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Sell your house every five years. At first that sounds like it makes about as much financial sense as "if someone throws a left hook at you, lean into it". Interestingly, it's about the best possible thing a person can do. The reason is internal revenue code section 121.
Section 121 changed all the rules. The proceed reinvestment requirement was removed, as well as the age 55 limitation, and the one time exclusion was changed to no more than once every five years. Also, the exemption was increased to $250,000 for single filers and $500,000 for joint filers.
These changes created one of the best possible investment opportunities for the average homeowner. It allows an average family to make up to $500,000 every five years tax-free. That's a $75,000 tax savings at current capital gain rates, or $100,000 savings under current Alternative Minimum Tax (AMT) capital gain rates.
Coupled with some creative financing solutions this can make for an attractive financial opportunity for the homeowner. To do this the homeowner has to assume they're selling their home every five years. Once that assumption is made, new opportunities open up. Most mortgage companies offer thirty-year hybrid loans. For the first five years the loan has a fixed low interest rate and, after that, increases becoming an adjustable rate mortgage. However, if you're going sell the property at the end of the fixed period, it doesn't matter. The trick is to minimize the up front costs and push everything into the back end. Don't pay any points to lower the interest rate, and be willing to accept a higher back end interest rate in exchange for a lower front end rate, and/or having the mortgage company either wrap the closing fees into the loan or cover their expense. It won't matter because the homeowner won't be there when it's time for the rates to increase, they'll have moved on. However, they need to be wary of exit expenses such as early payoff fees.
While the mortgage itself will decrease minimally over the five-year period if only the minimum payment is made, the capital appreciation and related tax savings will more than offset the difference, especially when combined with the opportunity to pay off the mortgage at a faster rate while making the same payments as a fixed mortgage. At the end of the fixed loan period, the owner needs to sell their current home, acquire a new home and refinance.
As an example, let's compare two situations. The first will be a thirty year fixed mortgage at 7%. The second will be a hybrid mortgage with a 5% fixed rate for the first five years and an arm for the remaining twenty-five years. Both will assume a 10% down payment, a home price of $200,000, appreciation at 5%, and a final sale in year thirty (without reacquisition). While the fixed mortgage example will hold the same property for all thirty years, the hybrid mortgage example will sell every five and repurchase, using a new mortgage (identical to the last each time, but always for the remaining value of the loan), and $5,000 in closing and repurchase costs (wrapped into the new loan). The hybrid mortgage will also pay the same amount as the fixed each month, with the difference serving to pay down the loan balance.
After thirty years, the fixed mortgage has no payment due, a 0 loan balance, and a property value of $893,000, with a built in gain of $693,000, and a tax due after sale of $29,000 (15%, after a s $500,000 section 121 exemption), for a net amount of $864,000. They hybrid system would have no payment due, having paid off the debt in year 23 (seven and a half years ahead of the fixed loan), and a property value of $886,000 (the $5,000 transfer expense was deducted from the new property value on the fifth sale and repurchase), with no built in gain (because a section 121 exemption was utilized every five years), for a net total of $886,000; a difference of $22,000, in addition to the manipulated earlier payoff (an additional $100K+ of savings).
Increasing the property appreciation rate to 6% and using a $300,000 base home price changes the final result from a net savings of $22,000 (excluding payments) to $201,000 (20% AMT rate), with the hybrid system paid off in year 22 (an additional $170K+ of savings).
However, such a coordinated tax and leveraging system is not without it's drawbacks. It requires careful analysis of the loan instruments employed, and the tax savings aspect can have its teeth pulled if the property fails to appreciate over each five-year period (remember 1987-1992?). Alternately, a fixed mortgage does provide comparative stability. While a coordinated loan and tax savings system employing only the short-term aspects of hybrid mortgages can result in a substantial savings, it needs to be balanced with each borrower's individual risk/return comfort level and financial situation. To do so, a borrower's needs should be coordinated through a competent tax advisor and lending agent.
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