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4 Financial Considerations Before You Downsize

21 January 2022

For empty nesters and other homeowners who don't need a large house anymore, downsizing may seem like the perfect solution. From a practical standpoint, a smaller home generally takes less time to maintain, unless it's much older than your current one. Plus, in today's booming real estate market, you'll likely come away with a financial windfall from the difference between what your current house might sell for and the price of a smaller one.

However, it's important to do your homework before taking the plunge. From a purely financial perspective, you might come out ahead. But the windfall might not turn out to be as much as you expect once you factor in the following four potential costs:

1. Transaction Costs

You'll incur closing (or transaction) costs on both the sale of your current home and the purchase of the new one. If it's been many years since you bought your current home, beware: Transaction costs may be higher than you remember.

As the seller of your current home, your biggest cost will probably be the commission for your real estate agent or broker (assuming you use one). The industry standard has long been 6% of the selling price, but some agents may be willing to discount. The commission is generally split equally between the buyer's and seller's agents.

It's possible to sell your home without a realtor, but only about 10% homes are for-sale-by-owner because it can require a lot of work. Your net proceeds without a realtor may be reduced due to:

  • Seller inexperience,
  • Insufficient market intelligence,
  • Marketing costs, and
  • A more limited pool of buyers willing to purchase without the benefit of a buyer's broker.

In addition, some buyers may have an agent that you'll need to pay a commission to (but generally half the amount you'd pay if you had your own realtor, since the traditional 6% commission doesn't need to be split between two realtors). Other transaction costs that sellers incur include a portion of transfer taxes, attorney fees and home inspection fees and, possibly, a homeowners' warranty as an incentive for buyers.

Buyers also pay for an assortment of closing costs. Examples include:

  • Attorneys' fees,
  • Title fees, and
  • Potentially some local taxes.

For buyers, the biggest category of costs usually relates to securing a mortgage. However, if you downsize, you may be able to avoid these costs if your net sales proceeds are sufficient for you to pay cash for your new home.

If you'll need a mortgage to buy your new home and make improvements, lenders' fees generally range between 1% and 3% of the loan amount. In general, the larger the size of the mortgage, the lower the fee as a percentage of the amount borrowed.

Keep in mind that some transaction costs can be negotiated, depending upon the strength of your bargaining position. For example, if your community hasn't seen many home sales in recent months, underemployed realtors who are hungry for your business might be willing to lower the traditional 6% commission rate.

2. Fix-Up Costs

Before you sell your current home, you might need to make some expensive repairs or aesthetic enhancements to get top dollar. The costs of getting your home sale-ready vary. Some houses can be spruced up with just new paint; others may need a new roof or asbestos abatement to attract buyers.

Conversely, before you move into your new home, you might need to buy appliances and make some improvements. For example, buyers nearing retirement might want to relocate the master suite or the laundry room to the main level. Or you might need to remove carpet to minimize allergens — or install a fence for your favorite furry friend.

3. Moving Expenses

Moving costs vary depending upon the distance you move, the time of year, and the amount of furniture and other items that will be transported to your new home. For local moves, the main consideration is how much of movers' time will you need. You can reduce it by doing most of the packing yourself.

These days, the hourly rate charged per moving company employee on a job is typically around $50, according to Forbes.com. So, a local move from a four-bedroom home could run you around $2,000. Long-distance moves can add up to several times that amount.

In general, if you're moving long distance, you should get at least three quotes from reputable movers. Ask your realtor (or friends and neighbors who've moved recently) for recommendations. For various reasons — like trust and scheduling — you might not necessarily feel comfortable with the lowest quote.  

For cross-country moves, be aware that the crew (except the foreman and a driver) that's used at your old home will probably differ from the crew at your new location. You'll be expected to tip your movers at both ends of the ordeal. It's also customary to buy lunch (and possibly dinner) for the moving crew.

4. Capital Gains Tax

When you sell your home, you could owe federal capital gains taxes. In addition, if you live in a state that taxes income, your state tax bill may go up in the same proportion as your federal tax that year.

Fortunately, you can potentially exclude tax (pay no federal income tax) on a certain amount of profit from selling your principal residence. Specifically, single taxpayers can exclude home-sale gains up to $250,000, and married joint-filing couples can exclude up to $500,000. However, you must pass the following tests to be eligible:

Ownership test. You must have owned the property for at least two years during the five-year period ending on the sale date. Two years means periods aggregating 24 months or 730 days.

Use test. You must have used the property as your principal residence for at least two years during the same five-year period.

Periods of ownership and use don't need to overlap. For example, you could rent a home and use it as your principal residence for Years 1 and 2, and then buy it and rent it out to others for Years 3 and 4. If you then sell the property in Year 5, you'd pass both the ownership and use tests and qualify for the gain exclusion privilege.

Important: To qualify for the larger $500,000 joint-filer exclusion, at least one spouse must pass the ownership test and both spouses must pass the use test.

There's another qualification rule for the home-sale gain exclusion privilege: It's generally available only if you haven't excluded a gain from any earlier sale occurring within the two-year period ending on the date of the later sale. In other words, the gain exclusion privilege generally can't be "recycled" until two years have passed since you used it last. For married couples, the larger $500,000 joint-filer exclusion is only available when neither spouse excluded a gain from an earlier sale within the two-year period.

Certain exceptions apply for military members, diplomats and intelligence officers who have had to live away from their homes for extended periods of time .

If you owe capital gains tax, the taxable amount of your gain is based on your tax basis in the home you sell, which could be higher than the purchase price. Contact your tax advisor for more information.

In 2022, the capital gains tax rates are:

  • 0% for single people with taxable incomes up to $41,675 (up to $83,350 for married couples filing jointly and $55,800 for head of household filers);
  • 15% for single people with taxable income up to $459,750, and 20% on higher amounts; and
  • 15% for married couples who file jointly with taxable income up to $517,200, and 20% on higher amounts.

Also be aware that the 3.8% net investment income tax (NIIT) may apply to any gain that exceeds the home-sale gain exclusion limit if your income is over a certain amount. The NIIT applies only if your modified adjusted gross income (MAGI) exceeds:

  • $250,000 for married taxpayers filing jointly and surviving spouses,
  • $125,000 for married taxpayers filing separately, and
  • $200,000 for unmarried taxpayers and heads of household.

Remember that your income in the relevant tax year will jump in the year you sustain a significant capital gain. For example, the tax hit for a couple filing jointly with taxable income below $517,200 who report a $100,000 gain on a house sale (above the $500,000 joint filer exclusion amount) would take a $15,000 federal tax hit (and possibly another hit on their state income taxes) on the sale of their primary residence.

Plusses and Minuses

When you add up all of these possibly obscured costs and deduct them from the sale price of your home, you might be slightly disappointed. However, there's one last step.

Estimate the savings you'll receive each month from simplifying your lifestyle. From a lower mortgage and reduced property taxes to cheaper heating, cooling and insurance bills, the savings from living in a smaller home can be substantial. Plus, there may be nonfinancial considerations to factor into the equation, such as better weather and enhanced accessibility.

This disciplined approach will help you make an informed decision — rather than just relying on gut feelings or emotions. Your financial advisors can help you perform a comprehensive financial analysis to determine what's right for your situation.

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