Renting or selling the rental property

[Nords]

For all our inner engineers, here's a real-world rent vs sell question with lots of numbers. I'd appreciate a critique of my logic and my math.

A couple months ago spouse and I spent 26 consecutive days rehabbing our rental. We juggled three contractors and did our own HGTV "Groundbreakers" yardwork so it was great exercise but not much fun. For the last five years it's been rented to my parents-in-law, who we thought would be living in it for the rest of their lives-- our long-term care gift. I expected to depreciate it for two more decades and we may still do that. However now that the PILs have returned to the Mainland the property has essentially been dropped back into our laps. It was never part of our ER planning, and it's slowly dawned on me that we've won the real estate lottery.

I wasn't very interested in landlording strangers again, but the same rehab effort (yardwork, ceilings, carpeting) would have been necessary for seller's curb appeal. Tenants just dropped into our laps, too (federal GS-12, shipmate of shipmates) and they signed a year's lease. At Hawaii's home prices I doubt they're moving.

Spouse's attitude was "There now (pat pat), that wasn't so bad, was it?" while my reaction has been "Run away fast!" However the decision is in abeyance for the lease so now I have plenty of time to figure out exactly what our cash-on-cash return is and what our after-tax profit would be.

Help me make sure that I have the math right. I've been reading IRS Pubs 527 (rental property, http://www.irs.gov/pub/irs-pdf/p527.pdf) & 544 (asset sales, http://www.irs.gov/pub/irs-pdf/p544.pdf), and punching numbers into TurboTax.

We bought the property in 1989 for $277K (with a huge mortgage and a dumpster of sweat equity). While we were living in it we pumped in another $82K (including closing costs, refinancing, & house/landscaping improvements) to raise the basis of the land & house to $359K. I've kept receipts and tracked that number in Quicken so it's solid.

We depreciated the house (not the land!) on 27.5-year MACRS at the basis of fair market value-- $152K from the tax assessment. So far we've depreciated $52K.

The neighborhood's prices are obscene-- it's assessed at $628K. In round numbers a FSBO would fetch about $700K after closing costs. Our cap gains would be $700K - $359K = $341K. In addition we'd have $52K of depreciation to pay recapture taxes on.

Let's assume that before we sold the house we were already at the top of the 15% income-tax bracket. (I'm not sure it's relevant but with our Roth IRA conversions that's usually the case.) If I'm correct on the tax rates, we'd owe cap gains taxes of 15% on $341K and 25% on $52k, so our total tax bill would be $64,150 (call it $65K).

We have a mortgage balance of $135K, so after taxes we'd walk away with $700K - $65K - $135K = $500K. I'd call that our equity.

The neighborhood's rent is also obscene, $2800/month, and our carrying costs are typically $1300/month. (That's mortgage, excise taxes, property taxes, income taxes, and $850/year for maintenance & repairs.) So our net is $1500/month or $18K/year. Dividing that into our cash in the house ($359K-$135K) is a cash-on-cash return of 8%. Dividing it into our equity is only 3.6%, which we can beat with just about any long-term after-tax CD rates.

After 18 years our net profit is $500K - $359K = $141K, or about 1.9%/year. We bought at the top of the market and watched it go through a decade of bear before it's come back up to its current value. Although there wasn't much annual capital gain, we'd also have to factor in all the rent profits ("dividends") over the years.

Ironically we could move back into it for a couple years before selling and avoid $52K of taxes on the $341K. Our opportunity costs (lost rent receipts) would be more than that, we'd have to rent out our dream house, and moving would be a colossal hassle that would never meet with spouse approval. In other words you couldn't pay her $52K to go through that for two years & two moves.

This decision has an emotional as well as a financial aspect. We did start our family there. We never really wanted to be landlords but during a mid-1990s military transfer it was "easier" than trying to sell into a depressed market. When we bought our dream house a few years later it was "easier" to rent out the old one than to sell it. A few months after that spouse's parents called and ended any thoughts of selling... until now. However there's still the question of "saving the property" for the next generation, who's at least 10 years away from being able to avail herself of that opportunity. Even then I doubt she'd want to be living in the house she grew up in, especially if she can [-]get her own life[/-] find her own place. I wouldn't want to just hand her a house and rob her of her own sweat-equity experience!

