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There's No Place Like Home For Saving Taxes

Bert and Ernie have been pals for a long time. They have the same $80K annual salary, and their employer, PBS, matches their $4K contribution to a 403(b).

They live across the street from each other on Sesame Lane and each owns his $200K Tudor-style home outright. They pay annual property taxes ($2K) and insurance ($700) on their home. Their homes are identical save for one feature: Bert gets the morning sun and Ernie gets the evening sun. Alas, their envy of each other is palpable.

A mutual friend Oscar has a solution. He suggests they each move across the street and rent from each other for 12K per year.

Ernie now loves watching the sun come up, and Bert now loves watching the sun go down. But something is wrong. Moving across the street lowers their sustainable living standards. How can this be?

Let's use ESPlanner to unravel this economic mystery.

When Bert and Ernie decide to rent from each other, their annual income increases by $12K due to the rent they receive. Their annual housing expenditures also increase by $12K. But this is not a wash. They must pay taxes on the rental income--and in Colorado where they currently live, their total state and federal tax is $3,556--16 percent more in this new housing arrangement than it was before.

This case illustrates the real benefit from owning a home--the receipt of tax-free income. The tax-free income here is the in-kind rental services we receive from living in homes we own. Economists call this implicit rent. Implicit rent can be an elusive concept because we take for granted the tax-free nature of receiving housing services from our own homes.

In Bert and Ernie's case, when they live in their own homes they are, in effect, renting from themselves. Bert can be thought of paying $12K in rent to Bert, and Bert can be thought of receiving $12K in rent from Bert. Same's true of Ernie. But the rent that Bert and Ernie can be thought of receiving from themselves never gets reported to the IRS and is, therefore, never taxed.

By living in their own homes, Bert and Ernie each enjoy a 10.7 percent higher living standard. Each gets to spend, on a discretionary basis, $37,271 each year, in today's dollars, rather than $33,670.

This discretionary spending (called consumption in ESPlanner) is spending above and beyond any housing expenses, tax payments, special expenditures, retirement account contributions, reserve fund contributions, insurance premiums, and regular saving.

Most people think that the tax advantage of buying a house or condo comes from the mortgage deduction. This is wrong. First, as we've just seen, there's a housing tax break accruing to Bert and Ernie, neither of whom have a mortgage. Second, any money we don't borrow to buy a home will earn interest income and be subject to taxation. So at best, taking out a mortgage when you could otherwise pay for your house is a tax wash. At best, you get to deduct the interest payments, but you have to pay taxes on the interest income on the assets you don't use to buy the house. We say "at best" because if you don't have enough deductions, you'll end up taking the standard deduction. In this case, the fact that you paid mortgage interest won't reduce your taxes.

Here's the bottom line. There's no place like a home you own from a tax perspective.