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The Big Tax Shelter Many Financial Planners Overlook

Richard Satran

Opening a new account with a financial adviser usually comes with a flourish of planning questionnaires and portfolio advice. But one of the most critical questions about your personal finances is often left out. What is the equity in your home worth and what will it be when you retire?

Not only is it the largest piece of many families' personal wealth, it also has unique advantages that can be used or abused. The right choice can pay off throughout a lifetime, and a wrong choice can be devastating.

"It's critical that financial planners start to look at it as part of a person's overall portfolio," says Barbara Stucki, who headed home equity initiatives at the National Council on Aging before founding NestCare FPC as a funding vehicle for seniors.

Financial advisers have often deflected talking about home equity by saying, "It's not an investment, it's your home." That was more true for generations past who bought homes in stable real estate markets and often stayed in them in retirement. But increasingly mobile lifestyles, rising healthcare costs and other generational shifts have changed that storyline. So have changes in tax laws and the volatility of all markets, real estate included.

[Read: 2 Simple Steps to Make Your Retirement Savings Leap.]

The biggest change: tax advantage for home equity. Possibly the most important shift in managing home equity came in the Tax Relief Act of 1997, which eliminated taxes on gains of up to $250,000 for the primary residence of a single person and $500,000 for a couple. The only requirement is that the owners must have lived in the home for two of the past five years. Before that, the tax benefit of a capital gain could only be used if it was rolled into a new home of greater value. For retired people, there was a one-time $125,000 cash-out break.

Now people get a pool of money that's greater than most individual retirement funds, and it has an even more generous tax status. Unlike retirement funds that are taxed either at withdrawal or deposit, as with the pre-tax contributions for a Roth plan, that half-million in home equity is a virtual tax haven, given the interest deductibility of mortgage payments and the ability to take a tax-free gain on any increase in the home's value.

The hitch, of course, is that you need to live somewhere, and that makes a home different than stocks or bonds. "If you are willing to sell it, it's an investment. If you are not, it's not," says Susan Fulton, a financial planner and founder of FBB Capital Partners in Bethesda, Md.

In the era of downsizing, the answer is often that people do plan to sell. Either way, it's important to monitor the home's value and pay down equity. "I've never met an unhappy 80-year-old whose mortgage is paid off," says Fulton.

Most overused line. The other big caveat many financial advisers give: "You can't count on making money on real estate." Those words are entirely true, as the housing collapse of a half-decade ago shows. Even before that, some local markets fell and never returned to their old levels. Overall, the Case-Shiller 20-city composite index of home prices remained 30 percent below the peak at the end of last year, despite 2012's 6.8 percent rise.

To be sure, the past five years have shown that there is really no 100-percent safe investment, stocks and bonds included. Still, prices have rebounded and over the long haul, homes have risen at a yearly rate of 3 percent to 4 percent, according to the National Association of Realtors. Even with the housing crash figured in, the average home price remains roughly 15 times the level of 1963 ($19,300 then, $288,400 now).

But like financial markets, real estate has been extremely volatile in recent years. For homeowners and borrowers it's confusing, and advice is thin.

[See 10 Ways Your Home Can Pay You Money]

"Financial advisers get paid to manage money, not your home equity," says David Richmond, founder of Richmond Brothers in Jackson, Mich. "It's really a question of who is quarterbacking your financial life, and whether you are including your own long-term strategy to build equity into your financial plan."

The refinancing boom that restarts anew each time mortgage rates fall and home prices rise has been a big income-earner for banks and the mortgage finance industry, but it's a myth that it is a "no-brainer" for the homeowner. Each new financing resets the clock on the repayment of principle. It puts the homeowner that much further from building equity, since it's mostly interest that is paid in the early years of the amortization schedule, although there is a great deal of variety, from interest-only to accelerated payback refis.

"Even if you are a baby boomer, you should be thinking of how you manage this asset over 20 or 30 years," says Richmond. "It's a very important asset. You can use it to borrow money, but you really should not borrow against it if it means you are spending more money than you have."

Nestcare's Stucki says home equity should be nurtured over the years so it's there when you need it. "People have to start tallying up different pots of money, including home equity," she says. "It's not going to be enough to have a retirement account and Social Security. Home equity can be used to fill a lot of gaps in financial planning. The question is whether there is enough of it left that will be unencumbered."

The Federal Reserve Survey of Consumer Finance showed that median family net worth fell to the level of the 90s, largely because of home prices, but also due to stock declines. "Unfortunately it's all a crapshoot," says Richmond, who advocates including home equity as part of a diversified strategy and says it should be seen as another way of avoiding putting your entire nest egg in one basket. House prices sometimes hold up better in times of inflation, for example.

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"Home equity is certainly important in financial planning. If you are a tenant paying rent, you are not building equity," says Tucker Watkins, private wealth adviser for Ameriprise Financial on home equity. People can also use it to borrow against. In many cases it makes sense, as long as the borrower has full awareness of the impact. Says Stucki: "It should be an orderly drawdown."

Lastly, for seniors at a certain stage in life, a reverse mortgage can be a sensible option because it requires no monthly payments and allows homeowners to stay put. A newly launched "saver" reverse-mortgage option acts as a credit line that draws down only a portion of home equity. Refinancing, too, is an option, but borrowers need to remember that the low rates that bring reduced monthly payments always have some negative impact on the equity you've tried to preserve. There are people who need access to capital for whom it works well, Watkins says, but "it's not for everyone."

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