The last 18 years have been a real testament to leverage & sweat equity. If loans weren't so cheap and credit so easy to get then we never would have become landlords. I have no desire to expand our empire, either, and personally I can cash out with no regrets. If we wanted to "save" something for our kid then I think TIPS or I bonds would do just as well as real estate, to say nothing of a small-cap value equity index or an international REIT.

Am I missing anything on the numbers, tax rates, or depreciation recapture?

I'm clueless on AMT-- is there anything here that would trigger it?

 

[brewer12345]

I would imagine that the big cap gain might well trigger AMT, but the only way to be sure would be to plug the numbers into turbotax and see what it says.

 

[hellbender]

I'm on my way out of town and can't do your post justice at this time, but at first blush you may have a problem with the way you depreciated the property. You depreciate your actual basis (less land value) not the fair market value. You appear not to have claimed the depreciation you should have.

Did your PILs pay anywhere near full market rent for the premises? If not you may have another potential problem.

AMT liability is a definite possibility that should not be underestimated. It can run into thousands.

More later . . .

 

[TromboneAl]

I think you've already decided to sell it, and that's what I'd do.

Even if your above estimates are off by $100,000, it's a slam dunk to sell it. Take pictures of it for memories. As you say, DD is not gonna want to move into a house that her Daddy bought her.

Sell the house and spend more time surfing; spend more time with the bunny; spend more time not cutting back brush.

 

[brewer12345]

spend more time not cutting back brush.

But its such a Presidential activity...

 

[hellbender]

Sell

There is really insufficient info to put together a reasonable proforma for this property, but it is hardly necessary. based only upon the ratio of the property value to the market rents, this thing is a pass. Like many high cost areas, the income generating prospects are poor compared to the value. The only way to realize a good return on investment is to play the appreciation game. This is always a speculation but even more so these days.

As I mentioned before, you may have some tax issues related to whether or not the property was properly depreciated and whether or not there is any possibility that the IRS will view your activities as "not for profit" based on renting at below-market rates to relatives.


AMT might be an issue. See: AMT and Long-Term Capital Gain
One way to get a handle on this is to pump your anticipated 2007 tax figures into the 2006 version of TurboTax.

 

[Sam]

So our net is $1500/month or $18K/year. Dividing that into our cash in the house ($359K-$135K) is a cash-on-cash return of 8%. Dividing it into our equity is only 3.6%, which we can beat with just about any long-term after-tax CD rates.
...
I'm clueless on AMT-- is there anything here that would trigger it?

I'm clueless on AMT too.

- You did not include the expected/projected appreciation rate for the property? 2% after inflation, 5%, or 0%?

- Your cash on cash number is based on your 1989 investment dollar, right? What would it be in today's dollar?

 

[Martha]

Given the return on your equity, I would sell. There is a good chance though that you will pay AMT on your non-capital gain income.

Hellbender, the property was put into rental service some time after acquisition (before it was their home), that is why the depreciation is figured on the fmv of the building at the time of conversion.

 

[hellbender]

The basis should have been the lesser of his actual adjusted cost basis or the FMV at the time of conversion. Something doesn't seem quite right here. In a rising real estate market (such as we have experienced over the last few years) the FMV is usually higher than the adjusted cost basis, especially for a property in which someone has invested significant sums of money and sweat equity.

Nords says he paid $277K in 1989 and added $82K in improvements plus unquantified sweat equity for a total investment of $359K+. Yet 10 years later at the time of conversion the FMV of the improvements was only $152K? I suppose this is possible if the land value comprised a huge part of the original basis. There is insufficient data to tell but it doesn't look right. Perhaps Nords can clarify.

Given the return on your equity, I would sell. There is a good chance though that you will pay AMT on your non-capital gain income.

Hellbender, the property was put into rental service some time after acquisition (before it was their home), that is why the depreciation is figured on the fmv of the building at the time of conversion.

 

[kcowan]

Nords
I would sell. You do not enjoy being a landlord for strangers. You already know how the real estate market there can slump. You suspect that DD will not want it (and may not appreciate it as much as she should). Keeping the house for its memories just does not cut it.

