Ready To Move, But Not To Sell
As the real estate market slowly begins to turn the corner, many prospective sellers face the question of whether to accept today’s lower prices or hold out for a more robust market. And many are weighing the pros and cons of turning their home into rental property as they wait out the recovery.
Whether moving for a job opportunity, to upsize, downsize or retire to a more pleasing climate, homeowners who are ready to move face a challenging real estate market. Many who bought at the top of the market must deal with the specter of owing more than their home is now worth, while others may find today’s deflated prices unacceptable and sense the market is poised for an upswing. Those who have already moved on to a new home prior to selling may face the prospect of carrying their previous home and all of its costs indefinitely.
Given this changing real estate dynamic, many homeowners are weighing the pros and cons of renting rather than selling their properties. But the decision to sell or rent is not simple and should include an examination of tax considerations and cash flow issues, as well as personal and financial expectations.
The Accidental Landlord
Homeowners who choose to rent out their homes rather than sell, or are pressed into it out of necessity, join the ranks of what some call “accidental landlords.” Many homeowners squeezed by the collapse of the real estate market have found that postponing the sale of a previous home by turning it into rental property can very quickly eliminate an array of problems, such as:
• The possibility of selling at a loss.
• Having a property languish on the market indefinitely.
• Cash flow issues that may arise if two mortgages are involved.
• The stress of anxiously waiting for an offer.
Additionally, landlord status may also offer:
• Tax advantages including deduction of mortgage interest and real estate taxes as well as expenses and depreciation that can offset rental income, depending on your particular situation.
• The ability to continue to build equity if a mortgage is involved.
• Time to wait out the market until prices rebound and sales improve.
Waiting Has Its Drawbacks
While becoming a landlord may solve a host of problems, there are some serious issues–both financial and personal that should be carefully considered such as:
• Losing the capital gains tax exclusion. Married couples filing jointly qualify for a $500,000 capital gains exclusion on their primary residence, as long as they live in the house for two of the previous five years. If the rental period lasts for more than three years, this tax benefit may be forfeited.1
• Depreciation will become taxable. If the capital gains tax exclusion is claimed following the property sale, any depreciation used to offset taxes on rental income will become taxable, thereby reducing the exclusion amount.
• Potential problems with tenants. Landlords often find themselves dealing with damage to property, legal issues or failure to pay issues that can result in a lengthy and expensive eviction process.
• Lack of diversification. Carrying two homes may result in an overall financial portfolio that is significantly overweight in real estate. Assets tied up in a former residence that is converted into rental property may be more wisely redirected into investments with a potentially higher rate of return.
Additionally, potential landlords should seriously consider the following questions:
• Is a potential appreciation rate of 3% to 5% per year over the next three years meaningful enough to make renting a viable option?
• Is the rental market strong enough to allow for a rent that will cover all carrying costs?
Reaching a decision on whether to sell or rent should be the result of a thorough examination of financial, tax and personal considerations. The advice of a real estate professional as well as a trusted financial advisor can help you reach the right decision for your particular situation. Please contact me if you would like to explore the pros and cons in greater detail.
Sources: 1 IRS, Publication 523, “Excluding the Gain,” p. 10, 2013. (http://www.irs.gov/pub/irs-pdf/p523.pdf)
If you’d like to learn more, please contact Irene F. Stolarz.
Article by McGraw Hill and provided courtesy of Morgan Stanley Financial Advisor.
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