Renting vs Buying

Joe Erickson

Joe Erickson
CPA and Shareholder

Written by Joe Erickson, CPA

People are often faced with the question of whether buying or renting a home is smarter.

Seattle has grown rapidly over the years, and many of our clients – either for themselves or their grown children – ask us whether renting or buying is financially more advantageous.  Like many things, this question requires a multi-faceted answer, and there are multiple factors to consider.  We will share a few key considerations that we find useful in helping clients determine which option is best for them.

Of course, non-financial factors, such as age and health, also play a part in your decision, and can be just as important as financial factors.  At Viridian, we find it helpful to break things down into three categories: financial issues, tax issues, and non-financial issues.  You will have to decide which of these weigh more heavily in making your own decisions.

Financial Factors

You have decided you want to buy, but aren’t ready to pull the trigger.  Let’s look at a few key financial issues that you can use to frame your decision.  We like to begin with price-to-rent ratio, rate of return, and time.

We will start with the price-to-rent (P/R) ratio for the market that you are in.  The ratio is a good reflection of the relative relationship between renting and buying in a particular real estate market.  P/R is calculated by taking the Fair Market Value of the prospective home and dividing it by the cost to rent that home for one year.  For example, if you have a $400,000 home that would cost $2,000 a month to rent, the P/R ratio is calculated as $400,000/(12*$2,000) = 16.67.  In 2016, the national average P/R was just over 19.  Thus, all other things being equal, if the P/R in your area is much higher than 19, that argues for renting, whereas a P/R much below 19 argues for buying.

However, knowing the P/R is only part of the puzzle.  P/R tells you how renting and buying compare to each other in a given city, but not how affordable housing is in that city versus other cities.  For example, Seattle’s price-to-rent ratio is 35, one of the highest in the country, so its P/R clearly argues for renting.  However, real estate prices are so high in Seattle that even renting is very costly.  For that reason, a second consideration is the average home price where you’re thinking of living.  You can then compare home prices and P/R ratios of several communities (suburbs and more rural towns are generally less expensive than cities like Seattle).

A third consideration is the rate of return (ROR) you anticipate on your investment if you buy a home. The P/R ratio doesn’t tell you anything about how much a home’s value will appreciate, and appreciation can definitely impact whether renting or buying is financially better.  Appreciation in home values varies considerably, and depends on a variety of factors, including population change.  From July 1, 2015 to July 1, 2016, for example, Seattle had the fastest growth in population of any major city in the country, with a 3.1% increase.  When more people are moving into an area, as they are here, demand for housing—and therefore home values—increases.  Whether and how much home values will continue to rise in future years is more difficult to estimate, and a high ROR on a home investment is far from guaranteed.

Finally, it is important to consider how long you plan to live in a certain home.  If you are planning on being there less than 5 years, the costs associated with buying and selling can more than eat up its expected appreciation in value.  For example, a $500,000 home sale with 3 percent closing costs, can cost $15,000 to buy and sell, so buying makes far less sense if you only plan on being in the home for a few years.

Tax Considerations

Now let us consider tax implications.  Depending on your financial situation, there can be tax advantages to buying versus renting.  Always consult with your tax advisor to see if there are things that you can do to help lower your year-end tax liability.

One advantage of owning a home is that both the interest that you pay on your mortgage and the property taxes that you pay can be deducted on your tax return.  A single individual who earns a $100,000 per year and pays $10,000 in mortgage interest and $5,000 in property taxes will generate roughly $700 in tax savings for the year.  The benefits of owning a home for yearly tax deductions are not nearly as great under the Tax Cuts & Jobs Act of 2017.   It is important to consult with a tax professional to determine what the overall impact of owning a home would be on your tax liability.

Another tax benefit, if you have lived in a home for five of the past eight, is that you are allowed to exclude up to $250,000 in capital gains on the sale of the home if you are single, and up to $500,000 if you are a married couple.  That $500,000 exclusion can result in up to $119,000 in tax savings for a married couple.  There are also some strategies for obtaining this credit multiple times if you own more than one property.

For example, John and Jane own two houses.  One is used as a vacation home and one is their primary residence.  They decide they want to sell their vacation home but have a large capital gain of $500,000 they will need to pay taxes on once they sell the property.  Instead of selling the property right away, they decide to go live in the home for five years first before they sell.  Since they lived in the house for five of the last eight years before they sold their home, they are eligible for the $500,000 exclusion.  

Another tax advantage of owning a house is that, when the property is passed to your heirs at your death, it receives a “step up” in cost basis.  The property value upon the date of death becomes the beneficiary’s new basis in the property.  For example, if you purchased a property for $100,000, if and it is worth $800,000 when you die, your heirs’ tax basis is that stepped-up figure, which means they avoid federal income tax its $700,000 in appreciation.  This is one reason that it is important to update your wills regularly and have a strategy for avoiding unnecessary federal and/or state income tax liability.

Non-Financial Factors

Of course, some reasons people choose to rent or buy have little to do with investment or tax implications.  Parents want to live in school districts where their children can get the best education possible, even when housing in those school districts is not the most affordable.  They may choose rent for a few years in a certain school district, even though it might technically be “more affordable” to buy.

Some people choose to buy rather than rent to reduce uncertainty, preferring a fixed mortgage payment to uncertain/rising rents, and so they can’t be forced to move because the landlord decides to repurpose the property.  Commute time is also a factor; a home in the suburbs might make far more financial sense, but many people prefer to rent in the city to be nearer to their jobs and thereby avoid extra hours on the road.  The “value” of such considerations can be hard to quantify, and varies greatly from one person to the next, but they are important nonetheless.

Take Your Time and Plan

The choice of renting or buying a home is a big decision, and one that will impact you financially for many years.  It is important to put thought and planning into your decision to really determine the option that is best for you.  Consider sitting down with a financial planner and/or accountant who will help you break down the pros and cons of each decision.  Make sure you take enough time and get the help you need so that you can make the decision that is best for your family’s future.

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