FAQ: Seller Subsidies/Contributions to Closing Costs

I'm often asked how seller subsidies, (also known as “seller contributions” or “closing cost assistance,” work. When a buyer purchases a property, he can expect closing costs of about 3% of the transaction price. (This varies widely by jurisdiction—consult a local REALTOR for more details.) The closing costs are a combination of (1) fees to lenders, brokers, appraisers, and attorneys, and (2) prepaid expenses, e.g., paid-in-advance property taxes or hazard insurance. Many of the prepaid charges vary depending on the day and month in which you settle. For example, if you settle on the 25^th of the month, you typically pre-pay 5 days of interest, whereas if you settle on the 10^th of the month, you typically pre-pay 20 days of interest. For this reason, if a buyer needs to keep closing costs low, it sometimes pays to negotiate an end-of-month settlement. As a general rule, buyers cannot finance closing costs, so a buyer needs to show up at settlement with funds for both their down-payment as well as their closing costs.

Closing costs come off of the seller’s “net” or the amount of proceeds after expenses. Let’s say the seller is listing his home for $450,000 and his selling expenses (fees, etc.) are equal to 8% of the transaction. If he were to receive his full asking price, his “net” would be 92% of the total, or $414,000. In this example, the buyer would need to pay $13,500 in closing costs (3%) + his down-payment.

One negotiation tactic that is very common in this buyer’s market is to ask the seller to pay a buyer’s closing cost ($13,500 in our example), so that the buyer minimizes the amount of cash they need to spend to get into the house. The buyer may actually have the cash, but might prefer to hold onto it as savings, or apply to his down-payment, remodel a bathroom, to buy furniture, or whatever. Tip: You may see “seller contribution” clearly advertised in a listing—don’t let this drive your decision too much—in this market, almost any seller would be happy to contribute to your closing costs whether they advertise it or not. By stating it in a listing, though, in essence these sellers are simply saying “I’m willing to take less than list price.”

Now, getting back to our example, let’s say that a buyer wants to make an offer on that $450,000 home, but after discussing it with his agent, wants to pay only $430,000. (And for purposes of this example, let’s assume that the seller wants to “net” the fair market value of $430,000.) The buyer may offer less, or may ask for closing cost assistance, or a combination. So if the buyer wants his closing costs paid for, he might offer $443,500 and ask for a seller contribution to closing costs of $13,500. The seller then nets $430,000. The buyer would borrow the full $443,500—in essence “financing” his closing costs across the life of the mortgage—but would only need to write a check for the down-payment at closing.

Taking it one step further, if a buyer were to ask for both a price concession AND closing cost assistance, the seller would apply both to his net. In our example, it’s unlikely the seller would accept an offer of $430,000 AND provide a full $13,500 contribution because his net would only be $416,500 rather than the market value of $430,000.

From a buyer’s perspective, asking for closing costs is a good way to minimize cash out-of-pocket in the short term, but the trade off is that the buyer is paying interest (via the higher mortgage) for potentially years. Be careful, though—many lenders have a limit of how much a seller can contribute; they want you to have some “skin in the game” in today’s market! Additionally, review your contract carefully—sometimes any excess contribution is returned to the seller.

From the seller’s perspective, the financial difference of giving a price concession or a closing cost contribution is usually immaterial—the impact to the net is essentially the same. (The only difference is that any fees that are based on a percentage of the transaction price will be slightly higher; in our example, they would be based on the $443,500, and not the net of $430,000. Still likely a very small price to pay to get a buyer to the table!)

