With additional reporting from Carl Unegbu & Aissatou Sidime
When Marceline Alburg refinanced her two-family home in Brooklyn, New York, last October, she had some lofty goals in mind. “I wanted to buy another property by using some of the money from refinancing as a down payment,” she says. “I’m looking for a two- or three-family unit with a storefront to put my business in, and then provide rentals to others.”
For Alburg, refinancing the two-family brownstone that she bought for $180,000 in 1999 is making her goals possible. Refinancing allows a borrower to pay off an existing home loan with the proceeds of a new loan using the same property as collateral. The Brooklyn-based natural-hair stylist, who specializes in dreadlocks, has run Just Loc’s—her beauty business—on the ground floor of her home for one year. She previously refinanced the property in 2001, taking on a $248,000 loan at 8.25% interest, which enabled husband Marcus and her to continue home improvements, pay off a time-share obligation, and pay back Marcus’ personal loan. By the time she was ready to refinance a second time in order to look for a second property where her business would be exposed to a higher volume of customer traffic, the value of her home had risen to $450,000. This time, she inked a $326,250 mortgage at 6.25% interest with Wells Fargo Bank, paying off the balance of the first refinanced loan, and cashing out $60,000 of the home’s equity, which she plans on putting toward the new property.
Alburg demonstrates just one example of how home ownership can lead to greater wealth. Whether you use a refinancing strategy like Alburg, decide to “trade up” from a smaller home to a larger home, or benefit from tax advantages, homeowners need to understand how they can best use their homes to build wealth that can help them reach all their financial goals.
REFINANCING
By making nearly five years of steady mortgage payments, Alburg has been able to leverage the value of her home in a way that has helped increase its value. Refinancing allowed her to borrow against the value of her home so that she could make home improvements that have contributed to increasing the home’s value even more. “The first refinance helped me finish putting all new fixtures in two of my bathrooms and I also totally renovated my kitchen,” she says.
In addition, Alburg’s second refinance is helping her buy another property, which will increase her wealth tremendously. If she can find a building with a storefront for her business, she will save on the cost of renting commercial space. She will also have the opportunity to receive rental income from any additional units in the building. And of course, her wealth will also be enhanced by the real estate appreciating in value over time.
Marc Giles, CEO of Overnight Funding Inc., a mortgage broker based in the Bronx, New York, says refinancing is used for two primary reasons: first, to reduce the overall cost of the loan by lowering the interest rate. Even a 1% drop in interest rates can substantially lower mortgage payments and interest charges for the borrower. The second reason to refinance is to cash out equity from the home to use for other purposes (equity is the difference between your debt and the appraised value of your property). Giles explains that homeowners can use money obtained from a refinance to serve as a down payment on additional property, to make value-enhancing improvements, like new bathrooms, garages, or swimming pools, to the current property, or to lessen one’s overall debt burden by eliminating other debts.
“You can pay off your current debt and get additional funds and a line of credit on the house,” says Giles. “Use the money cashed out to make prepayments on your other debts and even on the mortgage itself—that helps decrease debt and increase wealth as you get to make lower payments on the house and secure lower interest rates on things like credit cards.”
Roderick McDaniel, CEO and cofounder of Huntington Browne Real Estate, a mortgage banking and real estate sales entity based in Inglewood, California, says homeowners can make refinancing a long-term strategy by utilizing their home as leverage to make other investments or satisfy other personal goals. “As your equity builds, it is money you can take out and invest in the stock market or put your kids through school,” says McDaniel.
Alburg says people who want to duplicate her refinancing strategy should make sure they keep a clean credit history. They should be especially diligent when paying their mortgage,
because that will determine whether they are seen as a good borrower. She intends to use the money she obtains from refinancing for long-term wealth building. “After I secure my next building, I’ll build up the equity in it and look to refinance again,” she saysTRADING UP
Another way real estate owners can increase wealth is to “trade up” to larger, more expensive properties. This strategy, also called “upgrading,” typically involves using a substantially large equity position in the existing home as leverage to purchase or “make an exchange for” the new property.
Richard Flateau, president of the Bedford-Stuyvesant Real Estate Board in Brooklyn, New York, says the simplest approach to trading up is to first build up substantial equity in the home, and then use the equity as a down payment on the more expensive property. “You have to have enough equity to cover the down payment and closing costs of the bigger property—say 15% to 20% of the total cost of the larger property,” he says.
