Tax changes shift the equation in rent-or-buy decision

Ask someone to name the ingredients for the ``American Dream'' and the list almost always includes owning a home. Ever since the end of World War II, when the majority of Americans rented their homes, the idea of home ownership has been supported by family life styles, liberal mortgage lending, even government tax policy. Today, about two-thirds of Americans are homeowners. But now, some of the factors that brought that situation about are changing, and the rent-or-buy equation may need to be recalculated.

The costs of home ownership are higher, many two-earner families don't have the time or desire to maintain a house, and new tax laws have taken away some of the incentive for buying a home.

One of the factors in deciding whether to rent or buy concerns apartment construction. The 1986 tax act and some additional revisions in a 1987 law changed the picture for landlords. Simply put, the rules for ``passive losses,'' whereby the investor does not actively participate in the investment, have taken away much of the incentive for developers to build new apartments.

``The rules on so-called passive losses have made the after-tax return on investment real estate much less attractive,'' says Heidi Wilson, an economist with Baring America Money Management. ``You used to be able to use real estate losses to offset a good deal of other income.''

For now, this doesn't matter much, she says, because so many unneeded apartments were built under the old tax laws that there's still an oversupply keeping rents down. But as that inventory is exhausted, without new apartment construction, rents can be expected to rise, she explains.

``Before rental construction picks up again, we've got to chew through that vacancy,'' Ms. Wilson says. ``Then, assuming the tax laws haven't changed ... vacancy rates will come down and rents will rise.''

This would seem to argue for buying a home as soon as possible, but it's not that simple. The tax laws have complicated matters.

Until the 1986 tax law, a home buyer could always rationalize high mortgage payments by remembering that up to 50 percent of the interest and property taxes were deductible from federal income taxes. The deductibility is still there, but it's not as good as it used to be.

Today, the top tax rate is 33 percent, but for most people, the top rate is 28 percent. This means that 72 percent of the interest and tax payments aren't deductible. At the same time, the ``standard deduction'' has been steadily climbing. This deduction, which all taxpayers receive, is now $5,000 for a married couple and $3,000 for a single individual. If a couple's itemized deductions don't add up to $5,000, they can't itemize, and if they are above that level, only those deductions that are above the $5,000 level provide any real tax advantages.

Owning a home, however, is still the only way many people can qualify for a whole range of itemized deductions, so the tax benefits must still be taken into consideration.

Inflation must be considered, too. In the late 1970s and early '80s, house prices were increasing more than 10 percent a year. In some parts of the United States, like the Northeast and some West Coast cities, housing inflation was running more than 20 percent a year. So buying a house was almost always a good move, based on the expected return.

Today, that picture has changed and house prices are rising just 2 or 3 percent a year. Again, there are regional differences, including parts of the Southwest where houses have been going down in value, but the overall trend indicates slight inflation.

At the same time, someone who is paying less to rent his home can get at least a 6 percent return by investing the extra money in a money-market fund or certificates of deposit at a bank.

In New York City, for instance, it may be painful to pay $1,200 to $1,500 a month for rent, but with average housing prices close to $200,000, a 20 percent down payment could still leave mortgage payments of more than $1,900 a month, plus insurance, taxes, and maintenance.

Although this is an extreme example, ``you should push the numbers like this'' no matter where you live, Wilson says.

``I think people in this country have always thought of owning the house as a thing beyond economics. But there's a point where you cave in'' and examine the numbers behind the decision, she adds.

``It may be, for a while, cheaper to rent than to buy, on an after-tax basis,'' says Larry Biehl, a partner at Bailard Biehl & Kaiser, a San Mateo, Calif., financial planning firm. ``You have to factor in the costs of home ownership or the opportunity costs lost on your down payment [what you'd gain by investing the money elsewhere], and then your mortgage, insurance, and all the costs that are included in a normal rent agreement.''

At the same time, he points out, rents have lagged behind housing prices. ``Now, with mortgage rates back up over 10 percent, that's probably at a level where it makes more sense to rent than buy.''

Also, Mr. Biehl says, ``we don't think real estate will participate this time as an inflation hedge. This means that if prices are going up for everything else, somebody can't raise rents if they're dealing with 40 percent vacancies.''

In the long run, however, real estate has proved to be a good investment. And an important factor is deciding how long you're going to be in the home. Most economists say you don't get an enough of a return to pay the costs of buying and fixing up a house for at least four years.

The argument for owning your own home becomes even stronger if you stay in the house for several more years. If you can, make an estimate of how long you'll be staying and add up the rent you'd be paying for similar living space, including periodic rent increases; the price appreciation on the house during that period; and the tax deductions for mortgage interest and property taxes.

This will give you the after-tax rate of return, which should be favorable over an eight- to 10-year period, for example.

Your life style, or the way you live, is also important. A two-earner couple, for example, may not have the time or interest in keeping up a house and yard.

``A lot of couples resent being tied into home ownership and maintenance on the weekends and all that,'' Biehl says. ``More and more of them are choosing a flexible life style. So I think the decision is partly financial, but a large part life style.''