2008 Regional Outlook: "Fundamentals Sound"

George Mason University has updated their 2008 Outlook for the Washington, DC, metro area. It’s fairly consistent with previous presentations (perhaps slightly more positive, in my opinion.) Here are the key findings:

• Local job market continues to be very strong, with Washington, DC, having the lowest unemployment rate of the largest 15 job markets (US average = 4.4%, DC = 3.1%.) (See slide 5.) As I have commented here before, the job market is a great indicator of the housing market to come—people go where the jobs are, and they need a place to live. Because this area doesn’t have particularly high vacancy rates in rentals, that translates into pressure on rents (thus providing an incentive for renters to buy), or more demand for homes.
• This area has significantly fewer foreclosures (as measured per 10,000 units) than most large metropolitan areas in Florida, California, and the rust belt. DC (22), Arlington (27), and Alexandria (34) have the fewest foreclosures of any local county. (See slide 13) Think about those numbers for a minute. For every 10,000 homes in the District, just 22 are in foreclosure. This is consistent with other posts I’ve made about this area having two different markets—close in neighborhoods versus outlying suburbs.
• Days on market has increased significantly. (However, this can easily be misinterpreted—see my post on “Some Sellers Get It—And Get It In 30 Days!” Total units sold have declined (duh). Total active listings have increased (again, duh.)
• Percentage change in inventories has slowed dramatically and is consistent with 2003 levels. (See slide 23). We still have quite a backlog to work through, but at least for now it doesn’t appear to be getting any worse.
• Outlook: “Fundamentals are sound, 2008 will be moderately better than 2007.” (And by “better,” of course, they mean better for sellers.) “Housing prices will be flat until at least Spring & will be a mixed story across the region—some jurisdictions will be negative and others showing increases.”

So in summary, all real estate is local, and the DC market is, all things considered, not a bad place to be right now.

(If you found this interesting, see my related post: When will the DC real estate market turnaround?)

Some Sellers Do "Get It" - And Get it in 30 days!

The average Days on Market (DOM) is a good yardstick to measure whether housing inventory is moving. Generally, the higher that number goes, the more leverage a buyer has in negotiating. As the number ticks up, sellers get more and more anxious; buyers start to think: “What’s wrong with that house that it’s been on so long?”

There are two DOM statistics – Days on Market (MLS) and Days on Market (Property), or DOMM and DOMP. DOMM measures the days that a property has a particular MLS code attached to it. The MLS code is a two letter county abbreviation and 7 digit number, so something like AR1234567. DOMP measures the days that a physical address has been listed (though there are ways to cheat the system on this.) DOMP is a better indicator for buyers to use.

The average DOMP for active listings in Arlington right now is 107. (The average DOMM is 87, FYI.) That means, on average, each listing has been sitting for over 3 months. Looks pretty heavily in the buyer’s favor, right? Sellers appear to just not understand that they’re priced too high. But let’s look closer.

Looking at the 174 successful settlements for October 2007 in Arlington, I’ve graphed how long they were on the market prior to sale. We can see from this chart that the average of 107 (which would fall into the last column) isn’t a good representation of “successful” sellers. In fact, 45% of successful sellers had a contract in under a month, and almost 60% had a contract in under 60 days!

What are the implications of this?

• There are buyers out there for properties that are priced correctly.

• If a property is priced correctly—that is, the sellers “get it,” there is a good chance it will be under contract in 30 days, and a very good chance it will sell in under 60.

• On the other hand, for those sellers that don’t “get it”, the property will very likely sit for a long time—over 4 months. Right now there are 295 active listings in Arlington that have been on for over 4 months. In October, 34 settlements had a DOMP of that long. That means only 34 of 329, or about 10%, sold. Sellers, if you've been on for over 4 months you have only a 10% chance of selling. If you list a home and think, well we'll have an offer in 3 or 4 months--you're just not getting it!

In summary:

• Sellers – Price it right quickly, and it will sell quickly. There are buyers out there, but they are savvy and demanding.

• Buyers – Don’t assume that you have 3 months to make up your mind on that home you love—it could very well be gone if the seller already "gets it." If it’s priced well, the market will respond accordingly. How will you know if it’s competitively priced? Work with an agent, track micro-markets, and be actively looking in those micro-markets. Looking at an “average” won’t be enough.

