How H and L kept their condo and advanced their professional careers

This family was smart -- financially conservative; they did not make themselves cash poor in order to buy a house, but bought less than they could afford. They continued to save after buying. If more people were like them, the mortgage crisis would not have happened.

It's an excellent compromise, as it keeps their finances strong and their credit intact. And they do not lose their condo. When their financial situation improves and they are both out of school, they can move back in.

I question your apparent emphasis, this post and the prior one on this topic, on how they were hassled for having kids. You make it sound as if this is par for the course. While it often might be, it isn't legal, and it would've been nice if you'd perhaps at least mentioned that -- if they were ever denied housing because of their children, they had legal options.

Loan mod is out of the question clearly as only owner-occ properties are eligible.

"Would you give up your car and live in half the space in order not to sell your condo and lose equity? Ask your spouse. Could both of you agree to a plan like this?"

The "equity" if there ever was any, is lost. Hoping for another bull market in real estate in the next few years is clearly a losing bet. Being a landlord is a tough enough business, but at 28, and most likely undercapitalized it is a lot tougher. These two are just begging for a divorce, little or no cash flow, depleting savings, and increasing student loans in the worst job market in years, a recipe for disaster.

"They are hard workers and good planners" When I was 28, my grad school was already paid off (employer paid for it while I worked full-time), I had no debt, and was making six figures, I call that good planning...

Perhaps this rental is where they should have been in the first place?

I'm sympathetic to them, but not so sympathetic to the idea that actions don't have consequences. There was really no avoiding the fact we were in the worst recession in 80 years last year when they were buying - an obvious implication of that is the loss of jobs, and falling house prices.

I would argue that few hundred is not "extra". How much would they be getting in interest now on that down payment? A lot more than a few hundred I'd guess...

Certainly its not limited to them - I'm amazed on a daily basis by the stock market, and people I meet, who give lip service to the idea of a recession, but are wilfully in denial of the consequences.

People are acting like its 2001. And that was barely a recession. Its nothing like the early 90s or the early 80s.

Graduate school for what?

I'm a little curious about the tax implications of this. As I understand it, it is no longer the case that rental property can "convert" to a primary residence for capital gains exclusion after two years of owner occupancy. Does this now mean the property is considered rental property forever and they will never be able to get the exclusion? (Assuming that some day there is a capital gain to be had on the property.) I hope they got good tax advice before making this decision. Of course, I'm not sure they had other options. I'm glad it's working out for them.

I was struck by the same sentence. Sacrifice does not prevent a loss of equity. Holding onto a condo does not prevent a loss of equity. In fact, it could exacerbate it, as many sellers who chose to "ride it out" in 2007 and 2008 have already discovered. Those people also expected the boom to return after a brief slow period. Didn't happen. Not going to.

Making a big down payment did give them more freedom. If they had a bigger mortgage, they could never have covered their current expenses. But it's impossible to explain to most buyers that leverage can magnify losses as well as gains.

In any case, they would've had even more freedom had they just stayed renting. While they're stable for now, they remain very vulnerable. What if their tenant loses his job during this period of record vacancies? What if there's an unexpected condo assessment? What if the only job they find after they completing their degree is in CA or NC?

It's working out great--we're in University housing, who patently makes it their business to accommodate grad students--it's a shame other management companies and landlords are not nearly as responsive. Needless to say they deleaded our place in 2 weeks flat. After finding out I had 2 kids, which was no problem at all. Absolutely not a problem for student housing.

All our utilities are now utilities included, the place is University shuttle accessible, walkable to everything.

And yup, H certainly did make figures for nearly 3 years (and we came out with 120K in savings even post-firing)---and I had a modest research stipend in euros, but who on earth would pay off student loans at at a 2.25% interest rate when our payments are so low to begin with (with additional reductionof one full percentage point once we hit the 36th consecutive payment mark), and when we had so little student loan debt for our respective fields? We have investments, Roth IRAS, emergency funds, and are going to do very well financially. We always will be fiscally conservative, mainly because of my rural Appalachian upbringing where basic necessities were never a sure bet.