I think your depreciation calculation is just fine. If AMT is due, it will be even worse when you eventually sell it. Better to take the lumps now (i.e. don't let the tax tail wag the investment dog!)

 

[queeneev]

I too question why your depreciable basis is just $152k. I would think it would be your cost ($359k) times some factor that represents the building value to total value (in the midwest, land is typically 15 - 20% of total market value). If that assumption is valid for your area, your depreciable basis should have been more like $287k.

One thing to look into further (I am fairly certain of this, but please get a second opinion): I do think you only pay 15% tax rate on the $52k of depreciation, not the 25% tax rate. There is no recapture on property that has not been depreciated using an accelerated rate, unless you hold it for less than 1 year. The 27.5 year MACRS rate is the "straight line" MACRS rate, not accelerated. The recapture is specifically for property that has been depreciated using accelerated rates. When the MACRS rules were introduced (in 1987), you could no longer depreciate real estate under an accelerated method. Prior to MACRS there was ACRS, which had an accelerated rate for real property. And even those properties are no longer subject to recapture because the amount subject to recapture is only the "excess" of the accelerated depreciation over straight line depreciation. Since all ACRS property is 1986 or older, and the longest straight line life at that time was 19 years, all ACRS real property is fully depreciated no matter what life was chosen, so there is no excess.

Pretty pretty sure you have no recapture. Perhaps I sliced $5,200 off your tax bill? Look into that, read column 3 of page 27 of your "sales" pub linked above.

 

[Nords]

Sorry, didn't mean to leave everyone hanging. I've been digging in closets and doing more research.

I would imagine that the big cap gain might well trigger AMT, but the only way to be sure would be to plug the numbers into turbotax and see what it says.

One way to get a handle on this is to pump your anticipated 2007 tax figures into the 2006 version of TurboTax.

I'm clueless on AMT too.

Given the return on your equity, I would sell. There is a good chance though that you will pay AMT on your non-capital gain income.

If AMT was more comprehensible ("Do this, AMT will do that. Do the other thing, AMT will do more.") then I'd be able to figure out its triggers (and I guess more taxpayers would avoid it). Running our 2006 taxes with the addition of a home sale didn't trigger AMT, but I still feel like I'm tap-dancing in a minefield.

The annoying AMT issue is that there doesn't seem to be any sure-fire way to avoid AMT by an installment sale or by skipping a Roth IRA conversion or by deducting the Mother of All Charitable Donations. I'll just have to keep running all of those variables in TurboTax and see if anything triggers AMT. So far all I've been able to verify is that $36K of pension income, augmented by another $15K of stock cap gains/dividends plus ~$10K Sched E rental income, plus a $340K cap gain, does not trigger AMT.

I think you've already decided to sell it, and that's what I'd do.

I would sell. You do not enjoy being a landlord for strangers. You already know how the real estate market there can slump. You suspect that DD will not want it (and may not appreciate it as much as she should). Keeping the house for its memories just does not cut it.

Yup, if it was just me I'd be outbound & moving fast, but it has to be a spousal team decision. She & I are still talking!

I'll go with whatever the team decides (I have a 49.9% vote) but I want us to be absolutely clear whether we're in it for money or for the entertainment value. As landlords know, you just can't buy the entertainment value provided by some tenants.

One point was that we know this property's history & condition. If we pulled out and later bought into another house then we wouldn't be so sanguine about those unknowns. (Yeah, a good house inspector and a review of local zoning plans can help, but we've been studying this one for 18 years.) We still have to have our discussion about whether it makes sense to buy our kid a house. I'm thinking "affluenza, no way" and I suspect spouse is more motivated by parental comfort thinking. If we're just loaning our progeny our credit rating and our liquidity and she can more-or-less afford it, that's a different can of worms. There's nothing wrong with comfort thinking as long as we understand why we're accepting poor financial performance.

My scary spouse ace card is going to be "But what if your parents want to move back here someday and we still have a rental property?"

There is really insufficient info to put together a reasonable proforma for this property, but it is hardly necessary. based only upon the ratio of the property value to the market rents, this thing is a pass. Like many high cost areas, the income generating prospects are poor compared to the value. The only way to realize a good return on investment is to play the appreciation game. This is always a speculation but even more so these days.

