Reference no: EM132040223

Problem - Derek and Meagan Jacoby recently graduated from State University and Derek accepted a job in business consulting while Meagan accepted a job in computer programming. Meagan inherited $75,000 from her grandfather who recently passed away. The couple is debating whether they should buy or rent a home. They located a rental home that meets their needs. The monthly rent is $2,250. They also found a three-bedroom home that would cost $475,000 to purchase. The Jacobys could use Meagan's inheritance for a down payment on the home. Thus, they would need to borrow $400,000 to acquire the home. They have the option of paying two discount points to receive a fixed interest rate of 4.5 percent on the loan or paying no points and receiving a fixed interest rate of 5.75 percent for a 30-year fixed loan.

Though anything could happen, the couple expects to live in the home for no more than five years before relocating to a different region of the country. Derek and Meagan don't have any school-related debt, so they will save the $75,000 if they don't purchase a home. Also, consider the following information:

• The couple's marginal tax rate is 25 percent.
• Regardless of whether they buy or rent, the couple will itemize their deductions.
• If they buy, the Jacobys would purchase and move into the home on January 1, 2014.
• If they buy the home, the property taxes for the year are $3,600.
• Disregard loan-related fees not mentioned above.
• If the couple does not buy a home, they will put their money into their savings account where they earn 5 percent annual interest.
• Assume that all unstated costs are equal between the buy and rent option.

Required: Help the Jacobys with their decisions by answering the following questions:

a. If the Jacobys decide to rent the home, what is their after-tax cost of the rental for the first year (include income from the savings account in your analysis)?

b. What is the approximate break-even point in years for paying the points to receive a reduced interest rate (to simplify this computation, assume the Jacobys will make interest-only payments, and ignore the time value of money)?

c. What is the after-tax cost (in interest and property taxes) of living in the home for 2014? Assume that the Jacobys' interest rate is 5.75 percent, they do not pay discount points, they make interest-only payments for the first year, and the value of the home does not change during the year.

d. Assume that on March 1, 2014, the Jacobys sold their home for $525,000, so that Derek and Meagan could accept job opportunities in a different state. The Jacobys used the sale proceeds to (1) pay off the $400,000 principal of the mortgage, (2) pay a $10,000 commission to their real estate broker, and (3) make a down payment on a new home in the different state. However, the new home cost only $300,000.

d-1. What gain or loss do the Jacobys realize and recognize on the sale of their home (assume they make interest only payments on the loan)?

d-2. What amount of taxes must they pay on the gain, if any?

e. Assume the same facts as in part (d), except that the Jacobys sell their home for $450,000 and they pay a $7,500 commission. What effect does the sale have on their 2014 income tax liability? Recall that the Jacobys are subject to an ordinary marginal tax rate of 25 percent and assume that they do not have any other transactions involving capital assets in 2014.