Jonathan Clements's Blog, page 276

Setting an Example

THIS PAST FATHER���S Day, I was listening to a financial talk show. The host asked listeners to phone in and describe how their father influenced their thinking about money.

Callers related that their fathers told them to save early, to not waste money, to avoid debt and a few other basic ideas like ���don���t worry about keeping up with the Joneses.���

I told my wife I couldn���t recall my father ever talking to me about money. Sadly, the same was true about college and getting a job.

���Maybe he gave you the best advice by setting an example,��� my wife said.

My father didn���t have a career. He had a job. In fact, several jobs, including station master for a railroad and car salesman. He had little time for much other than work, seven days a week, 8 a.m. to 8 p.m., until the law prevented Sunday car sales. Vacations were rare and short. For many years, he worked strictly on commission���no sale, no pay, just an advance. He sold several different car makes early on, but the last 20 years or so he sold Mercedes.

I often wonder how he felt the day a customer purchased a 300SL for cash���literally���while he couldn���t afford a car. That cash was equal to about $108,000 in today���s dollars. While other family members all had houses, we lived in a small, rented apartment. When my dad was 63, he and my mother jointly bought a house with my sister and her family.

My father continued to work six days a week until the day in 1977 when his boss simply said that, at age 67, he wasn���t needed anymore. My parents never had credit cards. They didn���t have any investments, either.

I doubt retirement planning ever crossed their minds. You just kept working until you couldn���t. After his forced retirement, my parents did what they did all their lives���pretty much nothing. My mother was a homemaker until the day she died. They had no special activities, no desire to travel and no money to do so. They lived on Social Security and, I suspect, would have struggled except they lived and shared expenses with my sister. My parents were not unique for their generation. Their experience living through the Great Depression and Second World War not only made them financially frugal, but also it prevented them from taking any risk. What little money they did accumulate was in a checking account.

I once talked my mother into buying 75 shares of the utility where I worked. Frankly, I can���t recall how I did that, but I do know she would never enroll in the dividend reinvestment plan. For some reason, that was too much risk, while the tiny dividend checks were real money.

Did my dad set a poor example? I don���t think of it that way. But I grew up knowing I wanted more security. I don���t think of myself as materialistic, but there were a few goals I set. When I was 18, I told my father someday I would own a Mercedes. That took me another 52 years. On one of our rare six-day driving vacations, when I was age 12, we visited Cape Cod. My father expressed the fleeting dream of a house there. I bought one 32 years later. He never saw the car or the house. I did bring my mother to our Cape Cod house once. She wasn���t impressed and couldn���t wait to get home. She never visited again.

We are all shaped by our life experiences, both good and bad. Sometimes, we receive sage advice and ignore it. Sometimes, we just observe others and learn. And sometimes, we learn from making mistakes.

My experience showed me retirement can be more than sitting on the front porch, that saving is not the same as investing and that living on Social Security alone isn���t enjoyable for most people. I also learned that just rambling through life without goals is both boring and risky.

By example, Dad did teach me many good things, although I doubt he knew it. My feelings about work, money and responsibility, and the importance I attach to goals and perseverance in the face of obstacles, have served me well. And I learned all that by observing him.

Richard Quinn blogs at QuinnsCommentary.com. Before retiring in 2010, Dick was a compensation and benefits executive.��Follow him on Twitter��@QuinnsComments��and check out his earlier��articles.

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Getting Better

WHEN I WAS A KID in the late 1950s, if a toy was stamped ���Made in Japan,��� it meant it was cheap and poorly made. A decade or so later, that label began to mean something entirely different: If you wanted a top-notch TV, you were considering a Sony. If you were shopping for the most reliable car, Toyota, Datsun (later renamed Nissan) and Honda were on your list.

There���s a parallel today with China, and it became obvious to me via two hobbies: collecting pocketknives and collecting flashlights. As recently as a few years ago, pocketknives made in China were usually cheap and of inferior quality. But that began to change. Now, there are Chinese manufacturers producing first-class knives���with first-class price tags to match.

Ditto for flashlights. Almost two decades ago, flashlights using an LED emitter���instead of an incandescent bulb���appeared on the scene. From the beginning, Chinese manufacturers led the market in LED flashlights. Several companies, such as Fenix, Nitecore and Olight, quickly emerged, producing innovative and high-quality lights at very reasonable prices.