As Arif & TheFed have demonstrated, one of the nice factors about $50K homes is that rental property quickly leverages. But today's Oahu single-family home (median price ~$600K) is a huge capital investment with limited ability to boost the rent. A local realtor is shoveling money by 1031'ing Hawaii landlords into TICs because most of the landlords are blissfully-ignorant amateurs with cash-on-cash returns of only 2-3%, no rent increases in a decade, and so on. Hawaii RE gains come mostly from capital appreciation, and when you bought at 1989's market peak it's hard to make a killing at the next peak.

- You did not include the expected/projected appreciation rate for the property? 2% after inflation, 5%, or 0%?

Good question-- I doubt that the last 18 years will resemble the next 18. I'd say that, barring local economic shocks like another Japanese stock-market implosion or an interest-rate squeeze or a 9/11 tourist disaster, the next decade will go sideways until incomes catch up with mortgage payments. The area is built out so new homes won't be a problem, and the local military bases have just finished a major housing renovation that won't further impact the rental market. The tenant "wants" to buy a Hawaii home but I doubt they're saving enough money to be able to make it happen anytime soon. Meanwhile we'll bump the rent 3-4% each year and do just enough home improvement to keep everyone happy. These tenants could be classic "rent to own" people but I don't know if they have the financial acumen & consumer discipline.

... and whether or not there is any possibility that the IRS will view your activities as "not for profit" based on renting at below-market rates to relatives.

We know that mistake. The lease was signed at market rent for a long term, and local rents accelerated a couple years later. In fact it was getting to be time to do something about that, and knowing that their rent was going to go way up may have been part of their decision to move back to the Mainland.

I'm sure the IRS is intimately familiar with families handing rent checks to each other in exchange for buckets of cash under the table. The cost of enforcement is way more than the rewards, and I doubt they bother any more.

Your cash on cash number is based on your 1989 investment dollar, right? What would it be in today's dollar?

I never thought of adjusting for inflation! I bet that would give GAAP CPAs heartburn, too. However it'd take a lot more of today's dollars so the return would be a good bit lower.

A local realtor pointed out that cash-on-cash may be a good idea when you're negotiating a purchase, but I think return on capital or IRR is more important when you're thinking about selling. Even if cash-on-cash reached 10% we'd still be earning less than a long-term CD. The challenges of those calculations (which most landlords don't bother to attempt) are estimating cap gains, AMT, & depreciation recapture.

This post is getting pretty long, even by my standards. I'll deal with depreciation basis in the next post.

 

[Nords]

The basis should have been the lesser of his actual adjusted cost basis or the FMV at the time of conversion. Something doesn't seem quite right here. In a rising real estate market (such as we have experienced over the last few years) the FMV is usually higher than the adjusted cost basis, especially for a property in which someone has invested significant sums of money and sweat equity.
Nords says he paid $277K in 1989 and added $82K in improvements plus unquantified sweat equity for a total investment of $359K+. Yet 10 years later at the time of conversion the FMV of the improvements was only $152K? I suppose this is possible if the land value comprised a huge part of the original basis. There is insufficient data to tell but it doesn't look right. Perhaps Nords can clarify.

I think your depreciation calculation is just fine.

Hellbender, the property was put into rental service some time after acquisition (before it was their home), that is why the depreciation is figured on the fmv of the building at the time of conversion.

I too question why your depreciable basis is just $152k. I would think it would be your cost ($359k) times some factor that represents the building value to total value (in the midwest, land is typically 15 - 20% of total market value). If that assumption is valid for your area, your depreciable basis should have been more like $287k.

I had to do some closet spelunking; I couldn't remember how I came up with it either.

Hawaii tax assessments used to break down the property's value into land & structure. I know they divide aggregate sales into total square footage but I have no idea how else they come up with their numbers. However the year we put our home up for rental its assessed value was $152,300 for the house and $198,900 for the land. Hawaii homes are built to much lower standards than Mainland homes (slabs or posts, no insulation, no basements, no furnace or A/C) and that was probably pretty close to its replacement cost. Land is, of course, obscenely expensive and today is probably 60-75% of property value. (Toto, we're not in Kansas!) The total is $351K, less than our $359K basis, which made sense given the mid-90s declining market. So I happily went with the assessor's "fair" number and never looked back.

