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What's happening to the American dream house? CPAs can help clients develop a realistic understanding of a most important asset.

After a decade to runaway increases, real estate prices have stabilized and even fallen in many parts of the country. Some analysts assert that residential real estate is no longer the foundation for financial security that it has been considered since World War II. How can CPAs help clients understand what the current market means to them? This article provides a perspective on home ownership and how it fits into a prudent financial pan.


Economic memory is short. How many now recall waht was happening in the real estate market only a decade ago--and why? An advance guard of baby boomers was swarming like locusts through new suburban subdivisions and wall-to-wall condominiums. Their parents were trading up from the traditional family home to something more comfortable. And all with good reason: While the consumer price index was 13% and rising, a good home could be found with inflation-proof monthly payments. There was no such thing as an adjustable-rate mortgage. Home-loan interest was locked in at usury ceilings of 8% to 10%. Furthermore, high marginal income taxes cut the interest costs by as much as one-half. No wonder home prices soared.

It couldn't last--and it didn't. Demographics were bound to reverse or at least slow the trend. Coming up behind the 72 million baby boomers are 48 million baby busters, the age group now 18 though 29 and approaching their thirtysomething household formation stage of life. Conservatism in politics also helped end the homebuying rampage. First came deregulation, which helped push mortgage rates into the free market and allowed savings and loans to run amok. Next came tax reform. Real estate limited partnerships, those blind pools of tax-shelter money looking for developers, were out. lower tax rates were definitely in.

For a time, momentum and optimistic expectations kept real estate values climbing steadily. Yet it soon became apparent that only a minority of Americans could afford to buy their own homes. Most could not raise the down payment and those who could often didn't earn enough to qualify for the monthly payments. And despite a widespread slump in sales, one-family houses were still appreciating in value during the first half of 1990 at an average pace not much below the overall inflation rate. As always, there were exceptions (see exhibit 1 on page 54). But in the first quarter, a typical suburban four-bedroom home was selling for only 4.7% more than it went to a year earlier.



Sales of new and existing houses are extremely slow. Business is therefore bad for the construction industry and its suppliers. Worse, economists fear that when backyards no longer buzz with news of how much the Joneses got for their place last week, people will fell poorer--and spend less money. Thus, a housing slump could grow into a full-scale recession.

CPAs, particularly in their role as financial planners, should make themselves aware of the implications for homeowning clients and those in search of a home. Here are some of the key concerns and what they really mean for clients.


Many potential home buyers may look at the numbers and conclude, perhaps wrongly, that they will be better off renting. Building family wealth on the foundation of home ownership is a concept as deeply ingrained in the American ethos as the two-week vacation. However, Barron's weekly, which delights in challenging eternal verities, published an analysis last May, during the peak of house-hunting season, challenging the notion that owning a home really pays. Using current sale and rental prices for desirable houses in the East, Midwest and California, Barron's produced hard numbers giving tenants a substantial edge over buyers.

Numbers, of course, can be crunched every which way to prove a point. The Barron's exercise looked only at the first three years of ownership and assumed there would be no appreciation during that time. The article showed that a person could spend three years renting a certain $464,000 two-bedroom bungalow in Hancock Park, California, and pay $76,767 less than the cost of ownership--and the authors replicated the results in Paramus, New Jersey, and Evanston, Illinois. They proved the obvious: Except in times of strong housing inflation, it is seldom wise to buy a place to live only briefly. Our worksheet in exhibit 2 on page 55, using Barron's data on the Paramus house, demonstrates further that, without any appreciation at all, the renter still beats out the buyer after 10 years.

Buying comes out ahead even after three years, though, if the property's value grows at 5% a year, roughly the current rate of inflation, excluding the runaway price of oil. And after 10 years, the owner does much better than the renter. Under Barron's other assumptions, the reward of ownership, reduced to its current value, tops $66,000. The lesson worth passing along to house hunters who plan on long-term ownership is this: When renting beats buying, it's smart to wait for a break in prices. The best advice, then, is to tell clients to rent houses they like with an option to buy them.

More to the point, CPAs can review with perplexed clients the pros and cons of home ownership. Their most important reasons for choosing to buy or rent may have less to do with taxes, interest rates or rent than with temperament. Some people won't feel secure unless they own their dwelling. Others who never had owned a home may regret taking responsibility for replacing a broken boiler or a leaky roof. And there are some advantages of ownership known only to a well-schooled adviser. Here are a few.

