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Cash In, Trade Down, Drop Out
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f you're ready to cash in your chips by selling your well-appointed home for a simpler life, the Taxpayer Relief Act of 1997 has given you new incentive to do so.
Married couples can now keep up to $500,000 of profit ($250,000 for individuals) tax-free if they sell their homes, regardless of age or income. The impetus to unlock the equity in your home varies with every owner. But one way or another, it usually involves a major lifestyle change.
How can you decide whether dropping out of home ownership will support your particular goal? The answer is a combination of mathematical reality checks and common sense.
1. Determine your ultimate goal
Heed the advice of the Oracle at Delphi, "Know thyself." Why do you want to cash out? Some of the more common reasons include changing to a simpler lifestyle, quitting your job, the opportunity to take a sabbatical for a few years or to use the money to start your own business.
2. Decide how you want to live after you cash out
Turning your back on home ownership, or buying down, can be so emotional that the ultimate decision is often made precipitously. A better way is to quantify the financial impact of your action before you make your move. To do so requires some advanced planning. You need to know where you plan to move, the cost of your new lifestyle, the amount of money you'll get by selling your home and how you'll invest the proceeds of the sale.
3. Gather the hard data
In practical terms, equity equals the sale price of your home minus the debts and closing costs you plan to pay upon sale. Get a realistic appraisal. While you're at it, get a picture of the projected value of your home in the next five years to see if it pays to hold on for a while. Check out the total return on your equity as compared with your other investments. Total return is the amount your investment increases in value plus interest and dividends. (Total Return = Dividend or Interest + Gain in Value). Divide the total return by the purchase price to get the percent of return (Total Return divided by Purchase Price = Percent of Return).
If you're moving to another city, be sure you know if it's more or less expensive than where you're living now. Open your mind to housing alternatives. For example, "co-housing" communities usually consist of 20 to 30 single-family homes that you can buy or rent. Neighbors contract to share everything from child care to transportation to computer facilities. There are 20 co-housing communities nationally, beginning from a successful experiment in alternative living that started in Denmark in the 1960s.
4. Figure out a new budget
Out of the Rat Race by Susan Gregory is one of many books that contain cash-out models. An early primer of downscaling is Cashing in on the American Dream, which advocates rolling over the proceeds of the sale into Treasury bills and moving to such low-cost regions as Central and South America. See also The Five Best Retirement Destinations in the World, prepared by the staff of International Living. Similarly, in their book Your Money or Your Life, Viki Robbins and Joe Dominguez advise you to reduce your expenses and save enough money to walk away from your job and your home in return for financial independence.
5. Do the math
You'll need to make reasonable assumptions and guess at several variables. But, so long as you know what your house is worth, you can be fairly accurate.
If you plan to quit work and use this money to support your new lifestyle, check out your new budget and see if you will have enough income. Remember to include taxes in your budget. If you plan to rent, make sure you adjust the budget for rent increases.
If your plan is to save the money and build wealth for the future through investments, compute the amount you'll accumulate over the next seven years. Then project the equity that you would have built up in your home had you not sold it. Which is greater? The nest egg developed from investing the cash-out or the increased value of the home if you had kept it? Use an appraiser's estimates of the expected rise in your region to make the comparison. Most of these are figured on a seven-year basis, the moving cycle of the average American.
6. Finally, test your thesis
Simulate your new lifestyle as best you can. For some, this may mean using a vacation week to experiment with a new location. For others, it may mean renting or exchanging their home for a few years to see if they really want to sell. In any case, the Internal Revenue Service will cooperate. If you change your mind and return to the house, you still qualify for primary residence status so long as you occupied it during any two years in the past five before a sale. 
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Illustration by James O'Brien Copyright 1998 Microsoft Corporation