So, You Want to Buy in Montecito?

Borrowing Can Often Be a Safer Bet Than Just Putting Down Cash

To cash or not to cash, that often is the question when buying a Montecito home. “Many prospective residents are in the enviable position of being able to purchase one of our four- to twelve-million-dollar-plus homes with no financing,” says Sandy Stahl, a longtime Montecito real estate agent and resident. But, she cautions, is this the smartest financial decision? The answer can depend on opportunity costs and tax considerations.

Obviously opportunity cost deals with the spread between the costs to borrow money versus the return we might receive from investments we make. With last year’s unexpectedly strong stock market performance in the mid-to-high-teens and mortgage rates in the 6% range, the investment advantage of using leverage had appeal. The challenge goes back to that word “unexpected.” As with any investment there may be an equal or greater likelihood of a negative outcome as well.

Montecito real estate has been an extremely strong investment over the years, thanks to its relative scarcity and high demand. But will the influx of highly affluent buyers who seem unaffected by interest rate fluctuations or other economic factors, continue without apparent end? As with all great investments in their time, prudent investment management suggests the question continues to be posed.

By contrast, using leverage may bring tax benefits that can be a bit more predictable. For starters, mortgage interest paid on a primary residence may be deductible to a maximum of $1.1 million ($1 million on acquisition indebtedness, $100,000 on home equity mortgages) for a married couple; half of that for singles and married filing separately. So if a client can live with the inconvenience of monthly payments and assuming the loan costs and terms are reasonable, a mortgage may provide some tax relief.

Alternatively, if plans for raising the cash involve liquidations from an existing portfolio, a host of other considerations may arise. Key among these is the tax implications of doing so in a single year versus staggering the sales over several years.

To assist, some innovative brokerage programs could provide a flexible cash source and additional tax benefits. Not only are these programs a source of liquidity, but the interest paid is potentially tax-deductible to the extent that the client has taxable interest and dividend income.

Several key items should be kept in mind. Interest rate increases could cause the payments on an adjustable loan to rise, depending on the loan’s terms. Also, if you fall into the Alternative Minimum Tax (AMT), as more and more taxpayers are finding themselves, mortgage and investment interest deductions can be dramatically reduced. For example, clients in higher tax brackets who might otherwise receive $40 in tax relief for each $100 of interest paid can find that benefit reduced or even eliminated.

Finally, if there is a significant decrease in the portfolio’s market value a margin call is possible. Particularly when a portfolio contains a concentration in one or several stocks, this could pose some challenges. Several techniques can assist with this; more to follow.

Let’s consider the example of Roy and Shirley, who are contemplating the purchase of a $4-million home. Roy retired recently with some cash and a sizable investment portfolio that included a $5-million position in the stock of his former Fortune 500 employer. Roy and Shirley also own other investments capable of providing a secure income. The stock, being the product of a long-term purchase plan, has significant low cost basis. Liquidating a substantial amount could make them subject to capital gains tax. But they want to own their home free and clear and have concern over the portfolio concentration should the market decline.

One approach would have them consider a brokerage loan with perhaps a 5/1 ARM that would lock in the interest rate for five years (currently at about 6.25%, subject to change). The loan could be repaid incrementally over that timeframe or longer based on their preference, tax and market considerations.

Postponing sales of appreciated assets, especially following a strong market like ’06, can understandably generate some anxiety. Having a concentration within the portfolio can accentuate this even more. Roy and Shirley may be tempted just to liquidate and pay their taxes now rather than risk loss of their appreciated value should the markets turn downward.

Before they just act, it could be beneficial to consider a variety of hedging techniques that could potentially protect them. These include “collars” and “variable pre-paid forwards,” which would typically not affect marginability of the collateralized securities (good idea to inquire beforehand). Both are sophisticated investment tools that set limits on downside risk exposure and can allow varying levels of upside participation.

Bottom line: a cash purchase, while perhaps the simplest and most tempting, may not always be the best financial move. Much depends on your circumstances. Of course, this brief article is no substitute for careful review of the investment and tax considerations of your situation. Before making any decisions, it is a good idea to check with a financial planner, attorney or tax advisor.