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Buying Your First Home: Equity, Insurance And Taxes

Editor’s Note: This is the second of two articles adapted from “Buying A Home,” Chapter 8 of The High Achiever’s Guide to Wealth. Pick up your own copy here to read more on this topic and many others. Click here to read part one of this series.

Once all the closing papers are signed on your new home, you are apt to feel relieved and excited. Congratulations: You’re now a homeowner.

Buying your first home, however, does not have a one-time effect on your finances. Homeownership will touch many areas of your financial life, including savings, insurance and taxes. While even a two-article series cannot fully cover the financial impacts of owning a home, this second part will introduce you to some of the major considerations you should bear in mind after you have made it past move-in day.

Building Equity


Home equity is the difference between your property’s fair market value – the price it would sell for in the open market – and the remaining principal balance on your mortgage. If you, like most people, financed your home’s purchase, you will build your equity gradually over time.

When you hear homeownership described as a means of forced savings, equity is the mechanism in question. Each month, a portion of your mortgage payment goes toward paying back the loan’s principal. This portion is, essentially, you paying yourself. Your equity can also grow due to property appreciation. If property values rise in your area, the difference between your home’s value and the principal value of your mortgage will grow. Even though you owe the same dollar amount as before, your equity has increased.

That said, there is no guarantee that real estate in a particular area will gain value at a rate outpacing inflation, especially in only a few years. The belief that real estate values can only rise was a major factor in the housing crisis of the late 2000s. You should think of your home primarily as a purchase, not an investment.

You may eventually want to tap the home equity you have built. The most direct way to do this is to sell the property, downsize and pocket the difference. You may also use your home equity as collateral, either through a home equity loan or a home equity line of credit, often abbreviated HELOC. I discussed these strategies, among others, in a previous article, “Mortgage Strategies For Different Life Stages.” Borrowing against your equity can be a reasonable choice, but be careful. If you cannot make payments, you could lose your home and seriously mar your credit history.

Insurance


Most people know that homeowners insurance is a necessity. Not only does it protect your property, but most mortgage lenders require borrowers to keep their homes sufficiently insured as a condition of making the loan. “Sufficient” in this case generally means holding insurance for the property’s full or fair value – often the purchase price.

What first-time homeowners may not know is that there are a variety of types of homeowners insurance. Insurers offer eight main types of coverage, abbreviated “HO1” through “HO8.” If you own a condominium, co-op or mobile home, your choice will be obvious: type HO6 covers the first two, and HO7 the third. HO4 is renters insurance. That leaves five types for other property owners to navigate. Most homeowners find HO3 policies the best balance between cost and coverage. These policies are more comprehensive than HO1 and HO2 policies, and less expensive than HO5 policies. HO8 policies specifically apply to older homes, tailored to buildings that have historic significance or are registered landmarks. Your particular needs may vary, so take some time to do research.

Homebuyers who financed their purchase will generally include insurance premiums with their monthly mortgage payments. Lenders hold these funds in escrow and make premium payments on the owner’s behalf. Once you pay off your mortgage, you will need to take over the responsibility of paying insurance premiums directly.

The cost of premiums varies widely depending on the property’s value. For example, if you own a condo, you are only insuring property “from the walls in.” As a result, insurance will likely be relatively cheap. However, you are indirectly funding the building’s overall insurance policy through your condo association fee. Like other forms of insurance, homeowners insurance premiums also reflect perceived risk. If your property’s previous owner filed several claims within a short period, it can bump your pricing to a higher tier. Other factors may include the home’s building materials and the crime rate of the neighborhood. You can sometimes secure discounts by taking steps such as installing a security system or certain sorts of weatherproofing.

Costs also vary depending on the amount of coverage you need. One of the major differences to consider is between a policy that offers “actual cash value” coverage and one that offers replacement coverage. Actual cash value means the insurance company will reimburse you for the current value of your home and its contents, factoring in depreciation. Replacement coverage, as the name suggests, pays out what it would take to replace the home and its contents, and does not factor in depreciation. Most HO3 policies offer actual cash value coverage, while some HO5 policies offer replacement value coverage. Homeowners policies also sometimes offer guaranteed (or extended) replacement value coverage. This builds in inflation, paying whatever it costs to repair or rebuild your home (sometimes up to a predetermined ceiling). This coverage is the most comprehensive option, though typically the most expensive.

In addition to the value of the home itself, you need to consider the value of your possessions. In many policies, insurers cover possessions equal to 50% to 70% of the value of the home itself. If you collect art, own valuable pieces of jewelry, or have other possessions that ordinary homeowners insurance will not cover sufficiently, you may want to add supplemental coverage. You can investigate adding an insurance rider, also known as an endorsement or scheduled personal property, to your policy to cover particularly valuable items.

