First off, I’m going to apologize for this sounding kind of like economics homework, but it’s super important. My goal as a Realtor is to help my clients be savvy buyers, and savvy buyers need to understand these types of scenarios to ultimately get the most wealth creation from their homes.
This is an example that matches very closely to a situation I have seen in real life in Chicago. Single family homes in Chicago often cost about $1 million dollars, but their tax bills can vary greatly. Let’s say as a buyer you are deciding between the following two possibilities, and that you like them equally well:
House 1: $1,000,000 List Price, Annual Taxes: $21,000
House 2: $1,150,000 List Price, Annual Taxes: $14,000
Given that you like the houses equally, which one should you buy? The lower price with high taxes or vice versa? Let’s figure this out. Given current jumbo financing rates (about 4%), with a 20% down payment and a 30 year mortgage, here is what the monthly payments will look like for each house including taxes and insurance:
House 1: Monthly Payment – $5,670
House 2: Monthly Payment – $5,670
The payments are basically the same (there’s a little rounding difference). So, going forward, what is it that changes our outcomes: equity accumulation and taxes. You can write off interest on your loan and property taxes, but you also accumulate equity on properties over time. So, let’s say you decide to move from your house in 5 years, and you sell them for the price you bought. How different is the wealth effect (assuming a 35% tax bracket)?
House 1: $76,420 in equity, interest and property taxes total $257,740 giving a tax savings of $90,209, so the wealth effect for this house after 5 years is $166,630.
House 2: $87,883 in equity, interest and property taxes total $245,650 giving a tax savings of $85,978, so the wealth effect for this house after 5 years is $173,860.
The owner of House 2 is going to be over $7,000 better off than the owner of House 1. That may not seem like a lot, but the effect increases with time. Let’s look at another scenario. What if prices gain modestly over those 5 years? Let’s say 1% per year (and taxes increasing 1% per year with housing). Here’s how the numbers look:
House 1: $76,420 in equity, $90,951 in tax savings, $51,010 in house appreciation for a total wealth effect of $218,381.
House 2: $87,883 in equity, $86,473 in tax savings, $58,662 in house appreciation for a total wealth effect of $233,017.
The owner of House 2 is going to be almost $14,500 better off. The wealth effect from this scenario doubles the first scenario and gets bigger much faster with time than the first scenario. Also, imagine the buyers paying off the mortgages in 30 years. The owner of House 2 is going to have a house worth a lot more and owe less each month in taxes!
This took a fair bit of number crunching, but the conclusion is pretty simple. Even if your payments are the same, the house with higher taxes is going to provide you with less wealth than the lower tax home and the effect grows over time. Thanks for reading, and I hope this is a helpful step in making you a savvy buyer.
Mark: Great article and one that I hope many others will read. While a home in not necessarily just an investment, it makes sense to think of the possible resale of your home and come out ahead where you can. Annual property taxes should definitely be looked at closely when deciding which home to buy.