Should You Rent Out Your Home or Sell It?
Some people choose to become landlords rather than sell their homes. Could this make sense for you?
Four months ago, Darleen Burbridge, a 41-year-old hotel office manager from Staten Island, N.Y., was laid off. Now, after fruitlessly pounding the pavement for the past few months, she's decided to relocate to Florida. She figures that Florida offers better job opportunities in the hotel industry, a more affordable standard of living and -- let's face it -- better weather.
But one question remains: Should she sell her two-family suburban home or rent it out?
"I don't know what's better financially," she says. "Should I sell and take the profit and run? What if I go to Florida, hate it and come back? I won't have a house. I've heard horror stories about people who sell their home when they move, then come back and can't even afford an apartment." In her case, the stakes are high: The home she bought just three years ago for $235,000 is now worth an estimated $425,000. Selling now will lock in her sizeable gains, but could price her out of the market if she returns in a year or two.
Burbridge's situation isn't unique. As many as 5,373 Americans move every day, according to the U.S. Census Bureau. And these days, given the weak labor market, many are moving to find jobs. According to a survey by the career Web site Monster.com, almost half of U.S. job seekers were willing to reallocate for employment.
Of course, in most cases, moving means selling one's home -- after all, it's usually a necessary step in affording a new home. But for various reasons some people choose to rent out their homes instead. In some instances, people know that they'll be leaving only for a year or two -- perhaps while they pursue a graduate degree or take on a specific project at work. Sometimes the would-be seller simply can't sell at a price deemed acceptable, so he or she chooses to hang on until the market picks up. A more likely scenario these days, however, is that the owner wants to hang on while property values continue to soar. Others just want to keep their old home until they're confident they won't be coming back.
Whatever the reason, it's important to have a healthy grasp of the financial issues at play when weighing this decision. Here's what you need to consider.
The Tax Issues When You Sell
As you probably know, Uncle Sam provides a generous tax break for those who've lived in their home for at least two of the past five years. Married couples who file jointly can earn up to $500,000 in capital gains tax-free, while singles can enjoy $250,000 in tax-free gains.
Good news: Those who are planning on renting out their home for just a year or two will still be eligible for these breaks (provided they've lived in their home for at least two of the past five years). Should they sell more than three years later, however, they forego the tax exemption, meaning their gain would be taxed as a capital gain. (Thanks to the Bush tax cut, long-term capital gains are now taxed at a maximum rate of 15%.) "Once you start renting, the clock starts ticking on these two out of five years," says Robert Weinberg, a certified public accountant (CPA) in Orange County, Calif.
Consequently, for those whose renting plans would turn a tax-free gain into a taxable one, the general advice is to sell. "The rule of thumb is, if you have a large gain on your personal residence, you don't want to rent it out," says Benjamin Tobias, a CPA and president of Tobias Financial Advisors in Fort Lauderdale, Fla. "You never want to take a house that you're not going to have to pay tax on and convert it into rental property and pay tax on the gain. That's insane. It's like taking money and throwing it in the garbage can." One solution to this problem: If you're willing to move back into the house and live there for two years before you sell, you'll requalify for the exemption.
The Tax Issues When You Rent Out
Becoming a landlord also offers some handsome tax perks. While rental income is taxed as ordinary income, your tax bill could easily be eliminated thanks to the numerous deductions on expenses and depreciation. There is, however, one major exception: If you eventually sell the house and qualify for the capital-gains tax exemption discussed earlier, you'll be taxed on the amount you depreciate, which could make renting out your home considerably less attractive.
Let's talk expenses first. You can deduct pretty much any out-of-pocket expenses related to owning and managing the property, Weinberg says. This includes your mortgage interest payments and property taxes (same as if this were your primary residence). It also includes other expenses, including advertising or broker fees, the costs of repairs to the property, maintenance expenses such as cleaning services, utilities and management company fees, the cost of fire and liability insurance, and even travel and local transportation expenses incurred for the maintenance of the property and collection of rent.