H is assured a job in the fall (in another, yet related field after his 1 year of preparatory work in grad school). Things are fine.

PS., we're not vulnerable! Not by a long shot.

A few questions:
1) Have they notified their lender that the property is no longer owner occupied?
2) Have they notified their insurance agency that the property is no longer occupied?
3) Have they notified their local tax department that the property is no longer owner occupied?
4) Are "H and L" in graduate school in any fields in which ethics are considered a fundamental part of one's education (engineering, health, law, finance, social work, etc.)?

Oh yeah, and Hung Wang....there's no divorce on the horizon, sorry to disappoint. As a 27 year old married for 7 years, commitment has never been problem in my marital life or in my life in general. When two people come together with clear goals, as we have, the bond can become stronger. And ours will.

And also Hung Wang....did you have happen to have 2 kids, an academic wife wife with a job who earns much less (therefore precipitating the need for costly childcare), to support when you were so quickly paying off grad school loans?

"PS., we're not vulnerable! Not by a long shot."

Really?

I am glad that you were able to find a very good solution to being unemployed. If only everyone lived within their means and had ample savings like you, then we would not be in this financial mess. However, to think that you are "not vulnerable" to further financial difficulties is naive at best and unwise at worst. We are all vulnerable, just some more than others.

Susan,
Basic info about rental property and capital gains tax:
A place is owner occupied if the seller has lived there, as primary residence, for 2 out of the last 5 years. So, someone can rent a place for 20 years, then move in for two years and sell it as owner-occupied.
Any tax experts out there willing to give more details?

"PS., we're not vulnerable! Not by a long shot".

Alright let's visit this scenario for a minute. Let's assume both parties have no income and the unit has positive cash flow of $700 mo. Cost of living, food shelter, student loan debt service, 2 kids, etc. easily has a burn rate of $3k/mo. or $36k per year (to be paid with after-tax dollars). Assume a 10% vacancy on the condo, so positive cash flow drops to $7k per year. Assume grad school is $30k per year EACH and there is one year left for each (again paid with after tax dollars). 36k - 7k (assume this is tax free on Schedule E of the 1040., yields an after-tax cash outflow of $29k per year. This equates to say approx. $44k pre-tax. Concurrently $60k (at least) is being absorbed on the liability side by attending grad school. This debt must be paid with after-tax money (gross up to say $90k). Now we have a pre-tax need of $134k.
H/L mentions having savings of 120k (some of which is clearly retirement $ and would have to be discounted by 40% if liquidated). In theory, that 120k would need to be liquidated to satisfy the 119k in accumulated debt, let's say for simplicity it's a wash although it clearly would not be. Now you have two people say 28 or 29 years old still carrying some student loan debt from pre-grad school education, two kids, a depreciating, illiquid, piece of real estate, and no net worth to speak of, as all assets have been depleted (or at least spoken for on the balance sheet), looking for jobs in a very difficult job market. I would say without hesitation, you are vulnerable.

The $700 per month profit is suspect because that would be a phenomenal rate of return on a typical rental. Excess profits attract capital. If your neighborhood can support $700/month profit then you should have had no problem selling your condo.

A quick back of the envelope calculation shows the improbability of a $700 monthly profit. A 6% nominal return on a $700 monthly profit is worth $140,000.* If a rational investor believes that market has 20% further - from right now - to fall AND no appreciation above inflation in the future. The break even all in expenditure for the condo should be $700,000.

A 30% plunge in prices from today, no appreciation above inflation, and 4:1 gearing, the break even expenditure is $513,000.

* 700/.06/12
** 140000/.2

Rona, the rules on nonqualifying use have changed very recently. I have a link that explains the changes (add the http stuff, but no www):

taxes.about.com/od/capitalgains/qt/home_sale_tax2.htm

I'm wondering how this will affect those hoping to follow a similar strategy. Also, your couple were lucky that their condo rules permit renting. Some do not.

Susan

I posted earlier about how the $700 net profit is suspect. I ran a few more numbers and have serious issues with that claim. I have tried various scenarios, price points, interest rates yada yada yada . . . and there is no way I can generate a $700 net profit.

