Question: I am debating whether to sell my home or hold onto it as a rental property, do you have any advice?
Answer: With so many homeowners locked into low long-term interest rates and the rental market exploding, the number of homeowners who are considering renting instead of selling their primary residence has increased significantly. It’s one of the factors that has led to such low inventory levels over the past 18 months (and the resulting price surge this year). For those of you in the fortunate position to make a decision between selling or renting your primary residence, this week I’ll share some tips and reminders.
Do Not Forget About the Capital Gains Tax Exemption
You are exempt from paying taxes on up to $250,000 in capital gains for individual filers and $500,000 for spouses filing jointly if the property has been your primary residence for at least two of the previous five years prior to the sale. In simple terms, assuming you’ve lived in your home for at least two years, if you decide to rent it for more than three years, you lose your capital gains tax exemption (it must be sold/closed within three years of you moving out).
Capital gains is calculated based on the amount you sell your home for less what you purchased it for less any transaction costs and capital improvements during your ownership. It is not based on your mortgage balance at the time of sale.
For those with significant capital gains, this exemption is worth a lot of money so in a rent vs sell decision, you want to make sure that if you decide to rent, you are renting for long enough to generate enough value to offset what you’re giving up in capital gains tax benefit (aka don’t give up your tax exemption and rent for five years). I usually do not advise renting for just a couple of years and then selling before the three-year mark because there’s risk, cost, and effort involved in renting that probably is not worth two years of rental value and speculation on the appreciation.
A 1031 Exchange is not the Same as the Capital Gains Exemption
A lot of people confuse the concept of the capital gains tax exemptions with a 1031 exchange. The capital gains exemption is a full tax exemption on gains on the sale of a primary residence (up to $250k/$500k), while a 1031 exchange is the deferment of tax payment on the sale of an investment property if the proceeds of that sale are used towards the purchase of another “like-kind” investment property (along with other requirements being met). A 1031 exchange does not apply to any sale or purchase involving a primary residence.
If you decide to turn your primary residence into a rental (investment) property and forego the capital gains exemption, it can qualify for a 1031 exchange if/when you sell it if you roll the proceeds into another investment property. However, be very careful to understand the requirements of a 1031 exchange before you set a plan in place to use this IRS tax code.
Questions to Ask Yourself
There are a serious of questions and thought exercises I have clients do when they’re making the rent vs sell decision and I’ll share some of them here:
- What will you do with the equity/proceeds from the sale? If you are using it to buy a long-term primary residence or significantly improve your life (e.g. early retirement), selling makes good sense. If you will simply invest the money, the decision is mostly a comparison of two different investment vehicles/assets.
- What does the rest of your investment portfolio look like, and will it benefit from the diversification of a real estate asset? Real estate assets are somewhat unique in that they can create income and price growth (appreciation) at once, sort of like a growth stock with good dividends, which is a unicorn in the investment world.
- Will you manage the property yourself (receive calls from tenants and act quickly to address issues) or will you hire a property manager (expect to pay them 6-10% of the monthly rent)? If you will live locally, self-management may be a safe decision. If you are out of state/country, travel a lot, don’t have the time for management issues, etc then a PM is likely necessary. “Boots on the ground” that you trust, near your investment property, is necessary.
- Take full inventory of the costs, financial and your time/energy, that come with a real estate investments that do not come with owning most other financial assets (e.g. index funds). Are there significant updates coming due (roof, HVAC, appliances, etc) that you need to budget for? A friend of mine, who you may recognize from the Arlington real estate market, Matt Leighton, recently texted me “Don’t let anybody tell you Airbnb in passive income.” He is 100% correct, there is nothing passive about owning real estate (long-term rental properties and especially Airbnb) unless you pay handsomely for everything to be managed for you. FYI, Matt does excellent videos and for those interested, here’s one he did about his experience owning an Airbnb.
- Will you realize any tax benefits from an investment property (review with your CPA)?
Everybody’s situation is different and other key factors need to be considered in the rent vs sell decision, but I find that the tips and questions above give most people what they need to make a sound, thoughtful decision.
If you’d like to discuss buying, selling, investing, or renting, don’t hesitate to reach out to me at [email protected].
If you’d like a question answered in my weekly column or to discuss buying, selling, renting, or investing, please send an email to [email protected]. To read any of my older posts, visit the blog section of my website at EliResidential.com. Call me directly at (703) 539-2529.
Video summaries of some articles can be found on YouTube on the Eli Residential channel.
Eli Tucker is a licensed Realtor in Virginia, Washington DC, and Maryland with RLAH @properties, 4040 N Fairfax Dr #10C Arlington VA 22203. (703) 390-9460.
