Most people buy a “starter” home, which is typically smaller home or even condo. At the time they do, their income is likely less, they have a small family or have not started a family yet. Eventually, they “upgrade” whether because of wanting a bigger better home, or due to a growing family. Provided they do not need the equity of the starter home for the new home purchase, the decision then becomes what to do with the starter home, whether to sell or rent it out for income.
The following is a real analysis I did for a friend, but name and numbers changed up for the sake of anonymity. I will also highlight some common psychological bias that I saw.
Jack and Jill are a married couple. They bought the home for $250K with $50K down payment and due to market appreciation, it’s now worth $400K. They moved into a bigger home and wanted to rent this home out. Jill did some analysis and feels that the property can cash flow $4.5K annually. In the analysis, Jill only took into account what she expected (standard expenses, mortgage, property tax, insurance) and not what may happen (major things breaking down, vacancy tenant, evictions, etc.), which is a common mistake, but I will overlook this for now and assume the $4500 cash flow. In Jill’s mind, she is not losing any money, even in a downturn the property value will eventually recover, she is positive cash flow, she did not want to sell and wants to hold the property for years and even pass it onto her children.
When Jack and Jill ran this by me, I felt it was a “no-brainer” sell decision. Jack was on board. They eventually sold, but still to this day, Jill has some regrets. Here are my points:
- Section 121 exclusion, namely that if you live in the property 2 of the last 5 years, up to $250K capital gains per person, and $500K for married filing jointly, is tax free. If continued to rent out, this is lost. The best replacement is a 1031 exchange which is tax deferred. Always take free rather than deferred (there is a strategy that you keep deferring until you die where your beneficiaries gets a stepped up basis, and in that situation it becomes tax free, but this is complicated…and also you are dead). My advice was to take the tax free gains now. Assume the $150K capital gains with 25% tax (Fed + state estimated), that’s $37,500 otherwise lost to taxes. You must then take into account the opportunity cost if that $37,500 was invested.
- While Jill kept focusing on the $250K which they bought it for, I kept focusing on the $400K that it’s worth. It’s easy to get lulled into “this is what I paid for it”. However, if sold, that is additional equity that can be invested. Hence the calculation is ROE “return on equity” is a better measure than ROI “return on investment”. She focused that her ROI would be 9% based on $4500 / $50K down payment. But in reality, her ROE is 3% based on $4500 / $150K equity. At the time, the 10 year treasury bond was paying at 2% hardly making the rental worth it.
- I’m just going to add in that Jill did not do the analysis correctly. The longer she holds the property, the more of the big “gotchas” she did not account for may happen, such as a plumbing leak or a “professional tenant”. Each of these can easily eat up an entire year or more of return.
I recommended that if she really wants a rental, that she should sell, take the tax free capital gains, and re-buy a similar property. There’re some downsides to this, including the property tax will reset at the market level, fees associated with buying/selling, and possibly higher interest rate because the lender will classify as investment rather than personal (although it just happens at this time, interest rate reached the lowest it ever was, so I did not think this was a factor). However, even with the down sides, there’s some upsides, namely, she resets her basis to be depreciated. But outweighing everything it is very hard to overcome the $37,500 that she would lose.
Jill did not want to do this. Psychologically, since Jill already owned the property, it makes sense for her to rent it out, versus going out and buying a property to rent out. From an investment perspective, the 2 are essentially identical however. The difference is psychological bias. They ended up selling and reinvested the proceeds into something else.
This decision is effectively a case by case financial decision and there is no simple answer. It depends on market factors along with individual tax situations. Again, if you need to sell because you need the equity in the old home to pay the new, that’s not what I’m referring to. However if you were thinking of renting your old home out, but there’s significant unrealized capital gains, then that’s the time you may need to consider whether it’s better to sell.