The way it can be done is:
+ charge 33% on average rents that will increase a minimum of 3% per year;
+ annual capital appreciation of 3% per year AND no further fall in value;
+ no commission to Rona;
+ do not account for income taxes or capital gains;
+ assume non-jumbo and conforming rates (from 2008) on the loan;
+ no other general expenses such as accountants, repairs, and maintenance;
+ a + and assume no impact from converting a 3 br to a 2 br.

They may be cash flow positive - even $700 in fcf is a stretch to believe, but I guarantee they do not book a monthly net profit of $700.

As an aside, real returns in rental property as a small business in the rest of the non-major metropolitan areas is largely a function of tax arbitrage:
+ every scrap of a receipt is filed away for tax time for deductions;
+ and capital appreciation coupled with depreciation expense is a tax deferred store of value.

The professional residential rental firm can expect to earn 2.5 - 7% real return depending on the type of stock.

I'm also interested in taking a peek at the situation--in general--in 2-4 years when those who are heading back to school (as a reaction to the poor state of our 2009 job market, layoffs, etc) graduate with their degrees and are all looking for jobs at the same time. If we think the job market is over-saturated with applicants now, just wait a few years when the next wave hits.

This makes me think that now is the time to buy, if people are able to rent units out at such a profit.

So let me get this straight, neither H or L is working, they have two kids to supprt, they are both in graduate school (taking on additional student loan debt) and the way they are staying ahead is by tapping into savings? I take back what I said on the first blog entry, these people really are not very financially responsible.

"They are both willing to give up creature comforts for a few years. " With H projected to make 1/3 of his previous income, I would say that they are in for on heck of a reduction in standard of living.

H/L: Whatever happens, you guys will make it work. Worst case scenario is that you end up broke and have to start over. But you're young, well-educated and disciplined about money... So even if life delivers a lesson from the "school of hard knocks" this time around you've got plenty of time to recover. Best of luck!

Hung Wang: I agree this setup seems like a non-starter from an investment perspective. But I see no point in speculating about the overall financial "vulnerability" of this couple. There could be so many variables we don't know about (i.e. relatives who are wealthy and willing to help if necessary, other assets not mentioned, etc.)

Susan: In order to pay capital gains tax, you need a capital gain. The chances of that happening on this property anytime soon are roughly 0%.

I just re-read the original post and, like many people, was struck by the comment that no one will rent to a family with an infant and a toddler. My family is moving to the Boston area this fall and we have an infant and toddler. Is it really going to be impossible to find an apartment or is it just that we have to pay more than students would be willing to pay? My guess is that if H & L would have been willing to pay more for a rental than they calculated their mortgage payment to be, they would have been fine renting. Please let me know if I'm wrong. We have plenty of money to buy, but as an avid reader of this blog, I thought that buying would b a seriously unwise option.

re: getting rent a few hundred dollars more than the mortgage payment
As an experienced Landlord, I can tell you that there are many more expenses than mortgage to keep a rental running. Please ensure that you set aside that so-called extra money for insurance, water and sewer payments, maintenance and repairs to the unit. You are legally liable for all of the above

Ellen,

Are you willing to live somewhere OTHER than in the city itself and its immediate neighbors? Because, if so, our family had absolutely NO problem finding housing for our family (which includes a toddler and a baby on the way).

We looked in Burlington, Wilmington, Stoneham, Wakefield, Winchester, etc., and those towns had lots of options for us. But since we PREFER life in the suburbs, this wasn't a sacrifice. If you're looking well within the 128, this information probably isn't as helpful.

Yes, Lance, I know that. However, if the couple plans to keep the condo and someday to sell it at a profit when the market eventually improves, the tax consequences may become a significant factor. It may, for instance, make sense to sell and take a loss at some point, from a tax perspective. They need good tax advice.

I'm bringing it up here because it seems that most people aren't aware that there have been changes to the rules and may be making decisions based on what they believe still applies. So while this solution may work for this couple, it may not work for some others out there.

