale deposits in California, particularly those along California’s Central Coast and in the Central Valley, contain as much as 400 billion barrels of oil, equivalent to half of Saudi Arabia’s oil fields. But whether California experiences a new oil boom similar to one it saw in the early 20th century depends on whether the state’s extraordinarily sensitive environmental conscious can tolerate more fracking, particularly along the coast.

So will California see a new oil boom? Not immediately, but the potential is there to help improve a somewhat stagnant economy, create many thousands of jobs, and pump billions into state and local government coffers. The question is at what cost?

Housing costs

Texas has been referred to as one of the remarkable economic stories of the last decade. But its growth isn’t due to the wealthy fleeing to places with the lowest tax rates. If you look closer at the data, the people moving out of the state are wealthier than those moving in — so the lower housing costs and living expenses in Texas is a major magnet.

We all are aware of the ramifications of runaway real estate appreciation. From 2000 to 2006 as California experienced over 250% appreciation of real estate assets (Source: OFHEO). At the same time Texas was 50th in appreciation with less than 3% annual appreciation annually.

This lack of appreciation in Texas helped the state escape the foreclosure bust that crippled other states’ economies —less than 2 percent of Texas mortgage borrowers are in or near foreclosure, according to the Mortgage Bankers Association, while the national average is nearly 10 percent. States like Arizona, Florida, and Nevada faced mortgage borrower foreclosure rates of 13, 12, and 19 percent, respectively, in 2012. Texas’s relatively stable market may have been a factor in preventing housing prices from climbing. California and Nevada have been helped by investors shoring up prices. As of December, 10% of Florida’s home loans were still in some stage of foreclosure, the highest percentage in the nation. Behind it were New Jersey (7%), New York (5%), Nevada (4.7%), and Illinois (4.5 percent), according to CoreLogic. Among the five, only Nevada is a non-judicial foreclosure state.

Some credit Texas’s stability to state regulations on cash-out and home equity loans, which don’t allow borrowers to take out loans that total more than 80 percent of a home’s appraised value. California, Florida, and many other states had a run of 100% refinances with borrowers sometimes refinancing two or three times in a couple of years to retrieve money from their over-appreciated homes. These cash-out loans allowed borrows in other places to refinance their homes for more than their original mortgage value — driving up home prices and contributing to the eventual burst of the housing bubble.

Another factor in Texas that prevented housing prices from rising dramatically during the housing boom is the abundance of cheap, open land and easier building regulations. Look at land values on both coasts as well as the length of the entitlement process (the process from purchase through engineering to the start of development). 6 months to 2.5 years in Texas is a walk in the park compared to 7 to 10 years in California, Florida, Arizona and other ‘boom’ states.

Affordable homes are one of the key reasons Texas continues to thrive. The California average home price is $738,526 and the median price is $452,000. Texas is significantly less expensive with a $283,137 average price and a $144,900 median price. Affordable land and limited municipal and state regulation allow for less expensive homes. In Texas the cost of the home is traditionally 5x the price of the lot, or 3x the price of the lot in more desirable areas. In California, it is the opposite, where the land is typically the largest cost.

Cost of labor

Immigrant workers make up the majority of migrant farm workers in places such as California’s Central Valley and southern Texas doing seasonal work such as fruit picking and sorting. Seventy five percent of crop workers in certain areas are from Mexico and about half are undocumented, according to a 2011 U.S. Department of Labor survey. Immigrant workers make up a vital part of the construction workforce. In California, Nevada, Texas and Arizona, it is estimated a third of all construction workers are immigrants. Twenty percent of construction workers nationally were born abroad. Of these figures, more than half came from Mexico and another 25 percent from Latin American countries.

Both states have a pool of cheap, unskilled labor. However, skilled labor is another story. Businesses are moving away from areas with a high concentration of unionized skilled labor. As Dr. Mark Dotzsour from Texas A&M said, ‘Let’s face it. Employers come to Texas and other southern locations because they feel that they can make a higher profit. Taxes are a major consideration. So is the cost of labor. Clearly businesses are moving away from areas with a high concentration of unionized labor.’

The Bureau of Labor Statistics puts out information about the percentage of all workers in each state that are represented by a labor union. Here are the states with the highest concentration:

• New York, 24.9%

• Alaska, 23.9%

• Hawaii, 23.2%

• Washington, 19.5%

• Rhode Island, 18.4%

• California, 18.4%

• Michigan, 17.1%

• New Jersey, 16.8%

• Massachusetts, 16.2%

• Illinois, 15.5%

Here are the states with the lowest concentration:

• Arkansas, 3.7%

• North Carolina, 4.3%

• South Carolina, 4.6%

• Georgia, 5.4%

• Virginia, 5.5%

• Minnesota, 5.7%

• Tennessee, 5.9%

• Texas, 6.8%

Many companies like the flexibility associated with the ability to freely make decisions without the pressure of a union, so states with a low percentage of a unionized private sector labor force ranked near the top for many business owners and CEO’s. That coupled with a lower cost of living for a company’s workers has made moving companies to Texas more attractive.

The ability to make money motivates workers, suggesting an advantage for places with higher pay. The nation’s leaders in earnings per job were found in the Northeast, led by New York, Connecticut, Massachusetts and New Jersey. California, on the other side of the country, comes next. These states lost some of their appeal because steep living costs and taxes ate into the higher pay. Texas, a state with low living costs and taxes, ranked a respectable 13th in earnings.

As we have discussed the last few weeks, both states (California and Texas) have their strengths and weaknesses. Each has had their chance for their day in the economic sun. The question is what will the next decade bring? The strength of less regulation and lower taxes or the need for more government services? California’s habit of raising taxes to fund a burgeoning regulatory state isn’t without impact on its economy. Californians fork over about 10.6 percent of their income to state and local governments, above the U.S. average of 9.8 percent. Texans pay 7.9 percent. This affects the bottom line of both consumers and businesses.

Presently Texas seems to be the people’s choice.