Tax Tips for Home Buyers

Buying a home can bring a number of changes into your life, including financial ones. But for first time home buyers, those financial changes can be good news, especially at tax time. Most people know that there are significant tax benefits to buying a home, but often aren't clear on exactly what's deductible. So as 2007 winds down, I've compiled this brief list of tax benefits related to a home purchase. Not all deductions apply to every situation, of course, so think of this as a list of things to discuss with your tax advisor.

Mortgage Interest – Most homeowners are well aware of the mortgage interest deduction, as this is typically a large amount that makes the decision to itemize on Schedule A a no-brainer. You’ll receive a Form 1098 from your bank with the amount you can deduct on Schedule A. For most first time borrowers, but bulk of your mortgage payments for the first few years are mostly interest, so this one adds up quickly! Interest on second trusts and Home Equity Lines of Credit (HELs or HELOCs) are also deductible within certain guidelines. (Note: If you find that you are receiving a very large refund, you may wish to adjust your withholding using the IRS’ calculator here. )

PMI - Private Mortgage Insurance (PMI) is now tax deductible. But look out - this only applies to loans originated in 2007, so not everyone will benefit. There are also income limitations, and at least so far, this is just a one-year deal, so don't assume you can deduct it in 2008 and beyond. (Update Dec 2007: Congress extended the deduction for mortgages originating between 2007 -2010. Families with AGI up to $100K are eligible for the deduction, with the deduction being phased out up to an AGI of $109K.)

Points – Points—that is, mortgage interest that you prepaid at settlement—are also deductible. A point is equal to 1% of the amount borrowed. This one may or may not be on your 1098, but will be on your HUD-1 settlement statement from your closing. Can’t find your settlement statement? Ask you agent or settlement attorney for another copy. Some agents (myself included) automatically mail another copy to clients in the beginning of the year following the purchase. If you refinanced this year, then points can be deducted over the life of the mortgage.

Property Taxes – Your real estate taxes will also be deductible on Schedule A. It's easy to forget this deduction because most lenders collect it from borrowers as part of their monthly mortgage payment, and pay the local jurisdiction on their behalf. If you’ve prepaid, then the payment is deductible in the year of actual payment. So don’t forget to check that settlement statement to see if you prepaid any taxes that your lender may not be reporting!

District of Columbia First Time Buyers - First time buyers that settle on a purchase in DC before December 31 may get a $5000 credit (not a deduction--an actual dollar for dollar offset on money owed!) on your Federal Taxes. That's the same as Uncle Sam giving you $5000 of your hard earned money back just as a 'thank you' for buying in the District. Use IRS Form 8859. Also, DC buyers—don’t forget to apply for the homestead exemption that exempts the first $60,000 of value of your primary residence from property taxes.

Relocations – If you moved as a result of a job change, many of your unreimbursed moving costs may be deductible.

Upgrades and Updates to Your Home – If you made certain energy-efficient updates to your home in 2007, including high efficiency HVACs, new windows or doors, or tankless hot water heaters, you can qualify for a tax credit. Read more here.

Capital Gains – The first $250,000 in profits from the sale of your home ($500,000 if married filing jointly) is generally tax-exempt if the property was your primary residence for two of the last five years.

Now for the bad news: Some costs are yours alone—don’t try to deduct these expenses: HOA or Condo dues (though the property tax portion of co-op fees may be deductible--consult a tax advisor), property insurance, depreciation, general closing costs, repairs and maintenance, or local assessments that increase the value of your neighborhood (like installing sidewalks.) But hold on to any receipts; certain property improvements add to the basis of your home, and can help exempt profits when you sell.

While organizing all of the paperwork may take a little more time than was required when renting, the result is well worth it for most new homeowners. You may be pleasantly surprised with the difference in amount owed versus what you paid as a renter. Think of it as Uncle Sam's way of subsidizing your housing payment.

General disclaimer: This advice is not intended to apply to all situations, as exceptions and limitations apply. Please consult a tax advisor for your personal situation. IRS guidance can be found at www.irs.gov