Lifestyle changes raise the question: rent or buy?

Sarah loves the house she has lived in for 35 years. She and her husband bought it together and after the couple divorced, Sarah raised her two daughters there. The years have passed quickly and at the age of 72 she wants to downsize. Happily her girls still live nearby with their families so she is going to stay in the area.

Now Sarah is tackling the classic question:

Should she rent or buy her next home?

Sarah will have to consider how her money will serve her better. Can she sell her house and buy another for a lower price, which would help her finance the rest of her living expenses? Or would renting free up more of her capital?

Tax rules for one-time house sales

One advantage Sarah has is that the capital gain (the amount she earns when she sells the house, above her original purchase price and any improvements she has made) will be less than $500,000, so she will not owe capital gains taxes. The full amount of the sale, minus selling expenses and the small mortgage she still owes, will be available to help pay for the next steps in her life.

Sarah is hoping that even if she buys a house she can avoid a mortgage, but she knows she will have to factor in real estate taxes that she estimates at about $6,000 per year and regular house-related costs of another $20,000 per year or so for lawn care, snow removal, insurance, general maintenance and the like. In that case, a big chunk of her money will be tied up in the home. Of course, there’s always the potential for some unplanned-for major expense.

She has decided that if she rents, she will look at apartments and has found several with many nice amenities, including swimming pools where she would entertain her grand-kids. Sarah has calculated that if she invests most of the money from the sale of her house, she will need to spend about 6% of the net sales proceeds on rent each year. She will need one or more investments to return more than 6% — and to cover rent increases at the rate of inflation. For instance, if she nets $400,000 on the sale of the house, she will need $24,000 a year or $2,000 per month, to cover her rent. Can she find that kind of investment?

The planning basics

She can if she creates a “residential retirement plan” that allocates the house proceeds between a portfolio of dividend-paying stocks that earn, say, 3.5% and an income annuity generating between 7% and 8% in cash flow. Both have some tax advantages.

While the annuity payment will be fixed, dividends historically increase by about 8% a year; payments from the two types of investments should be enough to comfortably pay Sarah’s rent.

Her Social Security will cover her other living expenses. And the personal savings she has put aside can be used as an emergency fund, and eventually be left to the kids. Now she is ready to determine whether owning or renting will better suit her present lifestyle.

Like Sarah, you have to carefully examine the numbers and all the variables that apply when deciding whether to rent or buy. But by doing so, you can be confident that you will make the decision that’s best for you.