Karen Folk, Ph.D, CFP® Urbana, IL
Home renovation has changed in the last ten years or so. Fueled by huge gains in the price of real estate, homeowners used to tap home equity with little care because prices were expected to keep climbing, more than covering the cost of improvements.
Today, with the slowdown in real estate and the widening damage in the subprime loan market, it’s common to see home prices falling, not rising. And lenders are often a lot choosier about who they do business with. So before considering a home renovation, make sure your financial house is in order.
Start with your credit report.
If you’re considering borrowing, make sure your credit report and payment records are in the best possible shape. As in most economic crises, lenders go from being permissive to squeamish in an instant, so even people with good credit are going to be closely scrutinized. Check your credit report—you can get all three of your credit reports (from Experian, TransUnion, and Equifax) once a year for free. You can order them at http://www.annualcreditreport.com. Some suggest ordering them at staggered times throughout the year so you can catch potential errors in your report as they happen. Others recommend getting all three at once, so reviewing credit reports becomes only a once-a-year task. Reviewing your report can help you clean up any negative credit behavior like late bills or heavy credit card debt.
See what kind of payoff your planned renovations will deliver.
During the housing boom, many people believed almost any renovation would offer big returns. It wasn’t true then, and it’s especially untrue now. Take time to figure out what renovations now have the best chance for return on investment. One good resource is Remodeling magazine’s annual Cost vs. Value report (http://www.remodeling.hw.net/2008/costvsvalue/national.aspx). Many people find they won’t recover their investment in a remodeling project. It’s still OK to go ahead. Just renovate because it’s going to bring you comfort or pleasure, not because you’re expecting immediate profits. If you’re not renovating for yourself, but for a potential buyer, remember that they may not share your taste. You may love those new custom kitchen cabinets, but they may offer you a lower bid for your home if they hate them and want to replace them.
Know how long you’ll need to stick around.
When you sell, remember that most married couples can exclude from their taxable income up to $500,000 of gain, and most individuals filing single or married filing separately can exclude up to $250,000. You must have owned and used your home as your principal residence for two out of the five years before the sale. The exclusion is generally applicable once every two years. However, if you are unable to meet the two-year ownership and use requirements because of a change in employment, health reasons, or unforeseen circumstances, your exclusion may be prorated.
Beware the bump in property taxes.
More valuable property often leads to higher tax assessments. Make sure you can afford not only the cost of renovation but what you’ll need to pay in higher property taxes.
Don’t forget applicable sales tax deductions.
If sales tax was imposed on a major renovation or if your state or locality imposes a general sales tax on the sale of a home or the cost of a substantial addition or major renovation, you may be able to deduct it. This alternative is particularly valuable in low-income-tax states, and the sales tax paid on the purchase of some large items including the purchase of a home or major addition can be added to the taxable amounts.
Make sure your renovation leaves your home salable.
A discussion with a real estate agent can tell you what will add or subtract value. For instance, a big addition can take away from the value of a home if it’s not aesthetically in line with the rest of the neighborhood. Obviously, any renovation that keeps your house on the market longer had better be worth it now because it may damage your sales prospects later. The process of renovating your home is often disruptive. Many make the mistake of waiting until they’re about to sell the house before making the improvements they’ve dreamed about for years. But don’t forget, you’re living there now. The most important renovations are often those you’ll have the chance to enjoy.
Karen Folk, CFP®, a member of the FPA and ACA, adapted this column produced by the Financial Planning Association, the membership organization for the financial planning community.