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 Post subject: Am I falling victim to the sunk cost fallacy?
PostPosted: Thu Jun 10, 2010 2:42 pm 

Joined: Mon Jun 07, 2010 8:08 pm
Posts: 22
A common scenario: I bought a house several years ago which is down in value. (I'm renting it and the income from rental just covers the mortgage and condo fees - so I'm cash flow neutral on it. My goal in life isn't to be a landlord and I don't expect to ever be cash flow positive from renting.)

In considering selling the property, I'm of two minds.

1. It's down in value, so I'd like to hold it and wait until I can recover my full investment.

2. I'm #1 I'm succoming to the sunk cost fallacy because it's down in value, what's done is done and the past is the past.

However, isn't the sunk cost fallacy when you've got a sunk cost and you *can't* change that fact, so you shouldn't consider it as part of your forward thinking? If this is the proper definition, then I could change the fact that it's down by holding and waiting for the value to rise. A common example of the sunk cost fallacy is when you buy movie ticket and then decide that you really don't want to see the movie, however you feel compelled to go so you can feel like you got value out of the price of the ticket. The rational response is that the money is gone and you can't get it back, so having paid for the ticket shouldn't be part of your decision process.

In my example, am I falling victim to the bias?


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 Post subject: Re: Am I falling victim to the sunk cost fallacy?
PostPosted: Thu Jun 10, 2010 4:04 pm 
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Joined: Wed Sep 23, 2009 9:01 am
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You can't change the past. The amount you paid for the house is not directly relevant - but, it comes into play because of tax laws.

The way to look at this is to consider what you can do with the house/money moving forward. You have a house and a mortgage. You can sell the house or you can keep it.

If you sell the house then presumably you get nothing and you possibly owe the bank money.

If you keep the house you potentially gain from appreciation if the market recovers.

Since you are cash flow neutral presumably there will be no impact on cash flow either way.

The mortgage is a liability that impacts your ability to get credit, say for another house. It also helps your credit over the long term though.

Since you are renting the house you are operating a business. That makes the potentially tax deductible if you operate the business properly. This could be worth a lot so you might want to get competent tax advice on that little tidbit. You can also depreciate the property.

The sunk cost fallacy basically means that sunk costs normally don't impact a decision because you can't change them. That is the case here in the sense you can't change what you paid for the house. But depending on the details those sunk costs might impact the decision because of their tax deductibility.

While it might be nice to try to keep things simple, this is not a simple situation. You really need to do a careful analysis to make this decision.


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 Post subject: Re: Am I falling victim to the sunk cost fallacy?
PostPosted: Thu Jun 10, 2010 4:42 pm 

Joined: Tue Mar 23, 2010 3:31 pm
Posts: 405
It really depends how far from the break even point you are.

If you are many years away from break even, then maybe just sell it and avoid the hassle. If you are like 2 years away from break even, no sense in selling now. You can hold the house knowing each month is a potentially lower loss, depending on the details of the mortgage. Once you pass the break even point(where the remaining balance on the loan = its current market value), then each successive month you pay the mortgage with other people's money you gain future income when you sell it.


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 Post subject: Re: Am I falling victim to the sunk cost fallacy?
PostPosted: Fri Jun 11, 2010 1:44 am 

Joined: Tue Dec 04, 2007 3:49 am
Posts: 149
Location: Australia
If it's not costing you anything and it's not too much of a hassle being a landlord why not just keep it? It's price is likely to recover in time and every rent check you get is paying down the mortgage and eliminating the loss you will make if you sell.


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 Post subject: Re: Am I falling victim to the sunk cost fallacy?
PostPosted: Fri Jun 11, 2010 6:45 pm 

Joined: Sat Jun 30, 2007 10:35 am
Posts: 1444
cash neutral on a rental is actually cash positive, because the equity in the house isn't coming out of your pocket. when and if you sell it, the equity was paid for by your renter. even though your house is underwater, so long as you have a renter paying more into the house than you are, then it really doesn't matter if you are underwater once you build up enough equity in the house to overcome the underwater portion.

sunk costs are costs that aren't retrievable. your case, it is retrievable since your renter is paying those costs for you.


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 Post subject: Re: Am I falling victim to the sunk cost fallacy?
PostPosted: Sat Jun 19, 2010 3:28 pm 

Joined: Mon Jun 07, 2010 8:08 pm
Posts: 22
@DoingHomework - You make good points. Part of the decision to stay in or sell is tax (+ other) related, e.g. it's a

business decision. I also like your point about how the existing mortgage fits in. It is indeed a liability which is

a factor in future credit situations. Obviously renting the place shows $$ on the income side, but most banks consider

it at only 75% because they assume 25% vacancy. In my specific case, the house is certainly down in value but I'm not

underwater on the mortgage, so I'd walk away with some money.

