Read This Before Downsizing Your Home

Although the reasons for moving into a smaller house vary from person to person, downsizing often presents an opportunity to save money and embrace a desired lifestyle. This article explores how to recognize when it's time to downsize, hidden costs associated with the process, and important factors to consider before making the move.

Five scenarios suggesting it’s time to downsize

If you’re wondering when to move, a handful of circumstances might persuade you regarding such a large decision as follows:

1.     Your mortgage payment is more than 28% of your gross income.

Generally speaking—and as reported by many mortgage lenders—28% represents the maximum percentage of your monthly gross income you should spend on a mortgage payment. If your gross income is $8,000 a month, for example, you shouldn’t spend more than $2,240 on your monthly mortgage including costs associated with principal, interest, property taxes, and homeowner’s insurance. Above this threshold? You certainly aren’t alone. According to Harvard University’s recent “State of the Nation’s Housing” report, over 30% of households spend 30% or more of their income on housing. Even more concerning is this number rises to 50% (!) for approximately one in seven households.

As with any rule, exceptions do exist. For example, let’s say you (or your spouse) lose your job and thus only hover above the 28% threshold for a short period of time. Perhaps a spouse leaves a job (or cuts back on hours) to care for children or elderly parents. Either which way, if you can get by with a temporary drop in income, that’s fine. You might want to consider downsizing if you’re significantly over the threshold, however.

2.     You can't keep up with home maintenance and repairs.

A recent Bankrate.com “Hidden Costs of Homeownership” study found the average American spends over $8,880 per year on home maintenance and repairs: expenses that naturally vary based on the location of your residence and the size/type of your home, as well as the number of rooms given associated maintenance requirements. You’ll also spend more during some years than others. That said, an inability to keep up with maintenance and repairs on your home is perhaps another sign that it’s time to downsize.

As a general rule of thumb, you should set aside at least 1% of your home’s value every year for maintenance. If your home is worth $400,000, for example, you should save $4,000 a year (or $333.33 a month) to cover these expenses. Another approach is to sock away 10% of the total cost of your mortgage payment (including property taxes and homeowner’s insurance) to do so; if your mortgage costs you $3,000 a month, you should save $300 for maintenance and repairs on a monthly basis. If home repairs are sinking you further into debt or you’re unable to save for future maintenance costs, downsizing may make the most sense.

3.     You can't enjoy the lifestyle you want to live.

The decision to downsize also heavily involves your goals and desires. Want to pay off more debt? Save more money for retirement? Dine out or take vacations with friends more frequently? If you struggle to enjoy the lifestyle you want to live now (or in the future) because your home expenses are too high, downsizing is perhaps a top option. Holding on to extra space you no longer need, likewise, can keep you from achieving your ideal lifestyle since it often leads to higher costs and more maintenance than necessary.

The same can be said for other related costs. Move.org, for example, estimates that a typical U.S. family spends $401 a month on essential utilities such as electric, gas, and water. Downsizing not only helps you save on these costs, but you’ll likely also benefit from lower property taxes and homeowner’s insurance fees often accompanying a smaller place—meaning you can put more of your money toward “fun” expenses like leisure activities and trips abroad.

4.     You don't need that much space.

If you’re no longer using the space you’re paying for (e.g., multiple bedrooms), you’ll definitely want to consider downsizing. This scenario is prevalent among empty-nesters, who perhaps needed the extra square footage at one point in their lives but no longer do. If this applies to you, downsizing makes complete sense since moving to a smaller home can help you better utilize your living space and avoid bringing unnecessary clutter into your new environment.

5.     Your house has appreciated considerably.

While nobody can predict how the housing market will perform in the future, it might make sense to take advantage of a rise in your home’s value. Then again, it’s impossible to time the market perfectly, and you’ll also need to find another place to live and thus may buy at a premium price as well. Some homeowners decide to wait until after retirement or a market peak before downsizing, hoping for more favorable conditions. One possible option to avoid this? Sell and rent for a while before buying once the housing market cools again.

How to properly assess the value of your current home

Before you decide to downsize, you’ll first need to accurately assess the value of your current home to get a realistic idea of what it could fetch. Skip this step, and you might overestimate what your home is worth and in turn jeopardize your goals. While online estimators provide results in minutes, their accuracy is sometimes questionable (e.g., Zillow acknowledges a median error rate of 7% for off-market homes); these tools can potentially over- or under-estimate your home's value, with the margin of error notably significant in less-populated areas where home turnover is low.

