Is Downsizing the Right Move for You?

Dear Carrie,

My husband and I are in our late 50s and starting to think seriously about our retirement. We’ve been in our current home for thirty years, and have built up quite a bit of equity. Now that the kids are out of the house, we don’t need this much space, so are thinking about downsizing to a smaller, less expensive home. Can you help us think through the finances?

—A Reader

Dear Reader,

First, let me applaud you both for thinking ahead. Even if you don’t make a move for several years, it’s great to start the decision-making process now.

There’s no question that moving to a less expensive home can reap financial benefits, both in terms of a profit on the sale of your current home, and potentially in the form of lower monthly expenses. However, from deciding where you'll move next to weighing the life style changes that a move might entail, there's a lot to consider.

Let’s take a look at how various options can play out, starting with how much money you might be able to pocket by selling your current home. From there, we can look at a few different scenarios.

First estimate your cost basis and potential profit

To get an initial sense of how much you might profit by selling your current home, start by ballparking a sales price. This doesn’t have to be precise, so it’s fine to make an estimate based on sales of similar homes in your neighborhood.

Next, calculate your cost basis. This isn’t just your purchase price, but also includes associated fees for both the purchase and sale. Real estate commissions can be 3 to 6 percent of the sales price plus another 2 to 4 percent in transfer taxes, title insurance fees, attorney fees and other closing costs. In addition, getting your home ready to list can cost thousands; think about whether you will need to make any improvements or updates before you put the house on the market. Keep in mind that expenses related to selling your property do not typically add to basis. Check out IRS Pub. 523 for more details.

Add to this the cost of any capital improvements you’ve already made that have increased the value of your property (for example, an addition or major upgrade). Repairs, such as fixing the plumbing, don’t count. This is why it’s important to keep receipts of major home improvements. They can add up over the years!

On the other side of the equation, there are a few things that can reduce your cost basis. For example, if you have a home office and have claimed depreciation over time, you now have to subtract those deductions from your cost basis.

Taking all this into account, you can calculate your cost basis. Then subtract that number from your estimated sales price, and you’ll have a good sense of your pre-tax profit.

Next, find out if you’ll owe capital gains taxes on your profit

Under current law, if you sell your principal residence for a profit, up to $500,000 of capital gains is tax-free for a married couple filing a joint return (individuals can exclude up to $250,000). Any amount over $500,000 would be subject to both federal and state long-term capital gains taxes.

In other words, you might not have any capital gains tax bill at all, provided you meet the following requirements:

1. You must have owned the house for two years.
2. You must have lived in the house as your principal residence for two out of the past five years.

There are a few exceptions to these rules—for example, if you had to move before two years because of a job change or for what the IRS designates an ‘unforeseen circumstance,’ such as a divorce or natural disaster. In these situations, you can prorate the exclusion. Any depreciation is also subject to recapture of 25%.

Think about your options

Now that you have a sense of how much money you might make on a sale, it’s time to get creative. A smaller, less expensive home could not only mean a nice lump sum that you could use to supplement your retirement, but also provide considerable savings on a monthly basis, especially if you no longer have a mortgage. I suggest you run several scenarios considering different communities and homes at varying price points.  

Switching gears and looking at your budget, a useful exercise can be taking a closer look at what you spend each month living in your current home. Your mortgage and property taxes may be the biggest expenses, but be sure to include homeowner's insurance, utilities, and upkeep.

Now compare this to what you might spend every month living in a different home, again looking at different scenarios. If you move into a condo, for example, you’ll likely have to include HOA fees.

And just for the sake of comparison, you might also think about renting. On the plus side, renting can free you from a mortgage and upkeep. On the minus side, if you rent you won’t be building equity and you'll likely face rising costs in the future.

In other words, there’s no one-size-fits-all answer. A lot will depend on the housing available in your desired location, the relative cost of rents versus purchase prices, and your desire to own your own home.

Talk to your advisor

Once you've looked at these specifics, I also suggest that you talk to your financial advisor who can put these facts and figures in the greater context of your overall retirement plan.

For example, if you’re anticipating a significant profit from the sale of your current home, you’ll need to think about whether you want to use that money to purchase another home outright, or finance your purchase with a new mortgage. If you’re fortunate enough to have a nice amount of money left over, you’ll need to be very careful how you manage it. Your advisor can help you invest in keeping with your retirement goals and timeframe.

Consider the emotional side

Beyond the numbers, I'd give serious thought to how comfortable you'll be in a smaller place and how this move might impact your life style. Will you still be close to your family and friends? Your doctors? Your favorite activities? Be sure to consider all of these issues, so that when you do make a move, you'll be able to enjoy not only the potential financial benefits of your new home but also the pleasure you get from living in it every day.

Have a personal finance question? Email us at askcarrie@schwab.com. Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.