I swapped e-mails with a realtor who's been in the Oahu business since 1975. He pointed out some other interesting "oops" factors:
- Remember the old homeowner cap-gains rules when you could generally only avoid paying taxes on the sale of a home by rolling the cap gains into a bigger home investment? We bought the Hawaii home in 1989 (before today's rules) by rolling over $30K of cap gains from the sale of a Monterey condo. We have to go back and figure out if that's still subject to taxation. I hope not, but it's nice to work with a realtor who was actually in the business back then (instead of in kindergarten).
- Their website has a comparative market assessment tool. (Oahu Home Prices) They used our info to come up with an MLS comp (http://tinyurl.com/ytzfc7) that admittedly isn't an appraisal but is better than Zillow. Hawaii doesn't usually lead in this type of service, so I wonder if this tool is available with Mainland realtors too. The occasional automated e-mails seem like a nice way to keep track of a home's value.
- I included the costs of a mortgage refinancing (while it was our primary residence) in our calculation of the property's basis. That may be incorrect so I need to research the basis rules. It's only $1162 and doesn't affect the depreciation basis.
- He also mentioned that the quality of analysis of this board's landlords far exceeds what he usually sees. He's happy to work with any of us.

One thing to look into further (I am fairly certain of this, but please get a second opinion): I do think you only pay 15% tax rate on the $52k of depreciation, not the 25% tax rate. There is no recapture on property that has not been depreciated using an accelerated rate, unless you hold it for less than 1 year. The 27.5 year MACRS rate is the "straight line" MACRS rate, not accelerated. The recapture is specifically for property that has been depreciated using accelerated rates.
Pretty pretty sure you have no recapture. Perhaps I sliced $5,200 off your tax bill? Look into that, read column 3 of page 27 of your "sales" pub linked above.

Well I'll be darned, that just seems too good to be true! It is section 1250 property and there was no "additional" depreciation. I'll have to dig into it and work through the TurboTax forms to figure out what they're doing. (Your info jibes with some of the questions the software was asking.) I'd have to leave room in the 15% income-tax bracket (by skipping a Roth IRA conversion) or I'd end up paying the 25% rate anyway on that "ordinary income". $52K... I'd need a lot of deductions.

If AMT is due, it will be even worse when you eventually sell it. Better to take the lumps now (i.e. don't let the tax tail wag the investment dog!)

I don't see 2008's cap gains rates getting any lower in the next few decades, either. I need to bring up that issue with my spouse, too.

We talk a great game about not letting taxes affect our decisions, but it's never that simple. The soonest we'd unload this property would be April 2008 (lease expiration) while our kid was still choosing a college. I'd have to skip a Roth IRA conversion (no big deal) and I'd have to make darn sure that I didn't screw up the 2008 or 2009 tax returns for our FAFSA. (She graduates from high school in 2010 so I believe only the 2009 return is affected.) If the market corrects 15% then I'd have to consider the effects of selling off highly-appreciated Tweedy, Browne shares in favor of buying ETFs on sale. I'm sure that this could all be spreadsheeted-- eventually.

Yes, we could use the cap gains to pay off the mortgage on our primary residence. But we won't.

Once again the windfall's rent-or-sell issue has degenerated into inertia. There's no compelling reason to shed this asset. We don't need to put the money to work at a higher yield (easy to do) or to pay off debts. We have a good tenant and we expect to keep finding good tenants-- in nearly 11 years of rentals we've only had two vacancy months. We made significant improvements when it was a primary residence and we kept up with the maintenance/repairs as landlords, so it's not going to suck down much more capital in the next decade. Someday our kid (or my nephew the Army Ranger, or some other family member) could move into it and we'd figure out a rent/mortgage agreement. We're hypersensitive to the affluenza issue but we'd like to help out when it's appropriate. The property is a yardwork hassle every six weeks or so but my spouse is holding up her share of the labor with a lot less whining than I am. Financially we're wasting money, and that bugs me no matter whose money it is. Emotionally is more complicated and also more difficult to compare to a dollar value. The hot tub's temperature may be getting a bit warm but it's not boiling so we're happy little frogs.

"Good morning, honey, what would you do with $500K today?" We'll keep this discussion perking along for the next 10 months and look for tectonic attitude shifts. I'll also sign up for the comp e-mails to see how the neighborhood's prices are doing.

