Mortgages, Imputed Rent, and Early Retirement

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mcman286In a Quora question What do economists think about buying vs renting a house?, in addition to the previously-mentioned answer by Alex Tabarrok of Marginal Revolution, there was another well-ranked answer by Erik Brynjolfsson, professor at MIT Sloan. One of his three points was about the value of imputed rent (read the other ones as well):

Second, there’s a huge tax benefit to housing which comes from the hidden “dividend” it pays. I’m not talking (just) about the (too) generous mortgage deduction, but rather the fact that you don’t have to pay taxes on the implicit rent you earn on your house since its paid to yourself. A house generates enormous rental value each month — like a dividend. If you rent it to yourself, you take the money out of one pocket and pay it to the other one, and the IRS doesn’t tax that. In contrast, if you earn money some other way and then use that money to pay rent, you probably also have to pay taxes. That can add up.

From the Wikipedia entry on imputed rent:

Consider a model: two people, A and B, each of whom owns property. If A lives in B’s property, and B lives in A’s, two financial transactions take place: each pays rent to the other. But if A and B are both owner-occupiers, no money changes hands even though the same economic relationships exists; there are still two owners and two occupiers, but the transactions between them no longer go through the market. The amount that would have changed hands had the owner and occupier been different persons is called the imputed rent.

In other words, as a homeowner you could be considered both the landlord and the renter. Let’s say you would rent your house for $1,600 a month. If you were in the 25% marginal tax bracket, you have to earn $2,133 a month pre-tax to cover that rent (and pay $533 in income tax).

As part of my “rough model” of early retirement, I recommend setting your mortgage payoff date to coincide with your retirement date (for those that choose to buy a home). Part of the reason for that is that you won’t have to generate that extra income to pay your mortgage anymore. This could lower your marginal tax bracket into the next lower bracket, and also the tax rate on your capital gains.

For example, $1,600 in monthly rent equates to nearly $20,000 a year in after-tax expense, or nearly $26,000 in gross income at the 25% tax bracket. Here are the 2016 federal income tax rates (source):


Ideally, I would target my household expenses to stay in the 15% tax bracket for married joint filers in retirement. Being able to reduce my taxable income by over $25,000 would definitely help someone stay in the 15% tax bracket range. Also, if you are the in 15% ordinary income tax bracket, your tax rate on qualified dividends and long-term capital gains becomes zero!

Now, the idea of imputed income could be extended further. When I cook at home, I save the money from eating out an Applebee’s. Let’s say a dinner out costs $40 for the family. To reach $40 after-tax, I’d have to generate $53 of income at a 25% tax rate. Same with childcare, housekeeping, laundry, yard maintenance, etc. But housing is an area with significant impact, usually the biggest item in a household budget.

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  1. The “housing dividend” provided by your home is an often forgotten item during discussions related to long-term performance of home values. The chart from Robert Shiller showing how home prices went nowhere in inflation adjusted terms since 1890 doesn’t account for the value of using that home to live in. The right to live in the house provides a lot of value to the homeowner.

    Thank you for your article!

    Dividend Growth Investor

    • Stevie Wonders says

      That is why I laugh at the obsession over house price gains, or bogus assertions about “dead equity”. For most, imputed rent is by far the largest return on ownership. Assuming your market isn’t distorted by unbalanced rent to price ratios, imputed return (even after carrying costs) should be competitive to the alternatives, especially in today’s low return environment.

  2. Baughman says

    This is a powerful concept that I’ve been preaching for a while. The benefits of frugality are multiplied through avoidance of taxes. $1 not spent >>> $ 1 earned. $1 earned is diminished through federal, payroll, state, and sales taxes.

  3. I will share some real actual financial numbers here since I just looked at this myself. Please don’t judge me!

    Since 2011 we have owned and lived in a large (3000+ sq ft), nice house, around 25 years old, on >5 acres in a nice area with excellent schools in one of the higher cost of living states. My mortgage payment is $3200 per month.

    Around $800 of that goes into an escrow account to pay for our homeowners insurance and property taxes. About $130 monthly of that goes to pay insurance, and the rest pays our property taxes, which is tax deductible. My marginal tax rate is higher, but because I am subject to AMT, each dollar I deduct saves me $.28 on my taxes. So after adding back my deduction, the effective monthly property tax we pay is about $480.

