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brief debate about my forthcoming book on investing only in principal residences

Posted by John T. Reed on

Mr. Reed, congratulations on deciding to write a new book, especially one that challenges your previously-held beliefs. I would recommend that you name your book Movin’ On Up. However, I take issue with your newfound book's premise, namely for the following reasons:
1. Transaction costs: Loan fees, RE broker commissions, and closing costs. That would be at least a 7% loss every time one sells and buys. That’s an aggregate 35% loss over one’s lifetime if there are 5 transactions, using your every 7 years for 40 years strategy. 
1.a. This can be ameliorated by using a lower-commission brokerage such as Redfin, becoming an RE salesman/broker yourself (which might be worthwhile if this strategy is pursued), only selling For Sale By Owner, or by engaging with dual-agency brokers (not recommended and is unlawful in many states).

2. Major loss of property tax benefits. As far as I know, this would only apply in California. Due to Proposition 13, a complete reassessment only occurs when there is a new purchase. Each new purchase is a reassessment. The longer one owns a particular property, the greater the differential between what a longtime owner is paying and what a new owner is paying.
2.a. This is not a hidden problem because all one has to do is ask Californians why they haven’t moved and why they don’t plan on moving. I would say a quarter would give the reason as not wanting higher property taxes.
2.b. Of course this can be ameliorated by getting the most expensive place (final purchase) ASAP because the sooner one “starts the clock”, the more tax benefit realized.
2.c. The only way to completely ameliorate this is by taking advantage of Propositions 60 and 90, which allows old people to prevent reassessment when moving but only for one time and if the new purchase is the same price or cheaper. It also only applies in certain counties. Buying the same or cheaper could work against your strategy unless empty nesters decides to sell their larger square footage home for a smaller square footage home in a more expensive area.
2.d. Is the strategy practical in other states, particularly the Northeast where they have the highest property taxes in the nation (with annual reassessments and no state constitutional bar on tax increases)?
3. Very little paying down of principal for 10 to 30 years (depending on how long it takes to buy one’s final home). As you know, in amortized mortgages, interest payments are front loaded. If someone is movin’ on up every 7 years, their mortgage payments for decades will overwhelming consist of interest. If this is the case, then your overall strategy relies on appreciation to build equity.
3.a. Of course, this could be fixed by using non-amortized loans in anticipation of selling every 7 years or so. I know that you are against this type of financing but perhaps it would be best with your movin’ on up strategy.
3.b. I would like this discussed in your book with the use of visual aids such as amortization charts to show how much interest would be paid versus principal over the course of movin’ on up every 7 years.
4. Lazy equity: After 30 years of getting buying increasingly more expensive personal residences and plowing equity into down payments, there will be a lot of wealth inside the final home. In fact, most or all of someone’s wealth would be their home equity. The expression “house rich and cash poor” comes to mind.
4.a. Will that wealth come out during the owner’s lifetime or does it merely serve as a piggy bank for the children’s inheritance? If it does come out, how? Refinance? Reverse mortgage? Downgrading to a cheaper residence?
5. The strategy produces no income while at the same time increases costs. Perhaps this is addressed in the aforementioned point but most people get into RE investing to create an income for themselves, especially for retirement. Your principal residence strategy works in the opposite fashion: it calls for increasing one’s mortgage payments for decades (the movin’ on up period of 40 years that you mentioned) and extending having a mortgage up to 30 years after the final home is purchased. Even longer if there is a refinance subsequent to the final home purchase. The strategy requires an increase in income (to be found outside the strategy) to cover the strategy costs.
5.a. Your retort might be that "income property” is cash-flow negative nowadays, which is often true but eventually it isn’t. However, a principal residence doesn’t eventually produce income.
 
6. Less attractive for heirs. I do not think that RE investment should be done mainly with heirs in mind but it’s undeniable that it weighs on the mind of many an RE investor. I have seen siblings inherit expensive primary residences. One set of siblings rented it out for 5 years but after two tenants and very expensive rehabs in-between tenants (due to the sheer size of the house), they sold it but kept small rentals that they also inherited. Another set of siblings moved-into their late parents' ocean-view house in Palos Verdes (as tenants-in-common) with their respective wives but that didn’t work out (obviously), so it was sold. I think that most people would rather bequeath or inherit paid-off income-producing properties instead of a paid-off or partially paid-off expensive personal residence that is not profitable to rent out.
On the other hand, I will give you the following reasons that you are right.
1. Section 121 exclusion. With that, homeowners get a limited amount of the capital gains tax benefit found in Section 1031 without the onerous exchange requirements found in Section 1031.
2. You are spot on about this strategy decreasing political risk, legal liability, and landlord-tenant problems.
3. Better lending terms. You mentioned this in your article but I would expand on it, namely how owner-occupants get are judged by underwriters as lower risk. Also how government-subsidized mortgages (a guarantee/guaranty, actually) are available to them, specifically FHA with 3.5% down (note that PMI, for FHA mortgages with down payment of less than 10%, is now for the life of the loan) and VA with 0% down (with no PMI).
 