@ #2

I find it extremely offensive that Hung Wang is predicting divorce for this couple.

We may rationally disagree about the housing markets, the buy vs. rent question and many other things. However, to claim that people who disagree with you are "begging for divorce" is extremely inappropriate. Does Hung know this couple personally? Is Hung a marriage counselor? On what theory does Hung think he is justified to say that this couple is heading for divorce? Why would Hung think that this couple would not grow even closer if and when they face financial difficulties?

News to Hung: Not everyone wants to be a management consultant (or similar) where the employer pays for grad school. There are many other very respectable professions where the employers require but do not pay for a graduate degree. That fact does not make all those people in those professions "bad planners". There is no need to brag about your personal achievements here and predict divorce for other people.

Please keep the comments civil. Hung owes an apology to H/L.

Ellen,

If you are moving to Boston from out-of-state, that is another good reason for you to rent and not buy.

Even within 128, there are communities that rentals are available for families with small children. If you are willing to pay some premium, the rent of some newly-built "luxury" apartment complexes had come down quite a bit (with promotions). There is definitely no lead paint in those.

Michael M, your cynicism is astounding. But more important, you are completely off base in your understanding of what a property conversion (from residence to rental) means -- the implications are not what you think.

First, in terms of the lender, the situation as described here involves no fraud. In other words, they bought truly intending to live in it; they did live in; external forces forced a move -- job loss. Easily documentable. Lenders care about the residence/rental conversion but generally only when fraud is involved. No fraud here.

Second, the insurance. Again, no ethics issue -- they should get a new policy that covers them in more and different ways; and if they fail to convert their policy, they will find that any incidents may not be covered. But not converting the policy is not unethical -- it merely leaves them exposed to liability should something happen. The ethical problem would be if they kept the policy as-is but made a claim pretending they still lived there. But there is nothing whatsoever from this piece that should lead you to think that's happened.

Third, the taxes. Taxes will be an issue if they sell while it is a rental. Otherwise, not so much. Single family housing (or single condos) are not going to trigger a tax issue on the property that is different from the tax that exists if they live there. And if their locale does treat this as a business property, again, the nature of the business and the lower value of the property may mitigate that.

But your assumption that they are ethically challenged and have probably failed to follow all applicable laws is astounding and mean-spirited. There's*no* basis for it. You're projecting here.

I'm surprised at the people posting who seem eager to jump on the couple and convince them they have done horrible planning. In a terrible economy and in the face of job loss to continue to be able to meet all financial obligations says they've done some things very right.

Rona's notes,
Michael M is right about one point: H and L have to let Somerville know that they are renting. Their property tax will go up during the period when they are renting.
Susan, I work with buyers not sellers, so this hasn't come up yet for my practice. I will look into the capital gains tax laws and write on it soon.

jlen,

This is one of the most educated, literate,and knowledgeable real estate blogs going - kudos to Rona. So, please don't come in with such obviously false and misleading information.

"First, in terms of the lender, the situation as described here involves no fraud. In other words, they bought truly intending to live in it; they did live in; external forces forced a move -- job loss. Easily documentable. Lenders care about the residence/rental conversion but generally only when fraud is involved. No fraud here."

Every single mortgage I have ever signed contains the clause that the buyer will use the home as a primary residence and if they convert it to a rental, they must notify the lender. So, ignoring a clause of a contract to their benefit is unethical.

"Third, the taxes. Taxes will be an issue if they sell while it is a rental. Otherwise, not so much. Single family housing (or single condos) are not going to trigger a tax issue on the property that is different from the tax that exists if they live there."

Massachusetts has a residential exemption that reduces their tax burden. Continuing to take the exemption is unethical and illegal.

Susan,

I respect your suggestion for good tax advice. It is imperative for them to talk to a CPA now. As I stated earlier, people that don't do residential rentals as a FT business largely come out ahead on the tax related benefits.