Today, while there are still a few U.S.-based flashlight manufacturers, the LED flashlight market is completely dominated by Chinese companies, with literally dozens putting out high-quality and cutting-edge products. They offer incredible bang for the buck: I have numerous excellent Chinese-made lights that cost me under $30 and a few even under $20. Several of those I���ve ordered directly from the manufacturer in China, or else from Ali Express���the Amazon of China���with no-hassle China-to-Texas delivery in about three weeks.

The current ascendancy���and even domination���of manufacturing by China is no surprise to anyone who isn���t living under a rock. But my two little hobbies have brought home to me in a microcosmic and very personal way this simple truth: China will be the manufacturing force-to-contend-with for decades to come���one increasingly respected for producing top-quality goods.

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Enjoy the Show

EARNINGS SEASON is wrapping up on Wall Street. Analysts��� predictions and companies��� profit guidance is a bit of a dog-and-pony show, as HumbleDollar contributor Kyle Mcintosh recently described. Still, there���s some useful information to be gleaned from second-quarter results and from executives��� comments.

In particular, I look forward to the FactSet weekly earnings season update to see which pockets of the stock market have the best and worst figures. According to last��Friday���s report, a whopping 87% of S&P 500 firms have reported better-than-expected earnings, versus an average beat rate of 75% for the past five years. For many decades now, public companies have endeavored to beat the consensus earnings estimate by a smidgen, sometimes just a penny. Company executives, along with many investors, see it as a win. It���s all part of the show.

What I find more telling is how stocks perform after companies report results. Intuitively, a stock should pop after a big positive earnings surprise, right? Bank of America tracks the share-price performance of companies reporting earnings relative to the S&P 500. During the current earnings season, firms that beat on both revenues and earnings outperformed the market by less than 1% the day after posting results. The historical average since 2000 is closer to 2%-plus. Much ado about very little? It seems that way to me.

Moral of the story: Don���t get caught up in the show. Financial television frames each earnings report as a make-or-break moment for the stock and the broader market. It isn���t. Maybe you���re like me and enjoy the spectacle. But in the end, never forget that earnings season comes, goes���and is quickly forgotten.

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Why They Believe

THE 19TH CENTURY��feud��between the Hatfields and the McCoys doesn���t hold a candle to the debate between supporters of index funds and supporters of active management.

Those in the index fund camp cite decades of data���going back to the��1930s���to support their view that active management is a fool���s errand. In fact, Standard & Poor���s regularly publishes a study it calls��SPIVA, short for S&P Index Versus Active. Each time, analysts there reach the same conclusion���that it���s exceedingly difficult for an actively managed fund to beat its benchmark. As an example, on SPIVA���s website today, it reports that 75% of large-cap funds have underperformed the S&P 500 over the past five years.

Largely because of this data, actively managed funds have been��losing��assets to their index fund competitors. Still, despite the data, many investors aren't convinced, and it isn���t just a fringe element. The active management business remains huge, with trillions of dollars under management. Is it possible that so many investors are unaware of the long odds against them?

That may be true in some cases, but that isn���t the whole story. There are actually quite a few reasons people still support active management. Even if you remain on the index side of the fence���like me���I think it's useful to understand why others see things differently. Below are seven common arguments:

1. Probabilities.��Yes, the odds are long. But many investors who choose active funds understand that there���s a difference between��low��probability and��zero��probability. Even if the SPIVA numbers say that 75% of funds underperform their benchmarks, that still means that 25%���one out of four���outperform. Put that way, it doesn���t seem as crazy to seek out a fund with high potential. Moreover, that 75% figure isn���t uniform across all fund categories. There are several categories in which the odds are much better. In fact, a majority of actively managed funds have��outperformed��in some categories over the most recent five-year period. Also, that 75% doesn���t apply to every time period. It varies considerably from year to year.

2. Economic environment.��Index funds are designed to track the market. That���s great���until the market drops. For that reason, many believe that active management pays off during bear markets. The logic here makes sense. When the market drops, index funds simply drop in lockstep. But an active manager has the opportunity to take evasive action. That's because most crises build slowly. Even when the market has dropped 50%���as it���s done several times���it���s never happened overnight. Active managers have a window to respond before a crisis gets worse. Sound reasonable? Unfortunately, the data don���t back this up. Active funds have underperformed during many stock market downturns, including 2008 and��2020.

