In today’s real estate market, many homeowners would like to trade-up, but are perplexed with regard to the decision of whether to sell or rent their present home when they purchase their new home. For the past several years, we have seen increasing rents, making the possibility of renting a home potentially a great financial decision.
If you can have someone make your mortgage payment for you, why not continue to build equity in two properties instead of one? In this article, we will look at the considerations which may determine whether it will be a good idea to convert your property into a rental. It is best to consider all of the issues in order to arrive at the best decision possible for your situation.
First, will you make a good landlord? When you rent your property, you now are a landlord. That means you are responsible for coordinating repairs, getting a lease signed and keeping your eye on the property. These tasks become even more difficult if you are moving out of town. If you decide that you would not make a good landlord, this does not mean that renting is not for you. You could list the rental with a real estate agent and hire a property manager. This will lower your cash flow. For many, avoiding becoming a day-to-day landlord is well worth the price.
What will the cash-flow be? If you are overburdened with debt, taking on a new larger mortgage and then facing a cash-flow loss on your present home can be very burdensome to your monthly finances. You need to be realistic in your expectations by reducing the rental income for possible vacancies and maintenance. From there you can subtract the mortgage payment. If the result is positive or a break-even, then renting is not likely to hurt your monthly cash flow.
What are the tax consequences? There is good news and bad news. If you have a monthly negative or a break-even, you can write off the negative including depreciation on your income taxes if your monthly income is not too high. If you are in a 33% tax bracket, you are reducing your negative by one third (a $300 negative becomes $200).
On the other hand, renting your home may cause you to lose your capital gains exemption when you sell your present home. If you purchased your home for $200,000 and sold it today for $300,000, the $100,000 gain would be exempt from taxation, a major benefit of home ownership. But rental properties are not exempt. You can rent for up to two years without losing the exemption. There are other alternatives to avoid capital gains taxes such as a tax-free exchange for another income-producing property or moving back into the home and converting it to the primary residence in the future. It is a good idea to check with an accountant before making the decision whether to become a landlord.
How about the down payment? For many Americans, the equity in their present home is the only way to come up with a down payment on a new home. If you rent the home, you are not going to receive the proceeds from the sale. One option is to obtain a home-equity line on the present home in order to fund the down payment. While this will decrease your cash flow on the rental property, it will lower your mortgage on the new property. Generally, you will come out ahead because you will be able to obtain a better loan on the new property. You can understand that you will get a better rate and/or not have to pay mortgage insurance if you put 20% down versus nothing down. And if you have a good rate on your present home, you will preserve the loan on your present home as well.
Certainly, there are many things to consider before making this decision. However, there is a major benefit that can outweigh all considerations. If home prices continue to appreciate, you will now have two real estate assets increasing in value. These could fund your retirement. If your present home was worth $300,000, ten years of appreciation at 5.0% would be a gain of $195,000. At $600,000 the gain would be twice this amount. Add the fact that you are reducing principal with every payment on two properties and the equity benefit is increased significantly.
