Liquidate assets to buy house or mortgage?

Question

My SO and I are planning on buy a house for about $900k. We have $200k in cash, and I'm considering selling several of my mutual funds (non-retirement) to finance the difference. These are funds that I have held for more than 10 years, with no recent contributions.

How can I go about estimating what my tax burden will be? My Google searches typically land on long explanations that boil down to "it's complicated". I'd just like a ballpark number.

Is there ever a situation where a mortgage makes more financial sense - where the mortgage deduction could lessen the bite of that capital gains tax?

Answer 1

This decision boils down to 3 factors:

• interest rate of your mortgage
• expected return of your funds for the next 10, 15, 20 years
• transaction cost and taxes

If you expect the stock market to perform better (after costs and taxes) than the interest on your mortgage, do not liquidate anything. On the other hand, with current P/E ratios of the stock market historical returns on the stock market have been rather low and it is quite realistic that a 10 year return from now might be only 1% annualized or even negative. In this case liquidation might be a good idea as you lock in your current gains and reduce the debt right now. It then comes down to a calculation how much you will lose by paying taxes earlier. This decision again could be dominated by expectations as Pete B. outlines in his answer. I will leave it as a link as I am not familiar with the details of US taxation and the intricacies of US politics.

So bottom line: The is no perfect solution. It all boils down to your expectations of future returns and taxes

edit:
There seems to be a bit of confusion what I mean with low returns. I am refering to the correlation of high valuations with forward returns. As an example take the following figure which plots the 10 year forward return against historical values for the CAPE. Note that this is from a 2015 article and markets have moved even further into high valuations since. This suggests that returns for the medium future will rather not be 10% annualized just because that was the historical average. Considering that a mortgage in the US is somewhere around 2.5-3% interest and this is both a guaranteed and "tax free" return, realizing gains and reducing debt does not look like such a bad option. (source)

Answer 2

It really is not that complicated to figure the tax on capital gains. For assets that you have held longer than a year, you pay taxes at the long term capital gains tax. Now, despite having held the funds for longer than 10 years, not all gains could be considered long term. Recent dividends and capital gains; and contributions, that occurred less than a year ago may be subject to short term capital gains.

You pay taxes on the gains. If you paid 100K for funds that are now worth 500K, you would owe taxes on the difference, or 400K.

Currently the short term capital gains tax is 0, 15%, or 20% which will depend upon your income. However, the Biden administration has promised to shake up how this is done and all capital gains may be taxed as ordinary income.

So there are a lot of variables in place, here are some to consider:

1. How much of that 700k is actually gain?
2. What is your current income?
3. What is the cost to originate a mortgage?
4. What will the future income tax climate be like?

A person may be better off cashing out all mutual funds now, paying cash for the house, then getting a mortgage and rebuying the same mutual funds. This would give a person a stepped up basis for capital gains and avoid higher capital gains taxes if they come to fruition. Keep in mind, that even if they do come to fruition, they could be changed back by future administrations.

The complication is making the optimal decision. Given the amount of variables and needing to predict the future, it is pretty much impossible to make the perfect decision.

In these kinds of cases you might be better off with a partial decision. Sell some assets to reduce the amount of the mortgage but still get a mortgage. Then reevaluate next year. Do you take out 50K and use those assets to pay down the mortgage? Maybe/maybe not.

Factoring in the mortgage interest deduction also adds a layer of complications to this calculation. In the past, just about everyone qualified for the mortgage interest deduction. However, now a lot less people do because the standard deduction is so high, there are limits to the amount of interest one can claim, and the rates are so low.

Here I would not suspect this will change with future administrations. Both parties have shown a keen interest in simplifying income tax returns. The large standard deduction does exactly that.

I am not sure of your google search, but this page was pretty comprehensive.

Answer 3

One aspect to keep in mind might be the leverage resp. the opportunity cost of selling your funds now.

If you think that you can make a higher profit (percentwise) than the interest rate of your mortgage would be, and you can afford the monthly mortgage payments even if your investments take a dip, it may be more adviseable to take the mortage.

This gives you two advantages:

• no capital gains tax right now
• keep your investments rising, making you money

Answer 4

How can I go about estimating what my tax burden will be?

1. Figure out your cost basis. That's basically how much you paid for your shares including re-investment. Your brokerage should give you the cost basis for each of your funds. With a good broker, you can access this online.
2. The difference between the current price and the cost basis is your capital gain. If you hold it for more than a year it's "long term". Otherwise it's "short term".
3. The federal tax calculation is indeed insanely complicated since the US tax code is really effed up. In "many" cases the long term gain will be taxed at 15% but it can vary anywhere between 0% and north of 30%. Hence "it's complicated"
4. There is also state tax to consider. E.g. short term capital gains in Massachusetts are taxed at a whopping 12% on top of whatever the feds want.

Is there ever a situation where a mortgage makes more financial sense - where the mortgage deduction could lessen the bite of that capital gains tax?

Sure. If you think that your funds will provide a higher rate of return than the interest of your mortgage, you should go with the mortgage. Taxes makes this again insanely complicated but for "normal" cases this often comes out to be a wash.

Answer 5

Other answers focus on optimizing the total profit of the investments against the cost of the mortgage. There is another aspect to consider: cash flow security.

What happens if your income drops for a while?

If you have a mortgage and some mutual funds, you can just keep paying your expenses from the funds.

If you have neither of these, you'll need to find a new source of income before your emergency savings run out. Typically it is difficult to get a new loan with good interest rate if you already have insufficient income.

Answer 6

Is there ever a situation where a mortgage makes more financial sense

• where the mortgage deduction could lessen the bite of that capital gains tax?

The mortgage deduction is a case of the tax tail wagging the investing dog. My 3.5% mortgage nets at 2.73% after federal tax deduction. In effect, this is a 'discount' of .77% on the cost of my mortgage. Tiny in comparison to the 10.73% (CAGR) return of the S&P over the last 100 years, or the 11.64% return over my own investing lifetime, i.e. since 1985.

We have a great Q&A, Oversimplify it for me: the correct order of investing in which my own answer suggests that paying off a mortgage sooner should come 6th, after a list of other debt/investments. On reflection, I'd say that letting a mortgage run its course, and in some cases, stretching it out longer than the traditional 30 years, makes more sense.

Good question, but we don't know the 'rest of the story'. Are you depositing to 401(k) or other retirement accounts? Do you have any other debt? It's far easier to put 20% down, and realize that you are still sitting on cash you'd prefer to not invest and pay down the loan a bit, than the opposite. Send all of your liquidity to the deposit, and then have all of the expenses of a new home, and find you are cash-poor. As others noted, liquidity is pretty valuable.