    The remaining $2400 of my monthly mortgage payment pays principal & interest. About $800 of that is principal, which is essentially forced savings that (all else equal) I will get back when we sell the house. The remaining $1600 is interest paid to the bank. Once again, though, that amount is tax deductible, so after adding back the reduction in my taxes the effective interest cost each month is right around $1150.

    So the actual net cost each month to live in our house is $1150 (interest) + $480 (property taxes) + $130 (insurance) = $1760. Now, we did put down just over 20% when we bought the house, but that amount at a 1% annual interest rate would only be earning around $75 per month after taxes, but that probably pushes our monthly cost to live in this house to $1835 or slightly more.

    In our school district it would cost around $2000 per month to rent a 1,500 square foot town house with no yard.

    We definitely have more maintenance expenses as a homeowner, but in our situation the economics are really much more favorable to owning than renting.

    • One common fallacy I note when people calculate the tax benefit on mortgage payments is that they discount the standard deduction that you can take on your taxes even if you did not have a mortgage.
      If you did not itemize your mortage/property tax expenses, you would still get a standard deduction for $12,600 for married filing jointly. So If you have $19200 ($1600×12) per year in interest payments, you are effectively only getting to deduct $6,600 ($19,200-$12,600) of this on your taxes due to having this mortgage. The other $12,600 is something you would have deducted anyways, even if you did not carry the mortgage. So your monthly interest expense after tax benefits is:
      ( $12600 + $6,600 x .72 ) / 12 = $1446
      Now, if you have other expenses that you are also itemizing only because you have a mortgage, that is another story.

      • For clarity, that is: ($12,600 + ($6,600x.72)) / 12 = $1446

      • Good point, but in my case I pay a multiple of the standard deduction in state and local income taxes which we deduct, so we’re pretty far from taking a standard deduction in my particular case.

        But in general, you are correct that that needs to be a consideration.

  4. Great article and discussion. Too many people make decision to buy a house without understanding pros and cons.

  5. I also think the circumstances make a big difference. We recently moved and where we live now, we pay $2800 in rent in a location that would cost us $5500 in a mortgage payment for the same exact house. In our case, we save the difference between that each month by sub-leasing a portion of the home. We estimate that we will accrue more in our investment, it will be more liquid, and we don’t lose any addition money on the upkeep and upkeep of our home near the beach. However, where we lived before, we had a house for 10 yrs, rented it for 7 yrs, lived there for 2 yrs total, and barely broke even on the sale of it this year. If we planned on ‘never’ moving (which is unlikely for us) then this would work well.

    • I think beach houses are often viewed half investment/half consumption good which is why you tend to see those dynamics. Even if a rich person can rent a comparable house every year for much less than the cost to buy (even if you subtract buy price from renting it out while they’re not there) they get a lot of value out of just telling people they own a beach house.

  6. John Dsouza says

    Why do you recommend setting your mortgage payoff date to coincide with your retirement date? If it is fixed rate mortgage there is no risk with increased payments. Plus for Early retirement the mortgage deduction would still be useful when you want to build the Roth conversion ladder so as to lower taxes. Or am I missing something?

  7. The Frugal Millionaire says

    Interesting article as always, thank you. I have a question for the community…I have owned four properties (three primary residences and one vacation home), and either paid cash for them or paid off the mortgages as soon as possible by pre-paying principal. Now that I am retired I wonder about: 1) the missed opportunity cost of having that money tied up in my home instead of being able to invest more in the stock market, and, 2) the best way to “unlock” that equity In retirement. Although living debt-free is great, selling the house would probably net enough to pay rent elsewhere for the rest of our lives and then some. Downsizing and reverse mortgages are also possibilities, although we don’t like the fees on the latter option. Thoughts?

    • Financial leveraging is a great or poor idea depending on what the government and federal reserve think of it. At this juncture, Fed seems to actively encourage it.

      It’s unfair, like Calvin ball, when the rules change in the middle of the game. But that’s life. Four properties… I’d say life’s good and wouldn’t worry over lost opportunities.

      • The Frugal Millionaire says

        Thank you for your comment.
        I may have left the wrong impression. I have owned four primary residences, but all at different times; i.e. starter home, larger home, married home, etc. My wife and I now have one primary residence and a small vacation home.
        Not worried, but while I’m aware of the role real estate plays in our net worth, I’ve always been curious as to the role it plays in our asset allocation.

  8. Hum.. so you’re implying that the money used to pay the principal of a mortgage is not taxable??

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