But I bet I scare the heck out of her with the question "What if your parents move back?" Or its corollary "What if your brother moves out here to escape them, too?"

Thank you all, I really appreciate everyone giving my numbers a good hard scrub. I'll keep an eye on this thread. As usual, no discussion in our house is complete without answering the question "What does the ER board think?"

 

[Martha]

We are getting a bit mixed up with semantics. The higher tax on the depreciation is from "unrecaptured section 1250 gain" and is taxed at a special 25% rate. Recapture of accellerated depreciation, which you don't have, is taxed at ordinary income rates. So sorry, you will have a tax at a 25% rate on part of the gain attributed to depreciation.

 

[queeneev]

Well now I am questioning my own self. I am going to drop in my own figures in my tax software and "see what happens". Martha, just what exactly is "unrecaptured 1250 gain" if it something other than depreciation recapture? Please allow me to think this through out loud (or in this post) and see if you can tell me where I am flunking. Generally speaking, you have a gain on the sale of anything if you sell it for more than it cost you. Call that the "appreciation gain". If you take deductions during your ownership, for depreciation, you get some tax savings while you own it, and when you sell, your basis is reduced by that depreciation. So you have gain on the difference between your cost and your depreciation taken. Call that "depreciation gain". (although it's really just giving back what you got in tax savings while you owned it and depreciated it - gain is a misnomer).

That's all the peices of the gain. Is there any other gain I am missing? If not, then let me continue on, and this is where I get confused:

You agree with me that Nords does not have recapture of accelerated depreciation. So he pays 15% on that piece. All that is left is the "appreciation gain". Is that the 1250 recapture gain you are referring to that would get taxed at 25%? That does not make sense to me. I think "recapture" rules were invented to prevent people from getting a 25% tax benefit on depreciation deductions, and then paying 15% on the gain when they sell. The IRS added the recapture rules to close some of that loophole. But again, we concluded that Nords' depreciation is not recapture-able. It simply reduces his basis on the gain calculation, which is capital gain.

I am not assuming you are wrong; I am only trying to see what you mean. I have a vested interest in the answer, as I have 3 properties myself, and toy with the notion of selling. I thought I had myself all squared away on concluding that I wouldn't have any recapture, because I have always only used 27.5 year MACRS.

There is no section in Pub 544 called "1250 recapture gain". The heading says "Depreciation Recapture". There is a sub-heading called Section 1250 Property, in which all that it discusses is depreciation recapture. "Gain on the disposition of 1250 property is treated as ordinary income to the extent of additional depreciation allowed or allowable." "You will not have additional depreciation if....you figured depreciation using the straight line method...(other exceptions not typed here)...or if the property was residential rental property...placed in service after 1986...These properties are depreciated using the straight line method."

On page 29 it walks you through determining how much gain is to be treated as ordinary. It asks you in step 2 to determine your 'additional depreciation', which we determined was $0. In step 3 you would calculate $0 of ordinary income.

Martha, I like your sig line, and I feel the same way. I like to discuss the tax consequences, but i am always fearful I am saying things incorrectly. That is why I am talking myself through this in this post , so you (or anyone else) can tell me where I missed something, if I did. I need to revise for own tax calcs for my rentals if I am wrong.

 

[Martha]

Queeneev, publication 544 isn't exactly transparent. The section you refer to primarily talks about circumstances where you may pay tax at ordinary income rates, rather than capital gains rates. This is the recaptured 1250 gain. Towards the end of the publication it talks about capital gains rates and has a brief reference to unrecaptured section 1250 gain:

"This is the part of any long-term capital gain on section 1250 property (real property) that is due to depreciation. Unrecaptured section 1250 gain cannot be more than the net section 1231 gain or include any gain otherwise treated as ordinary income. Use the worksheet in the Schedule D instructions to figure your unrecaptured section 1250 gain. For more information about section 1250 property and net section 1231 gain, see chapter 3."

If you go to the instructions to schedule D you can figure out the amount of the unrecaptured gain on which you will have to pay the special 25% rate. (If you are in a very low tax bracket this rate may be less IIRC). Hope this helps.

