A reader writes:
“My spouse and I don’t have a house to use as a tax shelter. We are transferring to a new duty station on the coast for 22 months and I am seriously thinking about buying a house there. Why throw away money on rent when we can buy and have a mortgage of about half of our housing allowance? It’s in a military area so it wouldn’t be hard to rent out when we leave. Problem is, my spouse has no desire to buy a house again after the two we sold during the housing recession. It was pretty ugly and stressful. Suggestions?”
This seems like an attractive way to pursue financial independence, but you’re hearing common high-pressure sales tactics from the real estate industry. The reality (and the math) rarely support the hyperbole. Even worse, you’re leveraging a large financial risk with a limited upside and a deep downside– on borrowed money.
I recommend that military servicemembers rent while they’re on active duty. Let’s walk through the different scenarios to see whether you reach the same conclusion. You might be hard-wired for the landlord life, but most people would prefer to avoid the labor and stress.
In a typical military renter scenario, you’d transfer to the coast. You’d spend just a few days learning about a new neighborhood, sign a lease (or a base housing agreement), pay a deposit, and move in. Then you can move on with the rest of the new duty station, unpacking your household goods, getting the kids in school, and returning life to some sort of normal.
In your ownership situation you’d transfer to the coast, spend just a few days learning a little about a new neighborhood, sign a purchase agreement, apply for a mortgage, pay thousands of dollars in transaction fees, and spend several hours reviewing and signing documents. Then you still have to deal with the rest of the transfer tasks while caring for your new home. The property would historically appreciate at about the rate of inflation (except when a hurricane hits). You’d only profit from the ownership if you were highly leveraged (nearly 100% mortgaged), escaped damage from natural disasters or accidents, and did most of the work yourself.
While you’re living in the home, a mortgage payment could be less than the market’s rental rates. As a short-term tenant you might feel that you’re throwing money away (even though you get to keep whatever housing allowance you don’t spend). However as an owner you’re subject to more expenses: property taxes, property insurance, homeowner association fees, maintenance, and repairs. Every property is different but your housing allowance is projected to cover only 99% of your rent and utility expenses. Unless you bought the home with a large down payment, now you’re spending more than your military housing allowance. It’s not designed to pay you for ownership.
When you transfer (less than two years later) you’d have to manage a rental from a distance. You’d hope that your new tenant produces cash flow while the local market generates more property appreciation.
Your first landlord challenge will be moving out of the house and returning it to flawless move-in condition, which you’d have to do whether you’re a renter or an owner. But then you’d have to either stay in the area to market the rental and screen new tenants, or you’d pay a property manager (or a realtor) a fee to put new tenants into the property for you. In the meantime your family would have to move to the new duty station and get settled in again. Buying a house has cost you extra labor on both the transfer in and transfer out, and (unlike renting) it hasn’t put any actual cash in your pocket yet.
While you’re living in the house you might spend the same amount of money on a mortgage or on rent, so the ownership expense might seem sensible. However when you moved out and became a landlord then you’d have to pay the mortgage (and all your other homeowner expenses) from the tenant’s rent– or else you’d have to pay the mortgage from your personal savings.
You’d have to cover the mortgage during the month that it might take to get a new tenant into the property. Even when you find the world’s best tenants you’ll still spend 1-2 months of time and money on the costs of getting them into the property and getting them back out at the end of the lease. If you’d simply been a renter then you would have dropped the key off with the landlord, haggled over your deposit, and moved to your new duty station without any further expenses at the old duty station.
As a landlord you might be able to manage the property yourself with a local contractor on call for repairs, or you might want to use a property manager. It’s hard enough to coordinate this when you’re hundreds of miles away– what if you’re stationed in Guam or Germany? The real estate “experts” frequently tell you about the successes while glossing over the failures, and you’ve already seen a little of that homeowner’s stress from the Great Recession. Transferring to a new duty station is hard enough without worrying about those issues.
My spouse and I have bought & sold four times on active duty, and twice we’ve been long-distance landlords. We made a little money once and lost much more money twice. The net result is that we’ve lost more money (and time) as owners than as renters. I’m not a fan of landlording but I can appreciate the benefits of diversifying my investments and building equity. Being a long-distance landlord is no fun at all– especially when the local real estate market is “temporarily” depressed, new tenants are hard to find at any price, and their rent is only 70% of your mortgage payment. We’re still landlords today on one place, and it took over eight years to achieve positive cashflow. When I reflect back on our decade of landlording during active duty, the stress levels were off the charts.
“House as a tax shelter” is another way to say “paying a dollar of interest on debt to deduct 15 cents on my tax return“. Somehow we’re supposed to feel good about getting a 15-cent discount while still spending 85 cents? In the 1980s, with mortgage rates at double-digit percentages and high tax rates, this approach might have generated 20 or even 30 cents of deductions for every dollar of mortgage interest. However you’re still spending large sums of money just to cut a little off your taxes.
You might not even be able to deduct that first dollar of mortgage interest. At today’s tax rates you’d have to exceed the standard tax deduction by paying at least $6200 (single taxpayer) or $12,400 (married filing jointly) of interest and other itemized deductions. Otherwise you get to take the standard deduction on your tax return whether you’re paying mortgage interest or not. Paying $12,400 of mortgage interest in a tax year implies that you have a 4% fixed-rate 30-year mortgage of over $300K. As a landlord you can deduct additional expenses and depreciation from your rental income, but again you end up spending money to offset your income. If the property lacks cash flow then you lose even more money just to be able to reduce your taxable income a little.
Don’t get me started on the taxes of selling a rental property. I’ll just mention that the federal depreciation recapture tax rate is 25% and (unlike an owner-occupied home) you can’t simply roll the profits (if any) into your new home. There’s a whole industry built around the tax concept of a Section 1031 exchange, and most landlords lack an exit strategy.
Instead of losing money to deduct a little of it on a tax return, I think it’s far better to rent a home and invest any unused housing allowance in stock index mutual funds or lifecycle retirement funds. In the long term of 5-10 years, the funds will grow faster than real estate– and with zero effort (or worry) from you. There’s less financial risk, zero leverage, and you won’t have to deal with tenants or hurricanes.
I recommend that you rent while you’re on active duty and consider buying only after you’re finished with active duty. Even after active duty you still have the average American’s risk of moving to a new home every seven years.
As you near the end of your active-duty time then you can save up cash for a down payment, spend months on market research in your chosen area (with no time pressure), and buy a cheaper fixer-upper in your favorite neighborhood. You’ll get an extra discount by buying during the winter when there are fewer buyers (and the sellers are motivated). You’ll save thousands of dollars with your value shopping, and it’ll make up for decades of “missed” ownership opportunities. Better yet, you’ll avoid years of financial risk and landlording stress.