In some cases, homeowners can move into a larger home without having to dram
atically increase their income. “Most people’s incomes tend to be higher when they trade up, but not always,” says Flateau. “If the price of the new property is a lot higher, then you probably need more income, but if you put more money down, it may be different.” In fact, a higher down payment on the larger property allows you to finance the exact amount of mortgage loan you can afford.Take Myrtle and Reginald Campbell. They wanted to trade up from the 1,475-square-foot, four-bedroom home they bought in San Antonio, Texas, for $72,000, to a larger home that they decided to build themselves. Their new 1,959-square-foot, three-bedroom home cost $174,000, including land and construction, more than twice what their first house cost them, but they didn’t skip a beat.
Myrtle, 43, an insurance claims representative, and Reginald, 43, a courier for Overnight Transportation, sold their smaller home for $88,000 last September, $16,000 over the original cost of the home. They used the proceeds from the sale to pay the $10,000 deposit plus closing costs on their new home in Schertz, Texas. The Campbells’ great credit scores and household income of $90,000 allowed them to finance $166,000 of the $174,000 purchase price at an interest rate of 5.99%. The $1,300 mortgage payment is comfortably affordable for a couple with their income level.
“We always wanted a bigger house,” says Reginald. But the size of the home is not the only benefit the Campbells enjoy. “I knew that taxes were cheaper being outside of Bexar County [the home of San Antonio]. Insurance is cheaper too. And I wanted my daughter to experience a new environment,” he says.
There are other ways to trade up. McDaniel says a more sophisticated swap of smaller and larger properties is done with a “Section 1031 exchange.” In this kind of exchange, the real estate owner can avoid tax liability from a property sale by purchasing another property within a six-month window using the escrowed proceeds from the first sale. Another way to trade up is through a trust deed exchange. For people who have paid their mortgages in full, they can exchange the smaller property for a lar
ger one, with the difference in the values of the two properties being liquidated through periodic payments per the terms of the trust deed.
By trading up, Flateau says, the real estate owner can take control of a larger asset, which has the potential to lead to greater wealth. He notes that going from co-ops and condos to two- or three-family homes is more typical in trade up transactions in places like New York than in other markets. He also says there are tax advantages to trading up, such as the exemption from capital gains tax on the proceeds of the sale of the smaller home.
So when is it best to trade up? “Generally when people have built up substantial equity in their property, then they could look at a second property or trade up,” says Flateau. But he cautions that risk factors, such as determining your financial ability to take on a larger mortgage and the operational risk of managing a larger property, should be weighed carefully before trading up.
TAX ADVANTAGES
Owning real estate can yield tax savings to the owner that can add to your wealth. “You can write off mortgage interest, real estate property taxes, and mortgage points that are treated as interest, like when you buy down your points on a loan before a purchase,” says Ari
Dodoh, an accountant based in New York City. “Of course, you can only deduct these expenses if you itemize instead of taking the standard deduction. Schedule A of Form 1040 lists the deductions a homeowner can take.Real estate owners are exempt from paying taxes on the proceeds of a sale up to $250,000 for singles and $500,000 for married couples. This allows a sale or refinance to yield big dividends after equity has been built up in a property.
The tax advantages are even greater for commercial real estate. There are a wider variety of tax deductions and credits, plus the property earns a higher income flow and the usual equity increase. Most important for commercial property are the depreciation rules, which allow owners to write off the cost of their property over a number of years at a set scale. This causes a tax benefit during the depreciation period because the tax deductions are occurring at the same time that the property value is increasing. “This is the greatest benefit in tax law,†says New York-based CPA Jeffrey Rothstein. Rothstein notes that the depreciation benefits are generally so large that people simply use this tax saving to buy other property.
So if you are a real estate owner, there are a number of things that you can do to increase your wealth. Whether you refinance, trade up, or capitalize on tax savings, one of these options can help you build a foundation for securing your financial future.
THE PERKS OF PROPERTY
The simplest approach to trading up is to first build up substantial equity in the home, and then use the equity as a down payment on the more expensive property.
Refinancing
PROS
Save on mortgage payment interest costs
Cash out money for other purposes like paying down debt
CONS
Can take years to pay off mortgage interest
Closing costs dilute benefits
Can increase mortgage payment
Trading Up
PROS
Allows owner to obtain larger, more expensive property without high cash outlay
CONS
Possible higher mortgage payment
Increased cost of managing larger property
Tax Advantages
PROS
Write off mortgage interest and property taxes
No tax on the proceeds of sale up to $250,000 for singles, $500,000 for married couples
Depreciation on commercial property
CONS
Initial cost of property taxes