 

[spideyrdpd]

If you did a 1031 you could avoid the tax issues.
I take it you have looked into other tic's they dont all have that low a return . Of course you get more of the money into the investment which would increase the yield.
Although I think I would rather go with a triple net lease. Buy the property that a walgreens sits on. Or maybe a couple of properties.

There are also supposedly some ways to avoid taxation with trusts. Supposedly the irs has squashed the pat's although there may be a way to use it to make avoid the amt? Since it annuitizes the payments?
I am sure will boohoo it though

 

[outtarentals]

Nords, Just a couple of thoughts.
1. Is there no state tax in Hawaii? In California it's 9.3% which is added to the Fed depreciation recapture rate. 25 (Fed) + 9.3 (State) = about 34 %. The capital gains tax rate is 15 + 9.3 = approx 25%. Perhaps it's different in Hawaii.

2. If you sell, how about commission, escrow fees, etc. ?

3. I question your $850 per year for maintenance of a rental property.

IMHO, before I made any decisions, I would get a CPA to run the figures if you sell - well worth the cost even for us do-it-yourself diehards!! AMT reared it's ugly head with me and at the very least you can get advice on what tax steps to take or postpone the year you sell the property to avoid losing deductions that year. outtarentals

 

[Nords]

If you did a 1031 you could avoid the tax issues.

Don't think we're interested in a 1031 or TICs or commercial real estate or tax-avoidance trusts. Getting out altogether seems a cleaner approach. I know there's probably more money in the commercial side but I think if we do RE at all it'd be residential where we have a direct personal touch.

Nords, Just a couple of thoughts.
1. Is there no state tax in Hawaii? In California it's 9.3% which is added to the Fed depreciation recapture rate. 25 (Fed) + 9.3 (State) = about 34 %. The capital gains tax rate is 15 + 9.3 = approx 25%. Perhaps it's different in Hawaii.
2. If you sell, how about commission, escrow fees, etc. ?
3. I question your $850 per year for maintenance of a rental property.
IMHO, before I made any decisions, I would get a CPA to run the figures if you sell - well worth the cost even for us do-it-yourself diehards!! AMT reared it's ugly head with me and at the very least you can get advice on what tax steps to take or postpone the year you sell the property to avoid losing deductions that year. outtarentals

1. Good catch-- Hawaii cap gains tax is 7.25% but we can take a deduction on our federal tax return for that. I'm not sure about state depreciation recapture but I doubt Hawaii would let that slide! More spreadsheet work.
2. We'd do it by owner. There would be fees but most of them would be paid by the buyer and the whole effort would probably be under $1000 unless we threw a 2-3% courtesy to a realtor. Never fear, though, we'd [-]jack the selling price up[/-] arrange for the buyer to cover our expenses on that too.
3. Yeah, it's low after the next five years but it's good for the next few. The place has new ceilings, fresh paint, & new carpet. The kitchen has new sheet vinyl, the cabinets were refaced a couple years ago, and the bathrooms have been updated. The $850 is a lowball so that I can at least point out to spouse that I'm being somewhat optimistic in the estimates.

We'll keep talking. I like the time pressure of lower cap gains rates in 2008 and having to base our kid's FAFSA on a 2009 tax return...

 

[chinaco]

My Point of View. I am at a stage in life where I am trying to down-size complexity. Being a landlord is not my thing. Of course, If I were in ER, I might feel different... but when it comes to being a landlord and maintaining the property, I doubt it.

I would sell and reinvest the proceeds in the portfolio.

Do an NPV calculation on each expected outcome (portfolio invest vs house rental/sell) for the next 10 years. Then assume you sell the house in 10 years (This assumes that you eventually intend to sell). You will need to do some projections (estimates). You will need to understand the cash flows for all expenses (including wear and tear, property taxes, insurance, etc...) and earnings and gains. Then compare the two. On the Keep the house side of the equation (include an estimate for sweat equity as wages at some minimal acceptable rate for your effort say $20/hr)... Do it Net of Taxes. Plus don't forget to factor in %X of vacancy over the 10 years (that is probably reality). This will provide an apples to apples comparison. You need to identify what you believe to be weighted cost of capital. Businesses use this to compare two project. It is by far one of the best ways to compare alternatives. It is a little complicated. Although it is insightful, it should not be used alone to make the decision.