Then there's the "phantom deduction" called depreciation. Just divide the fair market value of the property at the time you start renting it out (excluding the cost of land) by its recovery period -- which is 27.5 years for residential rental property. Bingo! There's your annual depreciation. For example, if the home is worth $550,000, you divide that by 27.5 and get a $20,000 annual deduction. "The depreciation deduction will cover a lot of the (rental) income you're receiving, so it's a nice tax shelter," says Jeff Callahan, a CPA with Bederson & Co. in West Orange, N.J. "If you have another $10,000 in out-of-pocket expenses, which are also deductible, you can get $30,000 in rent tax-free," he says.
Improvements can't be deducted, but you recover their cost by depreciation. The good news is, you typically depreciate the cost of any appliances, carpeting, furniture or plumbing over only five years, says CPA Weinberg. So if you bought a new $1,000 dishwasher for your rental, you can deduct $200 a year from your rental income for five years. (This is pretty complicated stuff, so be sure to talk with a CPA before you file your tax returns.)
- Keep property as it appreciates
- Tax-breaks could offset income tax on rent
- Rent income covers mortgage, taxes and insurance payments
- Possible damages to property
- Could be taxed on the whole profit if you sell
- Potential legal or financial problems with tenants
- Likely tax-free capital gain
- Frees up equity that could be invested or rolled into new home
- Simplicity: Only one house to maintain
- Could be priced out of market if you want to return
- Lose potential property appreciation
- Could have to sell at a bad time for real-estate market in your area
Can You Afford to Rent?
For many homeowners, renting out a home is simply not a viable option; they need to sell in order to raise the capital necessary to buy their next home. And owning two homes requires deep cash reserves, says Karl Romero, a certified financial planner (CFP) with LPL Financial Services in Santa Ana, Calif. "What kind of discretionary income do you have to carry the home when you don't have a renter for a while?" he asks. What if a tenant skips one or two months of rent -- will you be able to make the mortgage payments anyway? Uncertainties like these could be risky for a moderate-income family, he says.
There's also the risk that a tenant could damage your property or cause problems that lead to an expensive eviction process. Frighteningly, an eviction could cost you anywhere from $2,000 to $5,000 and could last as long as 18 months, during which time the tenant is likely to refuse to pay rent, says Janet Portman, a Berkeley, Calif.-based lawyer with expertise in residential and commercial leasing. So you need to be financially prepared for the worst.
Is the House Likely to Appreciate?
If you expect prices in your area to soar markedly over a three-year time span, you may want to rent it out, says Tobias. But keep in mind that, historically speaking, real estate tends to appreciate at the rate of inflation (roughly 3% annually), so even if property values have risen in your neighborhood during the past few years, that doesn't mean they'll continue to do so.
Look at the house as an investment and think of it as part of your overall portfolio. Ask yourself: Are you diversified enough? If the majority of your net worth would be tied up in your two houses, you need more diversification, and you could be better off selling the house and investing the profit, Tobias says.
Is It a Hot Rental Market or a Hot Sales Market?
Sometimes the market is better for sellers than for landlords, notes Barbara Steinmetz, a CFP and real-estate broker in Burlingame, Calif. Call your local board of realtors or a real-estate agent and have them appraise the house -- get the numbers for the rental and the number for the sale, she says. Generally speaking, it will make sense to rent the house out only if it's in a relatively stable market and the income from rent will cover your mortgage and other related expenses.
Do You Ever Plan to Come Back to the Same Area?
If you want to return to the same area years from now, you could be priced out of the market if you sell your house. It would therefore make sense to rent it out.
Strangers in Your Home
For Steinmetz, one of the most important issues is how you feel about the property. If you're very attached to it, then you might "feel like (the tenants) are invading your space," she says. "It's very hard to rent out a home and come back to it to find out someone has trashed it." This may be especially true if you leave your furniture behind. "You have to take off the personal hat and remember this is now a business," she says.
Are You Cut Out to Be a Landlord?
Becoming a landlord isn't for the faint of heart, Steinmetz says. "What happens if a pipe breaks out and you're out of state?" she asks. Being an absentee landlord is impossibly difficult unless you have someone to oversee the property. If you're willing to part with 10% of the monthly rent, you could hire a property-management company to do it. Depending on your agreement, it could take care of everything related to the property -- from putting it on the market and screening your tenants to collecting rent, maintaining the property and even taking care of your mortgage.
Should you decide to seek the services of a management company, go through your local chapter of the National Association for Residential Property Managers, which represents managers of single-family homes, or your city's Apartment Owners Association if you own an apartment.