Other things that ought to be explored in your book:
1. Increases in other hidden costs, such as taxes and insurance.
1.a. Even after the Section 121 exclusion, what sort of capital gains tax will be paid every 7 years? What does that add up to after every 7 years for 40 years? Charts will be helpful.
2. What to do if your final home’s city turns to a dystopian nightmare (e.g.: San Francisco today or all cities in the future). 
2.a. I expect an economically stratified and de facto racially-segregated society, not unlike Brazil and South Africa of today. Gated communities will play a large role although you are against condo ownership, according to your recent article.
2.b. The possibility of a California “exit tax”.
3. Homestead exemptions. I know you wrote about it extensively in your Hyperinflation/Depression book but it’s very germane for your principal residence book because of the sheer amount of equity in the property. 
3.a.: Even with the highest homestead exemption in California of $175,000, that only protects 1.75% of the equity in a free-and-clear $10,000,000 home (the figure you used in your first article). Granted, the overall liability risk is lowered when compared to someone who has tenants.
4. Who this strategy works best for. I would gather that is works best for people who can expect to be promoted, or get significant raises, every five years.
Response from John T. Reed
All of your points are incorrect.
1. I am currently writing the transaction-costs article and it is all about amelioration. I did a 40-year spread sheet. The commissions amount to one or two million cumulatively, but the equity still amounts to two to four million after commissions. I also advocate every trick in the book like getting a real estate license on day one and keeping it the whole time, FSBO, etc. One huge trick would be insisting on seller financing. I never insisted but it would make almost all transaction costs optional and thereby avoidable, also operating in a state where the buyer pays title insurance and trying to negotiate that the seller does there when you buy. There are lots of things. Your main mistake is to look at commissions per se not the net gain after commissions.
2. Again, you lose sight of the net. You complain about losing the below-market assessment when you sell. If you sell every three of four years, that is not that great. You can move it to some counties. But you forget that Prop 13 is a good deal for brand new buyers. CA is in the middle of the U.S. on purchase-year-tax-to-value ratio. True it does get better over the years if you keep one house, but the object of the game is not to avoid paying 1% of your value as property taxes or to avoid commissions. It is to maximize equity.
3. Irrelevant. Avoiding interest is not the name of the game either. You have “big picture net of all” blindness.
4. The down payment percentage will rise over time and that will make you sleep better and lower your ROE in good appreciation years. But again, same lack of big picture focus. ROE in good years is not the name of the game. Final equity is. Plus you seem to be blaming the strategy. What is the solution? Buying rental property. But that has all sorts of horrors. I am almost 74. Been there done that. I have done both: owned a home and owned rental properties. If I had it to do over, I would rather just owned principal residences.
5. The income in only owning principal residences is in the form of not having to pay rent. You imply some alternative strategy has income but owning a more expensive principal residence does not. Where are you going to live in that superior strategy?
6. How is maximizing ending equity unfriendly especially in light of stepped-up basis? Seems like the best thing for heirs. My wife and I inherited seven properties. We instantly sold each and every one and paid zero taxes on any of the due to stepped-up basis. Where the heck do you get the idea that heirs have to move into the house? Or that heirs want to become landlords? God help the inexperienced heir who decides to become one as the result of an inheritance.
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You say you would expand on better financing terms. It is a whole chapter in the book. My blog post about the book is not the book. I do not know where you get the seven-years rule. My rule is every time you can move up to a 20% more expensive house.
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Condos are not the only kind of safe neighborhoods. We have a de minimis PUD and we used to have a guard gate. Now it is CCTV.
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You write about a CA exit tax. That is Third Reich stuff. Probably unconstitutional. My book is about all 50 states. It is also about investing in CA which has more of the expensive homes you would need in later years. You assume a need to leave the state. What is the basis for that assumption? We have no plans to leave so if there were an exit tax it would be irrelevant to us.
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I wrote extensively about bankruptcy homestead exemptions in the book already.
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You don’t need promotions. You can have your own business. And what kind of person does NOT get promotions and raises. You imply there are such people. I have trouble thinking of one. Income rising and peaking in your fifties is normal in America.
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The alternative to my principal residences only recommendation is to own rental properties. I shudder at the thought. And I owned them for 23 years when it was easier to be a landlord.  I was also a manager of other people’s properties for a year, too. I shudder at the thought of ever doing that again.

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