"We plan to move soon, should we turn our primary home into a rental or should we sell it?"
This is a question that comes up often with my clients.
It's usually a situation where they've owned for awhile and have a low interest rate.
The house has appreciated a ton in the past 5-10 years, and now they could rent it out for a profit.
So what do you do?
Unfortunately, it's not as simple as yes or no.
You have to know a few variables:
So many people think they want to own a rental, but then they do and they hate it.
I don’t know very many people who own one rental and are happy with it.
It takes a lot of time (it's another job) and learning to figure out how to best operate a rental.
You have to:
Most either take this learning and do multiple properties, or don’t own any at all.
If you're going to do it, you might as well replicate the learning through more rentals.
Some love owning rentals & others it’s a huge distraction from their job, business, etc.
You have to look at the numbers to see if this is a good decision or not.
Most just say the mortgage and costs are $4,000 and the going rent is $5,000, therefore this is a good decision.
But you also need to consider:
Then actually run it like a business to see if it makes sense.
This is the biggest variable that's often ignored.
If you didn't know, you get a $250k capital gains exclusion on your primary home if single and $500k if married.
So let’s say you are a high income earner like my clients and live in Texas.
Most of my clients pay 20% long term capital gains and 3.8% net investment tax.
If they sold a property that had a cost basis of $1,000,000 for $1,500,000 then they would have a $500k capital gain.
This would lead to no taxes if they sold vs. turned into a rental
$500k x 23.8 % = $119,000 tax savings
If they chose to turn it into a rental and did not sell within a few years, they would have to recoup this $119,000 tax savings. It would take a lot of cash flow and appreciation to offset this.
Most times rentals are best with little equity.
Why?
Because if you have $100k equity and $20k cash flow, that is a 20% return.
If you have $500k equity in the property and $20k cash flow, that is a 4% return.
Leverage is a huge reason rentals can be so great. Many times, people would be better off selling the property and taking that equity & using it for 2-3 properties with lower equity. However, if you have very little equity, then turning it into a rental property can be better as you are not missing out on the capital gains exclusion.
You also need to think about how you're going to afford the down payment on the next house.
Most people take the equity from their primary home and use it to fund the down payment.
If you don't sell, then you need to get to 20% down for the next jumbo mortgage which would require lots of savings.
Make sure you plan for this.
At the end of the day, it's a big decision.
You just need to look at all the variables and make the best decision for you.
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Financial Advisor