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The Returns: Capital Gains

Something in this story might already be telling you that it pays, in general, to stick with your investments. It does. And now you know the minimum length of the holding period: until the transaction costs are covered. After that, your choices are clear. You can switch to another investment if you feel the new investment will give you a higher rate of return. You will incur new transaction costs if you decide to switch, but. presumably. the new investment will, in time, cover those costs and produce returns to your liking. Alternatively, if no new investment can make such a promise, you can stay the course with your original investment, further minimizing the impact of the original transaction costs and maximizing your net take.

Applied to homeownership, it's interesting to consider that the buy-and-hold formula is largely induced by transaction costs: Homeowners generally will not consider cashing in until those costs are covered. And once they are covered, they still might sit on their properties, particularly if they're interested in making hay with their investments. And by "hay," I mean capital gains.

A capital gain is the increase in the value of an asset that you realize when you sell that asset. Jennifer and Carlos each sold their properties for $240,000, or 20 percent more than they paid for them. Twenty percent is a nice capital gain over five years.

If you round out the average holding period for homes in the U.S. to 5 to 7 years and look back at the appreciation of homes for the last 45 years, you clearly can see the possible magnitude of capital gains that homeownership offers. It's a pretty wide range: In the 45-year period between 1961 and 2005 (see Table 1.1), people who sold their homes in the five- to seven-year holding period realized a minimum 11.23 percent capital gain, on average, and a maximum 76.28 percent gain. These gains are based on the appreciation of owner-occupied residential real estate in the U.S., with the minimum gain coming in both 1966 and 1967 after a holding period of five years, and the maximum gain occurring in 1980 following a seven-year holding period. Both the low and high results are worlds apart, but, importantly, each leaped an estimated transaction cost of 10 percent and brought additional capital gains, to boot.

Table 1.1. Holding Period Appreciation for Owner-Occupied Residential Real Estate

 

1 Year

2 Years

3 Years

4 Years

5 Years

6 Years

7 Years

1/1/61

3.74%

           

1/1/62

3.93%

7.67%

         

1/1/63

1.89%

5.82%

9.55%

       

1/1/64

1.82%

3.71%

7.64%

11.38%

     

1/1/65

3.45%

5.28%

7.16%

11.10%

14.83%

   

1/1/66

0.14%

3.59%

5.41%

7.30%

11.23%

14.97%

 

1/1/67

3.93%

4.06%

7.52%

9.34%

11.23%

15.16%

19.09%

1/1/68

4.23%

8.16%

8.29%

11.75%

13.57%

15.46%

17.35%

1/1/69

8.12%

12.35%

16.28%

16.41%

19.87%

21.69%

23.52%

1/1/70

5.36%

13.48%

17.71%

21.64%

21.77%

25.23%

28.68%

1/1/71

7.53%

12.89%

21.01%

25.24%

29.17%

29.31%

29.44%

1/1/72

7.38%

14.92%

20.28%

28.39%

32.63%

36.55%

40.48%

1/1/73

7.92%

15.30%

22.83%

28.19%

36.31%

40.54%

44.78%

1/1/74

10.19%

18.11%

25.49%

33.02%

38.38%

46.50%

54.62%

1/1/75

9.81%

20.00%

27.92%

35.30%

42.84%

48.20%

53.56%

1/1/76

7.63%

17.45%

27.64%

35.56%

42.94%

50.47%

58.01%

1/1/77

11.87%

19.50%

29.31%

39.50%

47.42%

54.80%

62.18%

1/1/78

12.68%

24.55%

32.18%

41.99%

52.18%

60.10%

68.02%

1/1/79

13.43%

26.11%

37.98%

45.61%

55.42%

65.61%

75.80%

1/1/80

11.04%

24.47%

37.15%

49.01%

56.65%

66.46%

76.28%

1/1/81

6.53%

17.57%

31.00%

43.68%

55.55%

63.18%

70.81%

1/1/82

2.09%

8.62%

19.66%

33.09%

45.77%

57.63%

69.50%

1/1/83

3.62%

5.71%

12.24%

23.28%

36.71%

49.39%

62.07%

1/1/84

2.94%

6.56%

8.65%

15.19%

26.22%

39.65%

53.08%

1/1/85

4.19%

7.14%

10.76%

12.84%

19.38%

30.42%

41.45%

1/1/86

6.16%

10.36%

13.30%

16.92%

19.01%

25.54%

32.08%

1/1/87

6.39%

12.56%

16.75%

19.69%

23.31%

25.40%

27.49%

1/1/88

4.23%

10.62%

16.79%

20.98%

23.92%

27.54%

31.16%

1/1/89

0.22%

4.46%

10.85%

17.01%

21.20%

24.15%

27.09%

1/1/90

2.75%

2.98%

7.21%

13.60%

19.77%

23.96%

28.15%

1/1/91

5.40%

8.15%

8.37%

12.61%

19.00%

25.16%

31.32%

1/1/92

2.64%

8.04%

10.79%

11.02%

15.25%

21.64%

28.03%

1/1/93

3.35%

6.00%

11.39%

14.15%

14.37%

18.60%

22.83%

1/1/94

3.90%

7.25%

9.90%

15.29%

18.05%

18.27%

18.49%

1/1/95

3.03%

6.93%

10.28%

12.93%

18.32%

21.08%

23.83%

1/1/96

4.68%

7.72%

11.62%

14.97%

17.61%

23.01%

28.40%

1/1/97

5.05%

9.74%

12.77%

16.67%

20.02%

22.66%

25.31%

1/1/98

5.28%

10.33%

15.01%

18.05%

21.95%

25.30%

28.65%

1/1/99

3.75%

9.02%

14.07%

18.76%

21.79%

25.69%

29.59%

1/1/00

4.19%

7.93%

13.21%

18.26%

22.95%

25.98%

29.01%

1/1/01

6.14%

10.33%

14.07%

19.35%

24.40%

29.08%

33.77%

1/1/02

6.74%

12.88%

17.06%

20.81%

26.08%

31.14%

36.19%

1/1/03

7.26%

13.99%

20.13%

24.32%

28.06%

33.34%

38.62%

1/1/04

7.97%

15.23%

21.96%

28.10%

32.29%

36.03%

39.78%

1/1/05

5.56%

13.53%

20.78%

27.52%

33.66%

37.85%

42.03%

Perhaps more important, for the sample period in question, no evidence exists that the aggregate of home prices ever failed to post positive gains. This means that even if you hold a property for one year, you have a good chance of making a capital gain. (At face value, the data does not reflect local price dips, such as those experienced by Californians in the early 1990s. However, the broad data is more assurance that homeowners should ride out any price-decline storms.)

It would seem that residential real estate is something of a capital gains–generating machine. And the machine still functions when we figure in taxes. Since 1997, single individuals selling their homes have been exempt from paying taxes on the first $250,000 in capital gains they realize.[4] For couples, the tax-free amount is a whopping $500,000. Thus, in most cases, homeowners in America can roll over their investments from one house to another tax-free, quite often increasing their cost basis, or the price they pay for a residence. Put another way, the new home price becomes the new number from which the $500,000 in tax-free capital gains then is calculated.

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