By Eric Tyson, Ray Brown

If you’re an older homeowner, your home equity — the difference between the market value of your home and the outstanding mortgage(s) on it — can be one of your largest (if not your largest) assets. Many folks nearing retirement and retirees who own their homes find that their home equity is surprisingly large. Why? First, if all goes well, the value of your property increases over the years. Second, all those years of monthly mortgage payments add up; by the time you’re ready to retire, your mortgage balance should be low or even zero.

Your house’s equity can help supplement the cost of your retirement . . . with or without selling. Of course, the obvious option is selling your house and buying or renting something less expensive. The less-obvious option is taking out a reverse mortgage that provides you with income based on your home’s equity without selling your home. In this section, we cover these important options along with important tax and personal issues that you need to weigh before deciding what to do with your home when you retire.

Trading down

Perhaps, when you’re in your living room, you hear more noise than you used to notice. Or one day, you just can’t muster the desire to skim the leaves out of the pool that no one swims in anymore. And ever since your daughter went off to college, maybe you get a hollow feeling when you walk past her empty bedroom. You suddenly realize, now that the kids have moved out of the house, you have more space than you really need or want.

Even if you don’t have kids, you may find that, now that you’re no longer working, you don’t need to live within driving distance of the city where you spent your entire life working. You suddenly have the freedom to step out of the rat race and move to a place where life moves a bit more slowly (and costs a bit less).

If you’re like most near or actual retirees, these feelings may also accompany the realization that you don’t have as much money to live on during your retirement as you want. You may be “house rich and cash poor,” or, to put it another way, you have “more house than you need and less cash than you want.”

Don’t despair! You’re in an enviable position if you have a house with a good deal of equity in it. Now may be the time for you to trade down — sell your current house and either buy a less expensive home or become a renter. For some seniors, trading down is a wise move that can simultaneously meet financial and emotional needs.

(Huge) tax perk for house sellers

House sellers can shield a big portion of their house sales profits from taxation. Single taxpayers can avoid capital gains taxation on up to $250,000 and couples filing jointly up to $500,000 of profit.

As long as you lived in the house as your primary residence for at least two of the previous five years, this tax exclusion is available to you without age restriction, and you can take the exclusion as many times as you want (but no more than once every two years).

This law (passed in 1997) is more expansive than the old exclusion rules, which required you to be at least 55 years old. (The old rules allowed you to take an exclusion only once per lifetime, and even then allowed an exclusion of up to only $125,000 in house sales profit from capital gains taxation.)

Presuming that you’re willing to sell your primary residence, the new house sales tax law makes it easier to convert your home equity directly into liquid investments you can live off during retirement. Of course, such a strategy requires you to either trade down or become a renter. Trading to an equal cost or more expensive home won’t free up more of your money.

Renting versus trading down

Usually, trading down is financially savvier than becoming a renter. If you’re able to pay for your new home in cash, your housing costs during retirement could be greatly reduced.

The price range you should consider depends on a couple of factors:

  • How much other money do you have for retirement? If you’re really pinched for money to live on during retirement, you may be willing to buy a considerably less expensive home to free up more money for living expenses. Until you run some retirement projections to see where you stand, however, you won’t know how much or how little you need to carve off your home’s equity. And, as we cover in the next section, you can use a reverse mortgage to tap into your property’s equity while you still live there.
  • What do you want to buy? If your retirement dream is to live on New York’s Upper West Side or near the water in Hawaii, you may not be able to trade down much. However, if living in Manhattan is more your idea of a retirement nightmare than a dream, and you want to scale down and move out to the countryside, you can probably spend much less on your next home.

Some people sell their houses and simply rent in retirement. By selling, you free up all the money invested in your house and make it available to live on or do with as you desire. And when you rent, you have more flexibility to move in the future.

If you’re considering the sale of your house and becoming a renter in retirement, be aware of these potential drawbacks:

  • Exposure to rental inflation: As a renter, unless you live in a unit protected by local rental-control ordinances, your monthly rental payment is fully exposed to inflation. Today, $1,000 per month in rent may not sound like a mountain of cash, but consider that, with annual increases of only 4 percent, in 20 years, your rent will mushroom to nearly $2,200 per month. With 6 percent annual rental increases — which can happen if the United States returns to a 1970s-style period of higher inflation — that $1,000 monthly rent balloons to more than $3,200. Ouch!
  • Obeying your landlord: As a homeowner, you get to call the shots. You can change the interior and exterior of your home as you please. As a renter, you’re largely at the mercy and whims of your landlord. If you’re used to owning your own home and not having to answer to a landlord, adjusting to the realities of tenant life can be difficult. So, if you do sell and return to the ranks of renters, spend as much time inspecting and interviewing your prospective landlord as you do examining the rental unit. Remember that your landlord can sell the building, possibly forcing you to move again — with added expenses.