In real estate, making smart decisions is about more than just finding the right home - it's about understanding the financial mechanics that affect appreciation, leverage, and long-term wealth.
The Federal Reserve has just cut interest rates for the first time in 4 years. So now would be a good time to take a deeper dive into what this means for the housing market and how it directly affects you.
The Power of Leverage:
One of the most important concepts in real estate is leverage. When you buy a property using a bank loan, as most people do, you're putting in part of your own money and the bank is putting in the rest. Usually this is a 20% / 80% split. The fact that you're gaining control of the entire property as well as future appreciation of the property is what we call leverage. With leverage you're able to control a much more valuable property compared to if you paid 100% out of your own pocket.
Here's an example to illustrate the benefits of leverage. Let's say you buy a $1M dollar home, putting $200k of your own money down. The bank is loaning you the other $800k to make the purchase. Once escrow closes you own the entire home, not just 20% of the home. Fast forward 10 years and assume the housing market has appreciated 7.2% per year. The value of your home has now doubled from $1M to $2M. Here's the math behind this doubling in value:
Future Value = Present Value * (1 + Rate) ^ Years = $1M * (1+0.072) ^ 10 = $2M
If you were to sell for $2M you would first pay back the bank whatever is remaining of the original $800k loan - let's assume this is $600k. Then you would keep the rest. Your net sale would be $2M - $600k = $1.4M. (I'm ignoring closing costs for this example because the math works out the same both ways.) So in the end you bought a home using $200k of your own money, lived it in for 10 years, and will net $1.4M when you sell. Your $200k has turned into $1.4M in only 10 years! You could pocket this money or use it to buy a move-up house.
The Power of Scale:
When people buy a home they're sometimes presented with a choice between two similar homes at different price points. Maybe one home is slightly larger, or has a great location, or is in a top-notch school district. For whatever reason let's compare two homes that cost $900k and $1.1M respectively. Also, very importantly, we are assuming the buyer can afford to choose either property.
Some folks may be tempted to buy the lower cost home, thinking that this is a frugal move and will help them in the long run. However, financially speaking, most people would fare better buying the more expensive home. Let's go back to our Future Value formula and see what both homes do in 10 years.
Future Value = Present Value * (1 + Rate) ^ Years = $900k * (1+0.072) ^ 10 = $1.8M
Future Value = Present Value * (1 + Rate) ^ Years = $1.1M * (1+0.072) ^ 10 = $2.2M
By purchasing the more expensive home you would come out ahead to the tune of $400k. And you would be living in a nicer home all the while. Yes your monthly mortgage payments would be slightly higher, but the money spent is small compared to the extra $400k on the back end.
Using Historical Appreciation to Predict Future Gains
Understanding historical appreciation trends can help you predict the future value of your property. In San Diego County, from 2014 to 2020 (pre-COVID), the average annual appreciation rate was around 7.5%. Using this historical data, you can project how much your home will be worth down the road. I've been using 7.2% in my previous examples because it makes the math easy (doubling in 10 years). Now you see why I'm confident to use a number in the 7's.
Factoring in Tax Exemptions: Capital Gains Considerations
When you sell a primary residence you can take advantage of the capital gains tax exemption—up to $250k for individuals and $500k for married couples. Any appreciation up to those amounts is completely tax free. This is a huge tax savings and one of the main drivers for people saying that home ownership is the best way to build wealth in your lifetime.
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And on top of that, any appreciation above those limits will be taxed at a favorable "long term capital gains rate". Long term capital gains is a fancy way of saying you pay less tax on investments you hold for a long time. The amount of savings varies depending on your income and tax bracket, but it can be on the order of 10% to 20% tax savings.
Capital Gains = Selling Price - Purchase Price - Any Exemptions or Deductions
In our earlier example our $1M home sold 10 years later for $2M. The total appreciation is then $1M. For a single person the primary residence tax exemption would make the first $250k tax free, and the next $750k would be taxed at long term capital gains rates. If the homeowner is married, then the first $500k would be tax free and the remaining $500k would be a long term capital gain.
Take note of one important caveat about the primary residence tax exemption. To qualify you must have lived in the home for 2 of the past 5 years. This is usually not a problem since most people live in their home longer than 2 years. Where people can get in trouble is when they move out and consider renting their old home instead of selling it. Renting can be a good choice but the clock starts ticking on the exemption. After 3 years of renting you will start to lose your primary home exemption. And from 3rd year to the 5th year the exemption slowly drops until it reaches $0. This could result in a significant tax hit when you sell.
This is why it’s crucial to consider not just the appreciation potential of holding onto your property, but also the tax implications. The equation to understand here is the capital gains formula:
Leverage + Appreciation = Long-Term Wealth
Ultimately your house is a home to live in first, and a financial investment second. But because it is both you do need to consider both when choosing a home to buy. The right combination of leverage, appreciation, and tax strategy can set you up for significant financial gains over time. By understanding these key equations and how they apply to your real estate decisions, you can make the most of current market conditions and set yourself up for future success.
If you’re thinking about your next move, whether it’s upgrading or exploring your investment options, let’s connect. We’re here to help you break down the numbers and make informed decisions that align with both your lifestyle and financial goals. Please reach out. We LOVE this stuff.
This content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.