3. Risk.��Some investors see risks in the structure of index funds. Michael Burry,��famous��for predicting the 2008 mortgage bond crash, believes that index funds are a ticking time bomb. That���s because they buy mostly the same stocks. He uses the analogy of a crowded movie theater, with this ominous warning: ���The theater keeps getting more crowded, but the exit door is the same as it always was.��� He adds, ���The longer it goes on, the worse the crash will be.���



Is Burry right? That���s the tricky thing. No one can say. It was only two years ago that index funds surpassed actively managed funds in total assets. We���re in uncharted territory, and he might end up being right. I happen to��disagree, but no one can say with certainty that something that hasn���t happened before won���t happen in the future.

4. Mean reversion.��In the investment world, it���s common to talk about reversion to the mean. The idea is that things that are far above or below average won���t stay that way forever. It's possible this could occur with mutual funds. No one can say for sure what might make active funds shake off their slumber, but I���ve heard a handful of theories. The one that makes the most sense: Active managers are more nimble and could gain an advantage as more dollars go into index funds, which just passively mimic the market.

5. Personality.��When Gallup asks Americans what they think of Congress, approval ratings generally fall in the 30% range���not very good. But ask Americans what they think of their��own��representative, and a majority approve. It's the same, I think, with mutual fund managers.

Sure, the SPIVA numbers might say that actively managed funds underperform��on average. But when investors search for actively managed funds, they aren���t looking for average. Rather, they���re looking for stars���and they believe they can identify them. If a fund manager has a strong track record, that helps. If the fund manager has a strong personality, that helps even more.

While index funds are largely driven by computers, active funds have public faces. Some managers become quite well known. In the 1980s, it was��Peter Lynch, who ran Fidelity Magellan Fund with amazing success and authored several books. In the 1990s, it was��Bill Miller, whose fund once beat the S&P 500 for 15 straight years. Today���s biggest star may be��Will Danoff, the longtime manager of Fidelity Contrafund. When investors put money into these funds, they���re betting on the fund manager���s brilliance. The SPIVA numbers, I suspect, aren���t even a consideration.

6. Yardstick.��One of the criticisms of the SPIVA numbers is that Standard & Poor���s has an inherent bias. It earns millions licensing its indexes���the S&P 500, for example���to index fund companies. Because of that perceived bias,��some��have criticized the methodology that S&P uses in its SPIVA studies. I don���t find these criticisms compelling. But it's important to note that when S&P compiles its data, it does have an interest in the outcome.

7. Priorities.��As I often say, there are two answers to every question in personal finance: There���s the quantitative answer���and then there���s the ���how do you feel about it��� answer. If you look only at the numbers, index funds definitely score well. But for some investors, that isn���t the most important thing.

As I��noted��a few weeks ago, direct indexing has been growing in popularity. A large part of that, I think, is driven by investors who want the advantages of an index fund but hate the idea that indexes like the S&P 500 include tobacco and other distasteful kinds of companies. That���s another reason an investor might choose to go with active management.

When I was a kid, there was an��exhibit��at the local science museum. It was a model of a giant housefly���maybe two feet high. Attached to the exhibit was an explanation that a fly of this size would be physically impossible. I always found that interesting���that things don���t scale linearly, and that something that might work when it���s small might collapse under its own weight if it got larger. I���m still very much in the index fund camp, and so far I think they���re the best investment for most investors most of the time. But I always try to keep that exhibit in mind���because it stands to reason that nothing lasts forever.

Adam M. Grossman��is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam's Daily Ideas email, follow him on Twitter @AdamMGrossman��and check out his earlier articles.

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Making Sense

I SUGGESTED a thought experiment in my last blog post���one in which the stock market shut down for six months at the start of the pandemic. I believe it helps explain why financial markets recovered with such a vengeance.

Today, I take a different tack, one based on financial theory. It���s easy to forget that stocks are not pieces of paper (remember stock certificates?) or ticker symbols on a computer screen. Rather, they represent a claim on company profits, though only after bond and preferred stock investors get their due. These claims are perpetual, meaning they continue indefinitely or so long as the company remains a going concern.