If you live somewhere prone to flooding, you may need to secure separate flood insurance, as homeowners insurance typically does not cover flood damage. The National Flood Insurance Program regulates the price of flood insurance policies, so costs will not vary between companies or agents. If your home is in a flood-prone area, note that your mortgage lender may require you to obtain flood insurance in addition to homeowners insurance.

Tax Considerations


As a homeowner, you can expect to pay property taxes. Like homeowners insurance premiums, property taxes are typically included in monthly mortgage payments; in this case, too, the lender places funds in escrow and pays the city, county and state governments as required. Once you pay off your mortgage, you will need to remember to pay property tax yourself. Depending on where you live, taxes may be due quarterly, semiannually or annually.

Remember to budget for increases in property taxes. At a minimum, you can expect taxes to rise along with inflation. But depending on your local housing market and your local government’s financial situation, property taxes may rise more sharply. Municipalities arrange tax assessments on a regular basis to adjust property tax to reflect any change in the property’s value. If you disagree with a tax assessment, you can take steps to have it reviewed. The particulars will depend on where you live, so you will need to research the requirements of your city or town. Note, however, that you cannot contest your property tax rate; you can only contest the assessed value of your home.

A major historical benefit to American homeownership has been the mortgage interest deduction on federal income tax. If you itemize your deductions on your federal return, this deduction can reduce your out-of-pocket interest costs, especially early in your mortgage’s term. This is because in most mortgages, more of the borrower’s monthly payments are devoted to interest in the earliest years of the loan. However, the tax reform package that passed in late 2017 substantially raised the standard deduction, which means that fewer taxpayers find it worthwhile to itemize deductions. This, in turn, means that fewer people now benefit directly from the mortgage interest deduction.

Taxpayers who do itemize can also benefit from the state and local tax deduction, which includes property taxes. However, the 2017 law capped the total SALT deduction at $10,000 annually. High earners in high-tax states may already be using their entire SALT deduction on state income taxes, which means property taxes provide them no additional federal tax benefit. On the other hand, if you live in a state with no income tax, you may find it better to take the standard deduction than to itemize your housing-related expenses. Unless your property tax, mortgage interest and other itemized deductions together exceed the standard deduction, there is no reason to itemize.

If you do itemize your deductions and adding mortgage interest and property taxes increases those deductions significantly, you may end up entitled to a large federal tax refund. If so, you should reduce the withholding on your wages, assuming you are an employee rather than a freelancer. Reducing your withholding allows you to take home a bigger paycheck every month, reducing or eliminating your annual refund. With more cash in your pocket, you can better fund your – likely higher – monthly housing costs.

One other tax consideration is the effect of any work you do on your property. Most of this work will fall under the umbrella of general maintenance. These changes may improve your quality of life, and even raise “curb appeal” for an eventual sale, but they do not offer tax benefits. However, if you make what the Internal Revenue Service calls “capital improvements,” you can add to your home’s cost basis.

Cost basis is the starting point for determining whether you will recognize a gain or a loss on your home when you sell it. If you buy (or build) your home, basis starts as what you paid, including your down payment and your mortgage. Capital improvements can be added to your home’s cost basis, reducing the potential for gain – and thus taxes – when you sell. If your gain comes out to less than $250,000 for a single taxpayer, or $500,000 for a married couple, you may be able to exclude it from tax entirely.

Distinguishing capital improvements from repairs and maintenance isn’t always easy. In general, the IRS recognizes capital improvements as changes to a home that last for more than one year. These projects should also prolong the life of a home, add to its value or adapt it to new uses. For example, mowing your lawn is maintenance; adding an additional bathroom is likely a capital improvement. The IRS provides a list of examples in Publication 523, “Selling Your Home,” although it is not comprehensive. If you plan to claim a project as a capital improvement, be sure to keep documents tracking your associated costs. You may want to consult a tax professional, who can help you evaluate your project and guide you toward proper documentation.

A home is one of the largest purchases most people will ever make. So it is not surprising that the choice to buy has effects that continue long after closing. With some care and forethought, your home can offer a variety of financial benefits for years to come – as well as a place to call your own.

Vice President Eric Meeermann, who is based in our Stamford, Connecticut office, is the author of Chapter 8, “Buying A Home,” in our firm’s most recent book, The High Achiever’s Guide To Wealth. He was also among the authors of the firm’s previous book, Looking Ahead: Life, Family, Wealth and Business After 55.
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