A more reliable option? Consult a local real estate agent who can provide an accurate appraisal (considering assessed value, comparable sales, and unique home features or upgrades an online algorithm might overlook) and offer strategies to maximize your home's value. Consider hiring a professional appraiser for the most precise evaluation assessing every feature of your property impacting its value, which is often worth the cost (likely a few hundred dollars).

Hidden costs associated with downsizing

When downsizing a home, many people are caught off guard by several expenses including:

Home sale preparations

Most homeowners need to make cosmetic upgrades (e.g., painting or making minor repairs) to attract buyers. You might also consider hiring a professional stager to enhance your home's appeal and maximize its selling price.

Home inspection costs

Buyers may request modifications or repairs following a home inspection. In addition to cosmetic changes, you could be responsible for addressing bigger issues such as pest damage or problems with electrical, plumbing, roofing, or foundation systems.

Closing costs

Closing costs can range anywhere from 2% to 7% of a home’s sale price (according to Bankrate.com) and include payment for the mortgage balance, property transfer taxes, recording fees, and attorney costs. You’ll also need to pay real estate commissions at closing, sometimes up to 6% of the home’s sale price. It’s essential to plan for these expenses and stay organized during the moving process to avoid any surprises.

Moving fees

According to Move.org, the average cost for a local move (within 100 miles) is about $7,600. A long-distance move, meanwhile, can cost approximately $9,140. Keep in mind these estimates don’t include additional fees for packing services or moving coverage (insurance protection for your belongings). While using moving pods or renting a truck can help save money in this respect, you should still budget for these expenses.

Emotional costs

Beyond financial considerations, emotional factors can heavily influence your decision to downsize. The longer you've lived in your home, for example, the more memories you’ve created there—perhaps making it that much more difficult to leave. To tackle this emotional challenge, focus on the positive financial benefits of downsizing such as having more savings for retirement, cutting down on debt, or achieving the lifestyle you desire. You can also declutter your home by removing items you no longer use (e.g., old furniture gathering dust in the basement or bikes your kids have outgrown), this process often making it a bit easier to manage your attachment to the house.

Potential tax implications to consider

Before you decide to downsize, it’s important to be aware of taxes you may owe on your home sale profits (i.e., capital gains taxes). The good news here is that the IRS allows you to exclude up to $250,000 in gains (profits) from your taxable income (up to $500,000 for married couples filing jointly), provided you meet IRS ownership and use tests. You must have owned the house for at least two years and lived in it as your principal residence for at least two of the last five years up until the sale date to qualify (some exceptions to this rule do exist).

How to calculate capital gain on a home sale

The formula used to determine the amount of your capital gain is simply the net proceeds minus the adjusted basis of your home, the latter calculated as follows: take your original purchase price, add the cost of any qualifying capital improvements (e.g., an addition to your home, kitchen updates, or basement finishing), and add closing costs and settlement fees. Then, subtract any home value depreciation. If you purchased your home for $350,000, paid $7,000 in closing costs, and spent $100,000 upgrading your kitchen and bathrooms, for example, your adjusted basis would be $457,000. If you sell your home for $800,000, your capital gain in this case would be $343,000.

How to calculate your capital gain taxes

Continuing with this example, if you're married and filing jointly and meet IRS ownership and use requirements, you’d be exempt from federal taxes since your capital gain is below the $500,000 threshold (state taxes would still apply, however). If you’re single but meet the IRS requirements, you’d owe a 15% capital gains tax on the $93,000 exceeding the $250,000 threshold, resulting in a tax of $13,950 (state taxes would also apply).

In sum: when to downsize your home

Downsizing your home is both a financial and emotional decision, especially if you’ve lived there for years and created many memories within its walls. If you find your current income (or projected income, if you’re nearing retirement) can’t sustain your expenses or is preventing you from living your desired lifestyle, downsizing is perhaps a viable option.

Have questions about when to downsize? Schedule a free consultation with one of our CFP® professionals to get them answered.

About the author
The content in this post was developed by our team of writers and reviewed by our team of CFP® professionals here at Vision Retirement.

Retirement Planning | Advice | Investment Management

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. Schedule a no-obligation consultation with one of our financial advisors today!

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.