However, your capital gains comment is a red herring really. To take the benefit of a loss from a rental property (you cannot recognize a loss from a primary home), you must have an offsetting capital gain. Compounding the problem is the schedule of depreciation they choose that lowers the carry price of the asset. If it is $500M today, they depreciate the asset at $25M per year for 5 years, the basis is $375M. Any sale in excess of that amount is a capital gain.

WSJevons,

I think you're misunderstanding my question. If the family eventually converts the condo back into a primary residence and then sells at a future time, their ability to take advantage of the exemption becomes complicated by the changes in use (you pointed out some of the complications). It used to be relatively simple. And my point is - for others out there contemplating a similar solution - that these sorts of decisions need to be considered from a variety of angles and good advice is important. It wasn't clear to me that the couple in this story took these factors into consideration or had the benefit of this sort of expert advice when making the decision. Perhaps they did.

H and L, don't know if you are glad or regret your story being posted on here. welcome to the place where everyone is an "expert" on your situation, and knows so much better than you what your plans should have been and what your needs are.

i wish you success in your endeavours, and hope that your practical long-term educational and financial planning pay off big-time. what a great example i think you are setting for your children.

it's not all about the money...

I'm sorry, Chloe, but what should people be posting here? Should we be congratulating this couple for their brilliance.

For years, at dinner parties, events, etc., I listened to stories from people about their brilliant real estate investing and how much they were making. I quietly thought to myself that none of this made sense, and we learned that it didn't. Nobody was listening to the rational opinions then and look where that got us. Keep living in the past.

megan, personally i feel there is a lot of vinegar being thrown around. no one could have been able to fully predict the circumstances of today -- even the best laid plans in one's personal life can be way-laid by life events -- a death, a divorce, an illness, a job loss. i think most people that are in difficult circumstances today have experienced these events, but that does not make the news -- too mundane, drab, boring. it doesn't get people all excited.

congratulating? i don't know. they are making the choices they think are best for their family. what more can people do? i think there have been some helpful comments made about renting out one's primary residence etc., that perhaps they might not know or have considered. but all the criticism? a lot of real estate rage cloaks some decent advice.

chole - actually, if you look back on this blog, a number of us did pretty fully predict what is happening today. Ir really didn't take great leaps, just a basic knowledge of history and economics, and reading the business section.

If you see a real estate bubble, and see that real estate/construction is 20% of the economy or so, predicting that the crash will have spill on effects doesn't require that much work.

I've no criticism of this couple personally at all - I just want to emphasize that not realizing that actions have consequences is why we are in this mess. And as an aside, I think Hung was referring to the fact that financial stress is the biggest source of marital problems.

Oh, as an aside, thanks to WSJevons for taking the time to do the math. People can learn a lot from following along what he does.

Chloe,
Rona's post on H/L asked questions to which the contributors provided answers. Respectfully, people pointed out the potential pitfalls of their situation and future scenarios. It wasn't until H/L bragged about their financial acumen that people had enough. And really, we have all had enough of the spin, the twisted information, the fuzzy math . . .

H/L made a poor decision based on faulty logic and/or analysis. Their circumstances are certainly predictable.
+ H was likely a associate level lawyer 2-3 years into his career. (This is the point where you are put on a partner track or ushered out of the firm.)
+ The economic situation was bad when they bought a house and there was no end in sight.
+ Housing was terrible and predicted to get worse.

I appreciate your empathy, but save it for a more deserving couple. In the meantime, I and other contributors to Rona's blog will continue to point out where people went wrong or misrepresent the real story so others can learn from it.

I think WSJevons has a good shot at being right. A big firm lawyer a couple of years in is also at the point where they realize the money isn't good enough to pay for the miserable life, and decide to do something better.

I'm personally familiar with that "Omigod I hate this, I'd rather make less to do something I actually like" moment.

i'm sorry, but the calculations and conjectures about H's career are silly. there is no way the student loan obligations would be so low. and in fact, if H were a lawyer, i don't see how they would have been trapped in the living situation they were initially in. but anyway, i am not going to start guessing at careers.

there are lots of other career paths in the greater boston area.... or are we picking on lawyers now.

btw, i am not an attorney.