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For Sale by Owner Articles • Owners.com - Mortgages and Financing

All-Cash Deals More Costly Than Purchase Price

By Broderick Perkins
 
A growing number of buyers plopping down bags of cash for a home could be unaware of certain tax, investment and legal consequences.
The nation's longest economic expansion ever has spawned a new breed of home buyers so flush with cash they can afford to buy homes without a mortgage. Others are tapping a variety of financial reserves to out-compete heavy competition in sellers' markets.
Stock market proceeds were used in 23.9 percent of home purchases in the San Francisco Bay Area in the fourth quarter of 1999, a 27.6 percent jump from 17.5 percent in the previous quarter, according to the California Association of Realtors. An unknown number of the transactions were cash purchases.
"It's not just stock market money. People borrow from relatives and tap their 401K to come up with cash to get their bid accepted over others and are not fully knowledgeable about the consequences," says Richard Calhoun, owner-broker of Creekside Realty in San Jose, CA.
Transferring wealth from Easy Street to Main Street offers investment returns in the form of immediate home equity as well as a bundle saved on interest payments over the life of the loan.
But there are significant draw backs.
  • When you make a cash purchase, you give up a sizable tax deduction.
  • If top investment gains is your game, you could miss out on the possibility of larger returns for your money.
  • What's worse, in a down market, you could lose special legal protection for your assets.

The key is finding a professional number cruncher who can help you determine if an all-cash deal is your best bet.
When you buy a home for cash, here's what's at stake.
Tax consequences
The primary tax benefit of home ownership is the mortgage interest deduction. Most homeowners deduct all the interest they pay, interest on up to $1 million in mortgage debts secured by a first and second home on joint returns, according to IRS Publication 936 "Home Mortgage Interest Deduction." The maximums are halved for married tax payers filing separately.
Because the deduction applies to purchase loans, which you won't have in an all-cash purchase, you lose the deduction, along with the deduction of any mortgage points that could have been included in the cost of purchasing a mortgage.
However, you can deduct the interest on a maximum $100,000 in home equity loans. The equity loan tax deduction is actually limited to the lesser of the $100,000 maximum and the home's fair market value, determined by a complicated formula found in Publication 936.
You can deduct more than the interest on $100,000 worth of equity debt, provided additional debt is for qualified home improvements.
"The home buyer is limited to the $100,000 in equity, plus loans in which the funds borrowed are used to make improvements.," said Marie Sternberger, an enrolled agent in Sunnyvale, CA.
"There is no limit on dollar cost of improvements for which funds can be borrowed and for which the interest can be deducted. The limits would be on the home owner's ability to qualify for the additional loan and concerns about over improving," she added.
Sternberger says owners should retain bills, canceled checks, receipts, and other documentation that proves the money was used for home improvements.
"Remodeling the kitchen or bathroom, replacing the roof, adding a room, etc. Not a new Mercedes," she said.
Investment concerns
Wayne, PA-based Jack Guttentag, the "Mortgage Professor," says a no-mortgage home purchase isn't the best use of such a large chunk of cash, unless you've already amassed a diversified portfolio that considers, not only a return, but also risk and liquidity.
He says the return on a no-mortgage home purchase is the interest rate you would have paid for the mortgage. At today's rates, the no-mortgage investment gives you a return of about 8.5 percent, it's relatively risk-free, and it provides some liquidity. You can easily tap the equity and in a few days have the cash you need.
A financed purchase could be a better bargain
"A down payment is like buying stocks on a margin. You pay 8.5 percent on the mortgage, meanwhile your house has gone up 35 percent in value," Calhoun said.
Cash assets, say a money market account, has about half the return of a no-mortgage purchase and comes with equally low risk, but offers more liquidity. You may need such an investment for quick access, say in an emergency, Guttentag says.
The return on bonds could be higher or lower, depending upon the risk, but generally don't match up to the return on the no-mortgage investment.
"Only U.S. Government bonds are risk free, and they yield 1 to 2 percent less than the no-mortgage. Furthermore, bonds are not very liquid in the small amounts you would sell," Guttentag says.
Stocks are much riskier, can come with wild price fluctuations, but generally offer greater returns than an all-cash home purchase -- especially in the past decade.
Generally, the younger you are, the greater risk you can afford, provided inexperience doesn't cause you to overdue it. As you age, however, you want to protect your nest egg -- and not put it all in one basket, or in this case, home, says Guttentag.
Taxes and investment returns aren't all you'll have to consider
Calhoun says if you insist on paying cash, later take out an equity loan and the economy sours, leaving you unable to make your equity loan payment, you stand to lose your cash investment -- a far greater amount than if you only paid a down payment and financed the balance.
What's worse, in some jurisdictions, after the lender has foreclosed on your home, it can come after you for still more money.
"In California it's called deficit judgment protection. If you buy a home with a mortgage, all the lender can take is your home. If you buy a home for cash you lose the protection and the home is not all they can take. They can come back after you if they have a loss after the sale of your home," said Calhoun.
California real estate agents have intensified efforts to make consumers aware of questionable buying behavior stemming from the state's too-hot market. Agents, however, aren't qualified and could face liabilities if they attempt to advise consumers on issues beyond their professional abilities.
"These buyers are going in and losing the deductibility of mortgage payments and losing deficit judgment protection. We have an obligation to raise the issue, but we are not supposed to counsel them on tax consequences. They need to be aware so they can get proper counseling and make informed decisions," Calhoun said.

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