I think where I remain unsure is on the sunk cost fallacy side. Let's say for a minute that we take the tax issues,

deductions, liability issues, etc. out of the equation - we'll just neutralize them and temporarily assume they don't

matter. I can't change what I paid for the house (the cost is sunk) and therefore, whether it's up or down in value,

the sunk cost fallacy says (as you indicated) that I shouldn't consider it as part of the future decision since I can't

change the past. Where I'm confused though is that if I choose to hold and wait, and *if* the market recovers (let's

just assume it does), then I am indeed changing my gain/loss situation. This seems different to me than the example of

the movie ticket example, since the money spent on the ticket can truly never be "recovered". Waiting doesn't change

that fact. But in the house example, your gain/loss situation *could* be changed by waiting.

Thoughts?

@Savarel - I can't possibly predict how many years from break-even because there's no way of knowing the direction of the market. The good news is that even though at the current time I'd take a loss on the house, I am still decently above water on the mortgage.

@Vile Merchant - I did some checking in the area and it appears I will be $300 in the hole each month based on what I can get for rent. I was hoping for even-steven or maybe $100 or $200 positive.

@googoo - Interesting point. I think at the end of the day, the decision is 95% around if I can rent and cover my mortgage (or come out a little on top) each month. If I can do this and also stomach being a landlord, I think it makes sense to keep it.


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 Post subject: Re: Am I falling victim to the sunk cost fallacy?
PostPosted: Sun Jun 20, 2010 8:19 am 
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Joined: Wed Sep 23, 2009 9:01 am
Posts: 5286
I think in theory you could say what you paid for the house is a sunk cost. But in practice it is not. With a movie ticket you can't get your money back no matter what decision you make. With the house you hold an asset and a liability and your decision can affect what you get out of them. But it is an academic distinction. Your decision should be the choice that maximizes present value. Because depreciation and your losses have a value because of taxes they need to be considered.


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 Post subject: Re: Am I falling victim to the sunk cost fallacy?
PostPosted: Mon Jun 21, 2010 11:02 am 

Joined: Fri Sep 12, 2008 12:29 pm
Posts: 1592
Location: Seattle, WA
What you paid for the house is a sunk cost because you can't get that money back. In exchange for that money, you got an asset. That asset could be sold today for money, but you wouldn't getting your money back. You'd be getting new money in exchange for the asset you own. (Add "fungibility of money" to the ignore list.)

If you ignore, as you say, tax considerations and transaction costs etc., then not selling an asset at price $X is the same as buying it at price $X. That's why it doesn't matter what you paid for the place, and the cost is sunk. What you paid in the past doesn't influence what the asset is worth today.


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 Post subject: Re: Am I falling victim to the sunk cost fallacy?
PostPosted: Mon Jun 21, 2010 12:48 pm 
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stannius wrote:
What you paid for the house is a sunk cost because you can't get that money back. In exchange for that money, you got an asset. That asset could be sold today for money, but you wouldn't getting your money back. You'd be getting new money in exchange for the asset you own. (Add "fungibility of money" to the ignore list.)

If you ignore, as you say, tax considerations and transaction costs etc., then not selling an asset at price $X is the same as buying it at price $X. That's why it doesn't matter what you paid for the place, and the cost is sunk. What you paid in the past doesn't influence what the asset is worth today.


Except that, as a business asset, the property can be depreciated to produce income. The depreciation is based on the purchase price. People might quibble that the income you get is non-cash, which is true, but it is income.

"Sunk cost" is not a well defined term so I think that is why it is debatable. In most cases if something is a sunk cost then that means it is ignored for making decisions now. In this case, however, the extra depreciation must be considered to make a sound decision and that does depend on the price paid.


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 Post subject: Re: Am I falling victim to the sunk cost fallacy?
PostPosted: Mon Jun 21, 2010 1:10 pm 

Joined: Fri Sep 12, 2008 12:29 pm
Posts: 1592
Location: Seattle, WA
DoingHomework wrote:
Except that, as a business asset, the property can be depreciated to produce income. The depreciation is based on the purchase price. People might quibble that the income you get is non-cash, which is true, but it is income.

"Sunk cost" is not a well defined term so I think that is why it is debatable. In most cases if something is a sunk cost then that means it is ignored for making decisions now. In this case, however, the extra depreciation must be considered to make a sound decision and that does depend on the price paid.


