Better to sell or rent out your house?

Is your low interest rate loan really worth losing out on $500,000 of tax free profit from a sale? How much money are you leaving on the table in your quest to have a second “investment” property? Don’t miss the 4 basics every real estate investor should know.
Is it better to Sell or Rent out  my house?

This is the number one question on homeowner’s minds these days. With interest rates at double what they were last year and prices down from their peak homeowners are trying to decide whether to sell their house now or turn their house into a rental. 

Keeping a house means keeping a low interest rate in place but if the house is rented for too long, it may mean losing out on $500,000 in tax free profit. So how do you know what you should do?

You will want to talk to your accountant and when you do, make sure to ask about these 4 considerations:
  • The Section 121 exclusion
  • The Value of your low interest rate
  • The Profitability of your rental
  • Your Special Circumstances


Section 121 Exclusion

Let’s dig into each starting with the section 121 exclusion. A married couple can receive $500,000 of profit from a home sale tax free is they’ve lived in the house for 2 out of the last 5 years before selling.  So how much tax savings are we talking about? Depending on your other income and tax situation a $500,000 section 121 exclusion for a married couple may save between $120,000 and $180,000 in taxes.  So if you are thinking of renting your house out for 3 years or more you may lose that tax break.
Interest Rate

What about your amazingly low interest rate? If you sold your house you would lose that but what is it worth? Well if you are locked in at 3% you are paying 30% less each month than your neighbor with the same loan at an interest rate of 6%.  You are saving money each year but not nearly as much as you would gain from the section  121 tax break we talked about. As an example, a person with a $1,000,000 loan at 6% pays about $72,000 a year. The same loan at 3% costs $50,000. So it appears renting your house out and being a landlord would sort of save you $22,000 a year. Here is the catch. If you were to enjoy that benefit for 3 years that would amount to $66,000 in savings. Except as soon as you rented it out more than 3 years, you would no longer qualify for the section 121 exclusion and pay $120,000 to $180,000 more in taxes when you sold. So you lose out. Talk to your accountant about this more.

But Rent is so High

What if you are getting amazing rent on your house!  Shouldn’t you keep your house as a rental? Maybe. You’ll need to  determine if the rent you get is truly good  when compared to the market value of the house. One quick way is through calculating the Gross Rent Multiplier.  Just divide the market price of the house by the monthly rent. A Lower number is better. For example a $1,000,000 house renting for $4000 a month is a GRM of 250. That’s better than many rentals in San Diego but still much less profitable than investment properties in other cities. A GRM of 175 or lower generates enough cashflow to pay off housing bills including a regular loan,  a GRM of 175 performs more like other income producing investments. While on the other hand a GRM near 300 costs you money monthly (either out of your pocket for mortgage or in a lack of return on the equity sitting in the house. ) Remember that you can lose money on a rental and not know it! If you inherited a free $1,000,000 house that was only collecting $1,000 a month in rent, you could possibly just cover your bills because you would have no loan to pay.  However you may be losing $40,000 a year in lost opportunity costs because putting the $1M in a investment account could easily earning 4% each year. (at a lower risk)
So if so many rental properties lose money monthly why do people invest in them? Because they are gambling on appreciation which until April 2022 had amazing payoffs of up to 10 times more than an average year.  From 2019 to April 2022 house prices boomed irrationally. They went up so fast that the home value increase far outpaced monthly losses to operate.  However that boom has stopped leaving landlords stuck with a longterm investment, waiting for house prices to go back up while losing cash or opportunity costs while they wait. So does that mean renting out your house is a bad idea? Not necessarily.

Special Circumstances

Let’s talk about the fourth consideration: special circumstances. They fall into two groups, personal reasons and financial reasons. Let’s start with personal reasons. Maybe you want to try living somewhere else and want to keep your house as a backup just in case you decide to move back. Maybe you want to keep your house for a family member.  Both are excellent personal reasons to keep your house. The second group are financial reasons.  Maybe you want to rent out your place for a year until you retire at which time you’ll be in a lower tax bracket for any longterm gain from the sale.  Maybe you think you can make more money by renting your house out as an Air Bed-n- Breakfast and your house is in the perfect spot for renting short term. These and other financial reasons may mean it is worth it to possibly loose the section 121 exemption. 
To sum things up: 
Talk to your accountant about the section 121 exemption, discuss the balance amount and interest rate on your loan, calculate the profitability of your house as a rental  and consider special circumstances. Let me know if you’d like to get together to frame your questions. I’m glad to help.

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