In theory, the value of any company, and hence its stock, is the sum of its expected future dividends, discounted to the present. Don���t get hung up on the term ���discounted.��� It just refers to the fact that a dollar received in five years is worth less than a dollar received next year.

Imagine a dividend-paying company that���s able to increase its profits, and hence its dividends, by 5% a year over the long run. By adding up its discounted dividends���let���s say over the next five decades���we can arrive at an estimate of the company���s intrinsic value, which should be reflected in its stock price.

What happens to the company���s intrinsic value when we assume next year���s profits and dividends disappear because of, say, a global pandemic and economic shutdown? The answer is that it falls by just 3.1%, assuming a 7% discount rate. If the next two years of dividends are cut, intrinsic value falls by 6.1%.

In early 2020, the S&P 500 fell 34% in the span of a few weeks thanks to the fears brought on by the pandemic. Using our admittedly simplistic model of intrinsic value, a 34% drop in stock prices implied that the next 12 years of dividends were going to be axed. Did that really make sense? As investors recovered from their initial shock, stock markets staged a massive comeback. To many onlookers, the resurgence made little sense. But when viewed through the lens of what stocks actually represent���a claim on future dividends���it made total sense. What didn���t make sense was the initial market collapse.

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Eyeing That Check

THE SOCIAL SECURITY Administration began rolling out a new, smaller annual statement on May 1. As reported in Think Advisor and other publications, a small percentage of online ���my Social Security��� account users, who aren���t currently receiving benefits, will get the new printed statement.

The new statement is two pages instead of four. One significant improvement is a graphic that shows what your estimated monthly benefit could be if you started taking benefits in any of the nine years between ages 62 and 70. The personalized amounts are displayed in a series of horizontal bars. Previously, the annual statement provided estimates for only three ages: 62, 67 and 70.

Even if you don���t receive the new statement, you can get the new estimates by creating a ���my Social Security��� account through the Social Security���s website. Once you���re signed in, you���ll see a tool labeled ���plan for retirement.��� The display defaults to show your current benefit estimate, your estimated benefit at full retirement age and your estimated benefit at age 70. The tool has a slide bar that allows you to pick a new retirement age, down to the month, and get a benefit estimate for that age.

As you try different ages, the site remembers each estimate you generated. When you���re done evaluating specific ages, click the ���estimates table��� link and the site will create a table of your selected estimates suitable for printing or saving.

If you���re married, another helpful feature provided by the website is an estimate of your Social Security spousal benefit. Select ���include a spouse��� on the top right of the graphic and input your spouse���s estimated benefit amount at full retirement age. The graphic then adds a line estimating your spousal benefit based on your spouse���s personal earnings record.

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The B Word

I���M NOT SURE HOW anyone can achieve financial peace and prosperity without addressing the ���b��� word���budgeting.

I got my first credit card in my late teens. I bragged that���in my wallet���I had whatever my credit limit was and could do anything I wanted with it. By my early 20s, I was in credit-card debt. But as long as I could pay the monthly minimum, I didn���t think I had a problem. Of course, the interest rate was astronomically high���sadly, I never read the fine print to know exactly what it was���and my savings were nonexistent. I was not on the road to financial peace and prosperity.

With the help of a good friend, I began working on my financial situation. We started by putting together a basic budget. I didn���t know where my money was going. I made up some numbers as my ���budget��� and he had me track every expense for 30 days. I dutifully carried around a little notebook and wrote down every penny I spent, even if I put it on my credit card. It was one of the hardest and most sobering experiments I���ve ever undertaken. At the end of the month, my actual spending was $700 more than I had budgeted.

It would be a great story if I told you I changed my ways, started keeping and maintaining a budget, and lived happily ever after. Alas, my deeper awareness of how I spent my money did not lead to regular budgeting. I was able to cut my spending, but not enough to retire my credit card debt or start investing for the future.

Then I met Kathleen. She was a single mother making less than me and saving money. On our second date, I saw she kept a budget on her refrigerator door that listed every expense down to the exact dollar. I was terrified. But love conquers all. I learned someone could be so amazing that I could overlook her scary habits. We were married and I began to learn how to live on a budget.