I agree with you that the number (purchase price) matters, insofar as various tax calculations and whatnot use that number has an input. However the cost does not matter directly when making a decision to sell an asset or keep it and hope the price goes up. It only indirectly affects the decision in that it affects the outputs of those calculations, and said outputs are inputs into the decision.


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 Post subject: Re: Am I falling victim to the sunk cost fallacy?
PostPosted: Tue Jun 22, 2010 12:23 pm 
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Joined: Wed Sep 23, 2009 9:01 am
Posts: 5286
stannius wrote:
DoingHomework wrote:
Except that, as a business asset, the property can be depreciated to produce income. The depreciation is based on the purchase price. People might quibble that the income you get is non-cash, which is true, but it is income.

"Sunk cost" is not a well defined term so I think that is why it is debatable. In most cases if something is a sunk cost then that means it is ignored for making decisions now. In this case, however, the extra depreciation must be considered to make a sound decision and that does depend on the price paid.


I agree with you that the number (purchase price) matters, insofar as various tax calculations and whatnot use that number has an input. However the cost does not matter directly when making a decision to sell an asset or keep it and hope the price goes up. It only indirectly affects the decision in that it affects the outputs of those calculations, and said outputs are inputs into the decision.


I think we are saying roughly the same thing. If you have a rental property you paid $295000 for 3 years ago that is worth $200,000 now then the analysis goes something like this:

Keep it option: Your income is rent+$10,000 in depreciation. Your expenses are PITI+rental expenses. Based on the assumption that rent=PITI+rental expenses this option produces an income of $10,000 a year.

Sell it option: You get nothing, assuming you can sell it for the mortgage balance. You can't take a capital loss because it is a personal residence

Of course there are other things that come into play, and teh purchase price is somewhat like a sunk cost.

A better solution might be to keep it long enough to legally convert it to a business property so that you can take the capital loss.


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 Post subject: Re: Am I falling victim to the sunk cost fallacy?
PostPosted: Fri Jun 25, 2010 3:15 pm 

Joined: Fri Jun 25, 2010 3:06 pm
Posts: 81
I'll make it simple:

If you had the cash and didn't have the house, would you buy it at its current value?


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 Post subject: Re: Am I falling victim to the sunk cost fallacy?
PostPosted: Fri Jun 25, 2010 7:25 pm 
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Joined: Wed Sep 23, 2009 9:01 am
Posts: 5286
nelson wrote:
I'll make it simple:

If you had the cash and didn't have the house, would you buy it at its current value?


No. That is an incorrect method of analysis for a business asset.

Since the OP already holds the asset it has items of financial value embedded in it that do not transfer with title (ongoing depreciation and capital loss rights).

If he had the cash and was considering buying the house he might decide not to because he would only be getting the house if he made the purchase. Instead he actually holds the property rights to the house and the tax rights connected with his ownership of the house and use as a business property.

If you really want to make it simple then the correct statement is:

If you had the cash and didn't have the house, would you buy it at its current value IF THE SELLER THREW IN THE NET PRESENT VALUE OF THE REMAINING MACRS DEPRECIATION AND THE VALUE OF ANY CONTINGENT CAPITAL LOSS TAX DEDUCTION FOR YOUR SPECIFIC SITUATION AND ADJUSTED FOR FUTURE DECISIONS YOU MIGHT MAKE IN HOW YOU TREAT AND MANAGE THE PROPERTY.

I guess it's really not so simple, is it?


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 Post subject: Re: Am I falling victim to the sunk cost fallacy?
PostPosted: Sat Jun 26, 2010 4:22 pm 

Joined: Fri Jun 25, 2010 3:06 pm
Posts: 81
You're over-analyzing. Yes the tax implications have to be taken into account. But at it's most basic level selling the house is really a choice among opportunities. Economists call this opportunity cost. So again, would you rather have the house or the cash? Personally I'd like to hear what howiecamp's plans are with the money if he had it.


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 Post subject: Re: Am I falling victim to the sunk cost fallacy?
PostPosted: Thu Jul 01, 2010 12:07 am 
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Joined: Wed Sep 23, 2009 9:01 am
Posts: 5286
Except those things have real value. If it were a personal asset like a regular house you would be right. But it is not. The conversion to a rental property makes a huge difference.

And, depreciation is NOT an opportunity cost! You need to review your economics. Opportunity costs are about what else you could have done with your cash. Depreciation is a non-cash form of income. Mixing the two is just silly.


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