Protection from creditors. Let's say the husband owns a business. Under the laws of many states, husbands and wives can hold title as tenants by the entirety. This tenancy, as opposed to joint tenancy with right of survivorship, can prevent his creditors from seizing the house in payment of a delinquent debt.

In the case of huge medical expenses, the client may not have to sell the home to qualify for public assistance. Chronic illness can wipe out an elderly couple's retirement nest egg unless they ensure their eligiblity for Medicaid by transferring most of their assets to someone they trust, such as a child. However, many states make an exception of the applicant's home, which turns it into an especially valuable asset.

Mortgage payments build up equity. Home ownership thus serves as savings discipline, which is important to people who otherwise might not accumulate wealth.

Equity accumulates even if the house price doesn't rise. If a home does appreciate in value, taxes on that gain are postponed, perhaps indefinitely. CPAs should remind clients tha any capital gain they enjoy when selling a home is tax free if they reinvest the money in another primary residence within two years. Once clients are over age 55, they are entitled to $125,000


Location, location, location

Prices of single-family houses don't move up and down in lock step across the United States. While residential real estate was slumping in some cities earlier this year, it was soaring in others. The percentage changes in average selling prices shown here compare sales in the first six months of 1990 with those a year earlier. The house in question is a comfortable suburban one with four bedrooms, two-and-one-half baths and 2,400 square feet of living space. Its national median price was $195,800, but in greater Los Angeles, such a house went for $477,300.
City Change in value 1989 to 1990
Seattle +45.5%
Los Angeles +23.9
San Francisco +22.4%
Portland, Oregon +9.7
Charleston, South Carolina +9.7
Washington, D.C. +9.6
Detroit +9.3
Baltimore +8.9
Cleveland +8.5
National average price +4.7
Minneapolis +4.0
Denver +0.5
Phoenix - 3.0
Salt Lake City - 3.0
Boston - 3.6
Princeton, New Jersey - 5.1
Metropolitan New York City - 6.2
Manchester, New Hampshire - 7.0
Source: Runzheimer International

of tax-free gains on the sale of their primary residence if they don't reinvest the proceeds in a new home. Clients also should be informed, especially when the market is soft, that they can't claim any write-off if they must sell a personal residence at a loss.


Many homeowners regularly use home equity loans to finance cars and pay down credit card balances. But only in the past four years have blanks and finance companies heavily marketed home equity lines of credit, open-ended borrowing power that can be tapped as needed by writing checks. During that time, home equity has received a significant boost from the tax code, which phased out deductions on consumer interest (only 10% of consumer-loan interest is deductible for 1990 and none thereafter) but allows a deduction of all the interest on up to $100,000 of home-equity indebtedness. Credit secured by a home thus becomes the last surviving tax-advantaged consumer loan. In addition, this source of credit costs a lot less than most unsecured personal loans. Interest rates, though adjustable, generally are set a couple of points above the prime rate. Little wonder that one in four private houses now carries a second mortgage.

CPA-planners haven of doubt reassured clients concerned about heavy college tuition bills that they may be able to tap into their home equity for most of the bill--and deduct the interest from their taxable income. The underlying assumption has been that by the time children enroll, the house will be worth enough to provide the necessary borrowing power.

But will it? Certainly, until the rate of appreciation picks up again, increases in home equity will disappoint parents who have planned to use their homes as collateral for tuition financing. Lenders generally limit home equity credit lines to 80% of market value minus the mortgage balance. Amortization alone on a 30-year mortgage probably will not have produced a great deal of equity in a house bought less than 15 years ago and in some locations it is reasonable to wonder whether market value has risen enough to create significant additional equity.

Just because property values may have stopped rising--or have started falling--does not mean parents should despair of having home equity as a future resource. Real estate, like other assets, has gone through market cycles before. It was hard to sell a house during the 1981-82 recession, for example, and during a similar slump 20 years earlier. And while the current generation of young marrieds is much smaller than its predecessors, remember that millions of baby boomers postponed buying in the 1980s because down payments and mortgage rates were too high.