I���m not sure which is harder when you start budgeting���the commitment or the process of actually doing it. Since I chose to get married, the commitment was made. The process was a little harder to master. We sat down together and revised the tried-and-true budget that Kathleen had been using for years. This was before personal computers, so we had to use paper and pencil (although we could have used pen, because my wife didn���t change the numbers on a whim like I wanted to do).

One of the secrets she taught me was to list our expenses in our checkbook and track them before we spent anything else. This may seem obvious but it was a revelation to me. We would enter our paychecks and then record all the expenses for the next two weeks. While this made it more difficult to balance the checkbook���a concept I was only slightly familiar with���it was easier to track how we were doing. The details of budgeting may be obvious to many. But I���ve found one reason people don���t do it is because nobody ever taught them those details.

As we earned more money over the years, it was more fun to budget and save. Within a couple of years, we began tithing and giving away 10% of our income. We opened another checking account to make it easy to transfer money we were going to give away before we even considered spending it or saving it.

Eventually, Kathleen trusted me enough and I trusted myself enough that we became less obsessed with budgeting. It���s like when you start exercising or pick up any new habit. When you get into a regular routine, it becomes muscle memory and you don���t have to think about what you���re doing. For a decade or two, we didn���t do any budgeting and we did okay. A couple of years ago, we again started recording every expenditure, so we can enter retirement with a firm grip on our expenses, and so we can figure out what we want and need when our income is more limited. I���m surprised to say that I���m actually having fun tracking every expense.

When I was serving in a congregation, I was often blessed with the opportunity to officiate at weddings. I would always meet with the couple to get to know them and do a version of premarital counseling. We would discuss the service and the best way I could customize it to make it special for them. I���d also talk about the three biggest conflicts that come with marriage���sex, money and children.

Sex and children were fairly easy conversations. Money was almost always a challenge or an adventure. (One couple changed their mind about getting married after we had the conversation. Much easier than divorce, especially financially.) Falling in love and making a public commitment to spend the rest of your life with someone is one of the most sacred events in anyone���s life. The commitments that come after that day may not be as public or sacred, but they���re just as important���commitments like budgeting and living together with differences.

Almost every couple had different perspectives on how to handle money. Some wanted to keep it separate and some mingled it together. Some were worried and some hadn���t thought much about it. They say opposites attract, and my experience personally and professionally���especially in the realm of finances���is that this is nearly always true. One person is risk-averse, while the other likes taking chances. One person worries about money and debt, while the other wants to live in the moment and worry about paying things off later. One likes to put budgets on the refrigerator and the other runs away in terror. When I would bring up budgeting to most couples, they said they knew they ���should��� do it but hadn���t gotten around to it. I suspect that���s true for many, if not most, people.

The ���b��� word has gotten a bad rap. For too many people, a budget connotes pennypinching, financial claustrophobia and sacrifice. My 20-something self saw it as something for number nerds who don���t have a creative bone in their body. My 60-something self knows how hard it can be to have the discipline and rigor that it can demand, especially in the beginning.

I���m convinced that budgets can change lives because a budget changed mine. We just have to do a better job of marketing. I was schooled and practiced in sales and marketing before I learned about theology and grace. I ought to be able to help people see the wonder and magic of living with a budget. If my children are examples, I haven���t done a very good job.

Perhaps I can design a new line of refrigerators that come with a budget stuck on the front door. Or maybe I can add to my marriage-ceremony vows, highlighting how far the couple has come in making a spiritual and financial commitment to each other, including agreeing to spend X dollars on groceries, gas and goodies.

Everything that we can learn about investing, asset allocation, insurance, index funds vs. active funds, stock prices and bond yields is worthless if we don���t start with the basics. And nothing is more basic than having a budget. Knowing how much we have, how much we spend and where it���s all going is a reality check not only for our money, but also for whether we���re living our values. If we do it right, and we're lucky enough to do it with the right person, we might even experience another ���b��� word���bliss.