Before you do the calculation consider what you need to make over and above all expenses including your wages for effort on a Present Value (for 10 years) to make it worth your while. Let's say that after your wages, the property rental yeilded $10k (total PV) over the Stock/Bond alternative for 10 years of effort, would you do it? How about $20k. Move it up in $5k or $10k increments.

This way if the rental option yields more money you will have an understanding of your sensitivity for rewarding yourself for 10 years of additional complexity to your life.

For me: If I was not able to make at least an extra $10k/yr (100k total), no way that I would do it. In ER I do not need the money, so why spend time doing something I do not want to do. $10k/year over my wages would possibly incent me to take it on (assuming the average personal effort was low)... I am intending to ER to get rid of a job.

My gut tells me that unless you own property that is rapidly going to increase in value (to beat a diversified portfolio of stocks and bonds)... you will likely be owning a job @ $x/hr.

Net present value - Wikipedia, the free encyclopedia

 

[tryan]

I'ld say there's no better time to unload this one ... prices are at an all time high and TAXES are at an all time low. Wait until the Dems have the Whitehouse (and house n'senate too) and taxes will only get worse. AMT will be an issue but holding out for a "fix" is futile.

The only thing that trumps the $$ is having a place for your daughter. Young adults will have a heck of a time buying in HI going forward. Only you can answer that one.

 

[Nords]

Well that was painful but I think I've addressed all the questions. Here's what I've learned.

Sales are running hot in our neighborhood, so a 29-year-old 4BR 2BA 1800 sq ft home on a 5400 sq ft lot would sell for about $650K. (The county even repaved the street last month.) With nothing to lose and no rush to close we'd FSBO next April-- just as the season heats up.

This is a long-term rental property and our other income puts us at the top of the 15% tax bracket so federal long-term cap gains would also be taxed at 15%.

Depreciation recapture is taxed at 25%. Total depreciation through the end of 2007 will be ~$57K.

I can't find any evidence that Hawaii taxes depreciation but I'd appreciate it if any of you Hawaii veterans can point me to a reference.

Hawaii long-term cap gains tax is 7.25%.

Federal AMT is triggered. I have no freakin' idea how it's determined but the TurboTax website estimator puts it around $7500.

We sold a CA condo in 1989 and deferred taxes on the cap gains by applying them to the purchase of the Hawaii home (which is now a rental). This old tax rule went away in 1997 but it still applies to the sale of the Hawaii home. We're required to reduce the basis of the Hawaii home by the amount of the cap gains deferral. Our 1989 IRS Form 2119 (Sale of Home) lists that amount as ~$28K.

Tweaking our basis numbers (and subtracting the CA condo cap gains from the basis) gives us a sale basis of ~$330K.

Assuming a $650K sale and subtracting the $2000 in FSBO closing costs, the $330K basis, and the $57K depreciation leaves cap gains of $261K.

Taxes are roughly $39K federal cap gains, $19K Hawaii cap gains, and $14K depreciation recapture. Adding in the AMT gives a total tax of ~$80K.

This calculation is also complicated by the AGI's phase-out of deductions & exemptions but AMT will probably stay below $10K unless the sale price really zooms up. We can reduce a bit of the taxes by skipping a Roth IRA conversion and not making any charitable donations that year, so let's leave the house sale's total tax impact at a conservative $80K. I doubt it'd be higher.

So after running a $650K buyer's check through the title company's escrow, the mortgage company, and our tax returns, we'd bank $650K - $2K - $135K - $80K = $433K. $66K is the price we'd pay by not moving into the rental property for two years in order to avoid cap gains taxes. (I doubt we'd escape depreciation recapture!) The moving expenses (and the colossal hassle factor) make this a non-starter; I can nurse a lot of tax pain while I'm looking at that deposit slip. And oh yeah, a 5% CD would cough up $1800/month.

The tenants asked us this week if they could start a childcare business out of the home. ("Uhm, [-]NO!![/-] thanks for asking, let me check the homeowner's association rules and I'll get back to you.") With my pension, this unexpected windfall, and their requests I've lost all of my landlording ambition. Now we'll go over the spreadsheet with my spouse and see how she feels about those phone calls...

Did I miss anything?