Alternate sources. If the family abode isn't worth enough to cover college financing, other resources may be available. One possibility is a closely held business, if it has enough equity or cash in the till. The form of business entity--S corporation, C corporation, partnership or sole proprietorship--will influence the borrowing methods available. In general, the options include boosting salary, using undistributed profits or taking loans.

Taking extra salary or a bonus has pitfalls and drawbacks. Pulling cash out of a business can backfire, for example, if it triggers the accumulated earnings tax, as could be the case for some kinds of entities. In any case, a parent would pay extra withholding taxes on this "raise." Putting the college-bound child on a parent's payroll for the same amount would not cut the taxes any unless Mom or Dad could prove to the Internal Revenue Service that the child really earned the money. Otherwise, the income could still be taxed to the parent under assignment-of-income principles.

Borrowing money from the business may be a better idea, but clients must ensure that the loan is an arm's-length transaction, that the interest rate is high enough to avoid the imputed interest rules and that they can prove interest has been paid to the business. Failure to take these steps may prompt the IRS to recharacterize the loan as a taxable dividend.

What if the company has no ready assets? It could borrow the money, perhaps, and claim the interest as a business expense. But that gambit raises difficult tax problems. If the loan proceeds paid to the parent can be justified as a reasonable compensation, fine, although the parents will pay income tax on it. However, such a loan could put the business in jeopardy. If it can be characterized as a personal loan improperly secured by business assets, the IRS or a creditor might succeed in piercing the corporate veil. This could expose the owners to personal liability even if the business is incorporated.


Stagnant property values also could dash future retirees' plans to swap the house they raised their kids in for a condo near the grandkids and a villa in the Sunbelt. Those who retired a couple of years ago, when real estate valus were at their peak, sometimes sold their homes and replaced them with smaller ones. Thanks to the rollover rules and the $ 125,000 tax-free gain, this move produced a sizable addition to their retirement nest eggs and increased their investment incomes. Others used the leftover money to buy second homes.

Instead of envying those who did that, today's preretirees should take a lesson from the real estate market, which is simply reminding them that retirement planning calls for allocating assets among several types of investments. When real estate is in the doldrums, the U.S. stock market may


Buying vs. renting

CPAs can help clients resolve their doubts by using an illustration of the comparative costs. In this example, a suburban house in northeastern New Jersey can be bought for $400,000 and financial with a 10.5% fixed-interest 30-year, $320,000 mortgage plus two points. Or it can be rented for $2,300 a month. Closing costs, property taxes, insurance and rent are ballpark figures for the area, with rent, taxes, insurance and maintenance costs inflated by 5% a year. The buyer's combined federal--state marginal income tax bracket is 35%. All cash flows are reduced to present values based on a 6% aftertax opportunity cost.
Period of occupancy 3 years 10 years
Aftertax ownership costs:
Down payment, points, closing
 costs, interest and amortization $416,515 $426,426
Real estate taxes 11,629 30,856
Maintenance and repair 10,588 28,094
Homeowners' insurance 2,118 5,619
Total $440,850 $490,995
Equity, with no appreciation $335,848 $223,358
 Net ownership cost 105,002 267,637
Rental cost 73,054 193,847
Gain (or loss) for a homeowner (31,948) (73,790)
Equity with 5%
annual appreciation $388,786 $363,827
 Net ownership cost 52,064 127,168
Rental cost 73,054 193,847
Gain (or loss) for a homeowner 20,990 66,679

be performing well. Foreign bourses may be piling up even greater gains. Domestically and internationally, bond prices might be on the rise. Only by spreading their resources among several types of investments can people ensure themselves a stable and growing retirement portfolio. An appreciating house can count as one asset. But with other resources to call on, prudent investors can wait out a bad stretch in one or more markets without having to change their way of life.


Many CPA clients are undoubtedly concerned about their financial futures because of the questions being asked about the value of their most important asset. CPAs can begin by reminding clients that the current slump is likely just one part of a cycle. In addition, planners can help homeowners understand what their investments are worth and how to achieve their goals despite the vararies of the real estate market.
COPYRIGHT 1990 American Institute of CPA's
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Copyright 1990, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Author:Shenkman, Martin M.
Publication:Journal of Accountancy
Date:Dec 1, 1990
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