Sell or Rent: Deciding What to do With Your Home

The decision on whether to sell or rent your home is trickier than other financial decisions because of the emotional ties. To make the best decision possible, evaluate the income, growth, and tax advantages of selling vs. renting and how it would advance your long-term goals.

Income

Rental income can be a good source of retirement income—as long as the numbers work. One advantage of rental income is that it generally rises with inflation. However, the ability to raise rents varies with supply and demand in the local area, which may change during the ownership period.

Suppose you are keeping the house for income. In that case, you will need to do a market analysis to determine the appropriate amount of rent to charge. You will also need to fully understand ownership costs (maintenance, repairs, insurance, and so forth) to determine your net cash flow. Consultation with real estate agents and CPAs may be necessary.

Numerous online calculators can help you decide if your home is the best source of income or if you could do better with another investment. Most calculators will ask you for the expected monthly rent, ownership costs (taxes, capital improvements, and monthly maintenance costs), and the likely sale price of the home to calculate the "capitalization rate," which you can then compare with the rate on long-term Treasuries.

If the cap rate is higher than the current rate on Treasuries, keeping the home as a rental is a good deal; if not, it's not. Ensure you are not forcing the numbers to work by assuming too-high rent or too-low expenses. Accurate assumptions are crucial to understanding the investment merits of the deal. Ultimately, the sell-versus-rent decision will hinge on the ratio of rents to prices in your neighborhood. Low rents and high home prices do not bode if you're considering leveraging your equity for an ongoing income stream.

In addition to the ratio of rents to prices, you need to understand the tax rules pertaining to income property. Rental income is taxable; however, the following expenses are deductible from rental income on Schedule E of Form 1040:

• Real estate taxes
• Management expenses
• Maintenance expenses
• Traveling expenses to look after the property
• Legal expenses
• Mortgage interest
• Insurance premiums
• Depreciation of the building (not the land) based on a 27½-year recovery period
• Depreciation of furniture, carpeting, and appliances based on a five-year recovery period

These tax breaks make the deal more attractive than you had anticipated. On the other hand, the above list may make you aware of expenses you have yet to consider when calculating net cash flow. If you are investing for income, you need to be realistic about how much that net income will be.

Temporary Rental

If you are still determining if the relocation will be permanent and you want the option of moving back into the home, renting it out for some time may be a good solution. However, you should keep an eye on the calendar and, if you sell, do it within three years to qualify for the $250,000 / $500,000 capital gains tax exclusion. According to the rules, even if a home has been converted to a rental, sellers can qualify for the capital gains tax exclusion if they've lived in the home as a principal residence for two out of the five years preceding the sale. Be sure you allow enough time to get the house on the market, sold, and closed before the three-year window closes.

Leaving It to Heirs

As more young people get priced out of the housing market, you may want to keep your home for your children and grandchildren, renting it to the kids or unrelated tenants; this is also an excellent tax-planning strategy because your heirs will receive a step-up in basis when they inherit the property. Remember, if you rent the house to family members at below-market rates, you may only deduct expenses to the extent of the actual rent received (i.e., you can't claim excess losses).

Analyzing the investment merits of a principal residence converted to a rental property is slightly trickier than any other investment because of your emotional connection to the property. You've enjoyed living in the home, made money on the home, and now want to keep the home as an investment. But as with any investment, you must evaluate the house based on its economic merits in light of your personal objectives and considering the property's prospects for income, growth, and/or tax advantages.

Work With Clayton Financial Group

At Clayton Financial Group, we help our clients achieve their plans for life and take their growth and security seriously. We are an independent boutique advisory firm with national coverage and decades of industry experience. If you're looking for help with investment planning, tax planning, risk management, estate planning, and more, look no further: let's connect today.