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Balancing rising expenses against a fixed income

Summary

When investing in retirement property, make sure you calculate how rising future real estate taxes will impact the expense of ownership over time.

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Question for the CreditCards.com expert

Dear Maturing Loans,
I plan to retire in five years. I have 1.5 acres and plan to build a small house on it. I have the option of adding an another 4 acres to my 1.5 acres, but worry about the additional real estate tax burden I would have at retirement. What is a good benchmark to follow for real estate taxes only? What percent of your retirement income should be allowed for real estate taxes, assuming there is no mortgage? — Marian

Answer for the CreditCards.com expert

Dear Marian,
While there isn’t a benchmark for any single expense, there are guidelines you can follow so your expenses don’t get out of control. Each individual and family must look at their complete financial picture to determine what they can truly afford. By taking on this property and the additional real estate tax expense, you might want to ask if there are other expenses that come along with the additional property. You must look at the possibility of other expenses and their impact on your income in order to make an accurate assessment. For example, you may want to look at other property factors, such as zoning. Is the property nearby zoned commercial or residential? In the event of an emergency and you need to raise additional cash in the future, will you be able to subdivide your property?

Another consideration would be to examine the history of property taxes in your area. Some states give property tax rebates. There are other states, like New Jersey, that are looking to rescind these rebates for “wealthy” individuals.

Once you have taken these factors into account, you should have a better handle on how this expense will fit into your overall expense picture. One potential problem is that unlike a fixed expense, like a fixed mortgage, the property tax  expense will most likely rise over time, and it might rise higher than the rate of inflation.

Because of the propensity of property and school taxes to increase faster than the inflation rate, and the very strong possibility of someone’s income not rising at the same speed once they get on in later years, you need to be extra careful. That is, if this expense is 10 percent of your total income, it may be 20 percent to 40 percent of your total income in 20 years if your taxes double and if your income stays constant or reduces.

What you need to do is see if you have enough information and money to project out over the next 20-30 years to cover this expense.

You can get a rough estimate using a calculator. Use the rule of 72. (See “The rule of 72” box.)

The rule of 72
10 x 7.2 = 72
(10 years at 7.2 percent, your money doubles)

7.2 x 10 = 72
(7.2 years at 10 percent, your money doubles)

9 x 8 = 72
(9 years at 8 percent, your money doubles)

8 x 9 = 72
(8 years at 9 percent, your money doubles)

36 x 2 = 72
(36 years at 2 percent, your money doubles)

2 x 36 = 72
(2 years at 36 percent, your money doubles)

So, if we have a property that has a historical increase of 7 percent (or so) in property and school tax increases, we know that its cost will double in about 10 years, and quadruple in 20 years. If your income is growing at the rate of inflation (between 3 percent and 4 percent historically), then your income will grow by 50 percent in 10 years and double in 20 years. This comes out to your property cost roughly quadrupling over the next 20 years, compared to  the increase in your income only doubling.

Finally, you have to ask yourself if you could afford that 20-year rise in property taxes today.? That is, can you afford roughly double the cost today of what it really costs? If you can, and the above assumptions are indicative of your situation, then you can most likely afford that property and its associated tax and potential tax increases. If you cannot, then while you may be able to afford the property today, you will run into problems as time goes by, which is a headache you can avoid now.

Thanks for the question, see you back here next week.

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