Washington's Mount Vernon, Alexandria, Virginia (1731).
It is often said that a residence is the largest investment that a person makes in a lifetime — part of the American dream.
But should a residence be viewed as an investment?
On the one hand, market value tends to increase significantly over time. On the other, a residence is a source of annual expenses rather than income. It would be difficult to find a stock, bond, or other traditional investment with this combination.
Adams's Peacefield, Quincy, Massachusetts (1731).
In 1776, Adam Smith identified three categories of capital in The Wealth of Nations.
The first portion is reserved for immediate consumption and affords no revenue or profit. This includes food, clothes, and household furniture.
The second category is fixed capital, which affords a revenue or profit without circulating or changing owners. This includes machines, rental property (i.e., shops, warehouses, work houses, farm houses, stables, granaries, etc.), improvements of land, and the abilities of the citizens.
The third category is circulating capital, which affords a revenue only by circulating or changing owners, such as money, inventory, and raw materials.
Smith includes a residence in the first category with food, clothes, and household furniture because a residence is distinguishable from other real property used in a business.
The stock laid out for a residence, if it is to be the dwelling-house of the owner, ceases from that moment to serve in the function of a capital or to afford any revenue to the owner. The dwelling-house, as such, contributes nothing to the revenue of its inhabitant.
Although it is, no doubt, extremely useful to the owner, it is as clothes and furniture are useful to the owner, which, however, make a part of expenses and not of revenue.
Jefferson's Monticello, Charlottesville, Virginia (1772).
Although Smith categorizes a residence with personal effects, the Internal Revenue Code of 1986, as amended, treats a residence as neither personal effects such as food, clothes, and household furniture, nor as a traditional investment such as stocks and bonds. Several provisions incentivize investment in a residence, particularly with respect to the disposition of a residence.
Gain from the sale of a principal residence is excluded from gross income under I.R.C. § 121, and a residence acquired from a decedent receives a new basis under I.R.C. § 1014, which has the effect of eliminating built in gain existing on the date of death.
These provisions potentially permit income tax free appreciation for a residence.
Application, however, depends on the disposition decision. Potential traps for the unwary exist where a homeowner expects the exclusion under I.R.C. § 121 and the new basis under I.R.C. § 1014 to apply in all situations, particularly with respect to trusts and entities.
Madison's Montpelier, Orange, Virginia (1764).
A residence thus provides a unique combination of appreciation and day-to-day utility, paired with income tax incentives.
Smith identifies three categories of capital, but a residence belongs in a fourth category of its own.