Latest Posts
HERE ARE THE SEVEN��other articles published by HumbleDollar this week:

After years of quantitative easing by the Federal Reserve, inflation has suddenly taken off. John Lim looks at why���and discusses the implications for investors.
Are you married or once were? Adam Grossman lists 10 things you need to know about Social Security spousal benefits.
One of Dennis Friedman's retired friends has half his money in stocks���and the other half in income annuities. A smart strategy? Dennis ponders the plusses and minuses.
"I paid $36,000 for that depreciating asset," recalls John Goodell. "Looking back on my time in Afghanistan, having something to take my mind off the situation was the best investment I could've made."
Last year, Kyle McIntosh made a major career change. Thinking of doing something similar? Kyle has four pieces of advice.
Five steps to fend off cyber-thieves. Nine crucial estate-planning lessons. Why one writer is at 85% international stocks. Check out last month's seven most popular HumbleDollar articles.
If you sell your home, will you owe taxes? The rules are far from simple. Rick Connor offers a guide for the confused.

Also be sure to check out the past week's��blog posts, including Kristine Hayes on her home���s value, Ben Rodriguez on his dreams of Dow 50,000, Sonja Haggert on stock buybacks, John Goodell on market-timing and Mike Zaccardi on his $1,000 brokerage bonus.

Don Southworth is a semi-retired minister, consultant and tax preparer living in Chapel Hill, North Carolina. He recently completed his Certified Financial Planner education.�� Don is passionate about the intersection between spirituality and money, and he encourages people to follow their callings wherever they lead.��Follow Don on Twitter @Calltrepreneur ��and check out his earlier articles.

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Dog Days of Summer

MY SON AND I recently completed a cross-country road-trip with Poppy, our two-year-old goldendoodle. We got Poppy just before the pandemic and she���s our first dog, so we learned a lot on this adventure. If you���re a first-time dog owner planning a trip that involves hotels, here are three money-saving recommendations:

Call ahead. I booked rooms many months before our trip and ensured all hotels were ���pet friendly.��� As I was new to traveling with a dog, I figured it would be a good idea to check that a dog would be permitted in our room. I was happy to learn that all rooms were pet friendly but surprised there���d be an extra charge for Poppy at four of the five hotels. The cost per night for a dog ranged from $20 to $100, or an average of more than $60. I rearranged our itinerary to drop the hotels with the highest fees, which saved me more than $100.
Look for La Quinta Inns. I found that Marriott hotels charge a wide range of dog fees, but La Quinta Inns consistently charged $20 per night. La Quinta Inns aren���t spectacular, but the rooms were clean and the service was good.
Bring carpet cleaner to cover any accidents. At check-in, you���ll likely have to sign a separate contract covering your dog���s stay. Your dog will have to behave and you���ll accept liability for any accidents. In the end, we didn���t have any issues with Poppy. Still, just in case, I traveled with cleaning supplies so I could take care of accidents myself rather than pay a steep fine.

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Fourth Time Lucky

I HAD PLANNED a trip to Vietnam for 2020���which coincided with the start of the pandemic and got scratched. I naively rescheduled the trip for this summer. Unfortunately, countries that lack vaccines have been forced to lock down and keep out even vaccinated tourists like me, so that trip also got nixed.

Ever the optimist, I rescheduled for Europe in July. This time, it was the delta variant and changing travel restrictions that ended my third international trip before it even began. I asked my tour group what my options were. The folks there mentioned four countries: Iceland, Croatia, Costa Rica and Egypt.

I chose Egypt. The positive: There were very few tourists at the pyramids and the temples. The negatives, however, were numerous: wearing a mask on 10-hour flights, the risk of frequent flight cancellations, and COVID testing when both entering and leaving airports, even though I���m fully vaccinated.

This last requirement was the hardest to understand. For my flights, I had to have a negative COVID result within 72 hours. I also learned that there are two types of test���the rapid antigen test and the less rapid but more accurate PCR test. The PCR test was required to fly through London on the way to Egypt. I paid $220 for same-day PCR test results to ensure I could board the plane. My daughter, who was accompanying me, was able to get her PCR test at no charge from her university.

The testing went smoothly for us. But others in our tour group were forced to take more tests at the airport because their results needed to be within 48 hours of departure. Just before returning from Egypt, our tour group provided us with another COVID test for $150. The results were delivered to our hotel just three hours before our rescheduled flight was due to depart.

