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Calculating Your Total Return

To discover the total return generated by any investment, you must account for all the gains (income + price appreciation) generated by the investment, the cost base (the initial price of the investment) to which those gains will be applied, the tax treatment of those gains in all their forms, and the transaction costs.

So, in terms of total return, how did Jennifer and Carlos do?

Well, the cost basis in each case was $200,000. Because they each sold for $240,000, they each had a capital gain of $40,000. And because they each lived in their homes rent-free for five years, we can set their imputed incomes at a reasonable $20,000 each (a modest $4,000 a year in imputed rent). This gives us a pre-tax total return on the sale of each unit of $60,000. And now for taxes. The $20,000 imputed (rental) income is not taxed at all. Because single taxpayers can realize $250,000 worth of capital gains every two years tax-free, the $40,000 in gains is not taxed, either. This means that the pre-tax and post-tax total return is the same for each: a full $60,000, which is 30 percent of the original cost base. However, after subtracting 10 percent in transaction costs, or $20,000, based on an original purchase price of $200,000, the total return drops to $40,000. In percentage terms, a 30 percent total return falls to 20 percent, although this is still an attractive number.

And because Jennifer and Carlos finally got married, their total-return story climbs one more profitable notch. Again, for a married couple, the first $500,000 in capital gains on the sale of a home is exempt from taxes. Putting their resources together, if Jennifer and Carlos bought their next home for $400,000 and sold it five years later for $500,000, again moving up in life, they would pay no capital-gains taxes on that transaction.

When it comes to total returns, it's hard to beat homeownership. And the case can be made even better when you look at how homes are financed.

The Impact of Leverage on Your Total Return

As I've noted, Jennifer and Carlos are a lot alike—almost identical. But Jennifer is a lot smarter than Carlos, as I see it. Not yet revealed in their story is that, when they purchased their first homes, Carlos decided to pay the entire $200,000 up front, while Jennifer opted to finance her purchase by putting down $40,000, or 20 percent.

This was a very smart move on Jennifer's part. When she sold five years later, the $60,000 she cleared (capital gains + imputed income) represented a gain of 150 percent because it was based on an original investment of $40,000.

This example shows the impact that leverage can have on the total return of an investment (leverage being the degree to which an investor or business uses borrowed money). Borrowing often gets a bad rap because it is thought of as acquiring and spending money that is not yours. But leverage can increase a shareholder's return on investment because it is the use of smaller amounts of cash to obtain assets of greater value. Jennifer was entitled to the total gains of her house, which were applied to only her original investment when calculating her total return. So by putting down only 20 percent, or one-fifth, of the purchase price, she essentially leveraged her investment (or down payment) five times when compared to the purchase price. Yet by risking only one-fifth, she got control of the whole investment and captured the full capital gains produced by her property.

Now, whether this is a wise strategy depends on what homeowners do with the money they decide to not put toward their homes when they make their purchases. Let's say Carlos had decided to put down only 20 percent of the original purchase price, or $40,000, just like Jennifer. This means he would have had $160,000 to "put to work" in another endeavor. That's a good amount, and to make certain that the new endeavor would generate some additional hay, it would have to pay only in excess of the loan rate of his mortgage.

Let's say that in the five years he held his home, he netted 2 percent over the loan rate by way of a new endeavor (which could have been an investment in the stock market, the bond market, or a business). This means he would have added a 10 percent return (2 percent x 5 years), or a total of $40,000. This amount would be subject to taxes—capital gains, dividend, and/or income taxes—as well as the transaction costs related to the investment. But even when these are factored in, his additional take still would have been worth it.

Of course, maybe Jennifer simply didn't have that $200,000 to put down at the time of her purchase, making her smarter than Carlos only by default. But Carlos proved rather risk-averse, in that he did not leverage the investment in his home and put his available money to work where it could have grown in excess of the loan rate.

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