Remote working and the global pandemic have caused people to re-think where they want to live. For many in dense urban communities, the possibility of moving to a vacation community or a more isolated area may be appealing. If they own a home in the city, they may be wondering if they should sell that home or keep it as a rental. In order to make an informed decision here are a few things to consider. This article is strictly meant to be thought provoking and should not in any way be considered legal advice.
Can you afford to keep the home? This is often the foremost question to consider. If you’ve built equity, do you need to cash in on the equity by selling your home for a down payment on a new home? Also, if you are buying another home, can you qualify for a mortgage without selling the home you currently own? Even if you are not buying another home you should ask yourself if the rental income will cover the mortgage, maintenance, and management costs of the home as a rental.
Will you self-manage the property? One important decision you will need to make is whether or not you will hire a management company. A management company may greatly reduce the time, energy, and liability you incur as opposed to managing the property yourself. The management company will prepare the legal documents between you and the renter, collect the rents and deposits, coordinate maintenance, run background checks, and may even assist in the unfortunate need for eviction proceedings. In return for these and other services, you will need to pay the management company a fee. Commonly it is a percentage of the rental income and this should be factored into your operating expenses.
Are you ready for the risk? Every investment includes the element of risk and reward; real estate is no different. Thoughtful research of the rental rates, vacancy rates, and property appreciation rates should be taken into consideration.
On one hand, a well-performing rental property will have positive cash flow each month, ideally, the value of the property will appreciate over time, and the principal balance of the mortgage (if one exists) will decrease, thusly increasing the overall value of the investment. This is a great scenario. On the other hand, decreasing rental rates, declining property values, and vacancy can quickly become a financial burden. Ask yourself if you are prepared for such an event.
What is your tax situation? There may be tax benefits to consider such as capital gains taxes when renting. Generally speaking, if you’ve lived in your home and it’s been your primary residence for 2 of the last 5 years, you can take up to $250,000 if you are single (or $500,000 for a married couple filing jointly) of gain tax-free when you sell the home. If you have more gain and are using the property as an investment property at the time that you sell it, you may be able to use a 1031 exchange and defer the tax on the gain over and above the $250,000 (or $500,000). This can be important in appreciating real estate markets where you speculate the property will continue to go up in value. There are many other tax factors to consider, so for best practice always consult with a professional.
The overall mindset of anyone who considers becoming a landlord should be; take care and caution. Consult your real estate, tax, and legal advisors. Your initial due diligence will pay big dividends for years to come and the next time you’re faced with the same big decision you’ll be armed with knowledge.
A related issue is a question of how much time you must own a rental property purchased as a 1031 exchange replacement property -perhaps that home in the mountains – before you can move into it. We’ll address this issue in our newsletter next month.