On our last night in Egypt, a few of our group watched a belly dancing performance on a riverboat on the Nile. While on the boat, I got a call saying my flight was canceled and that I needed to take another, less convenient flight home. Since my COVID test results would expire if I didn���t catch a flight soon, I rebooked on a different airline leaving a little earlier.

Was my trip to Egypt worth the hassle? Yes. For me, the lack of tourists more than offset the airline and COVID testing challenges. And I wasn���t the only one who was happy. In Egypt, our tour group leader teared up. He was so thankful to be working again.

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Pay as You Leave

MY BROTHER and sister-in-law are approaching retirement age and will likely relocate so they can be nearer their children. The last time they sold a house, it took more than a year to find a buyer. But they���ve spent time and money fixing up their current home, and it���d likely sell quickly, especially in today���s hot real estate market. Their thought: Why not sell now, and then rent for a few years until they retire and move?

That possibility raised a key question: Would the sale of their home be taxable? It���s an issue that confuses many.

The Taxpayer Relief Act��of 1997 created a permanent capital-gains exclusion for those selling their main home. Today, the tax code provides a $250,000 exclusion on the sale of a primary residence for tax filers who are single and a $500,000 exclusion for those married filing jointly.

IRS Publication 523 provides detailed explanations and instructions���and it does a good job of making the topic understandable. Want to know more? Here���s a look at four key questions:

1. Are you eligible? To qualify for the exclusion, you must pass an ownership test, a residency (or use) test and a look back test. The quick answer: To be eligible, you must have owned and used your home as your main residence for a period totaling at least two years out of the five years prior to the date of sale. In addition, there���s a look back test, meaning you can���t have used the exclusion in the last two years.

There are some exceptions to the eligibility test for divorce, death and military or government service. Under certain circumstances, you may be eligible for a partial exclusion. These circumstances include a work-related move, a health-related move or unforeseeable circumstances.

2. Do you have a gain? To determine if you have a gain when selling your home, it helps to have good records. You need to know the selling price, selling expenses and the adjusted cost basis. The IRS uses these two formulas to calculate a gain or loss:

Selling Price ��� Selling Expenses = Amount Realized
Amount Realized ��� Adjusted Basis = Gain or Loss

Selling expenses are the costs directly associated with selling your home, including commissions and fees. Meanwhile, the adjusted basis is the total cost basis of your home. Publication 523 has an extensive section to help you figure out your adjusted basis. It includes the amount you paid for the home, closing costs associated with the purchase and the cost of home improvements. Improvements are things that add value to your home. General repairs don���t add value and hence aren���t added to the cost basis. On the other hand, if the repairs were done as part of a larger remodeling project, they may be included.



3. Is your gain taxable? If you���ve passed the eligibility test and determined you have a gain, you need to figure out what portion of the gain is taxable, if any. In addition to the ownership, use and look back tests, there are a few more things you need to verify.

You didn���t acquire the property through a 1031 like-kind exchange within the past five years.
You aren���t subject to the expatriate tax.
The sale doesn���t involve the transfer of vacant land or a remainder interest.

If none of the above is true, you���re eligible for the exemption. Again, this is $250,000 for single filers and $500,000 for those married filing jointly. If you have a gain larger than the applicable exclusion, the amount above the exclusion is taxable. There are worksheets in Publication 523 that take into account special circumstances and help you calculate the taxable amount of your gain.

4. Do you have to report the gain or loss on your home sale? You need to include the gain on your tax return if any one of the following three conditions applies:

You have a gain on your home sale that���s larger than the exclusion.
You received a Form 1099-S. If so, you must report the sale on Form 8949 even if you have no taxable gain to report.
You wish to report your gain as taxable even though some or all of it is eligible for the exclusion. Why would you do that? Let���s say you plan to sell another home within the next two years and are likely to receive more benefit from the use of the exclusion with this later sale. Of course, you might do that���opt to report a taxable gain on the earlier sale���only to realize it was the wrong choice. In that case, you can undo the choice by filing an amended return, but you must do so within three years of the due date for the tax return that reported the earlier sale.

Richard Connor is��a semi-retired aerospace engineer with a keen interest in finance. He��enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. Follow Rick on Twitter��@RConnor609��and check out his earlier articles.

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