Selling vs. Renting a Property

[inquisitive]

I currently have owned a property for about a year. For long-term real estate investment, am trying to decide what would make the most sense: selling this place in another few years, versus renting it out. Here is my reasoning:

If I depreciate the property to the point that I sell it, the options would be selling and realizing the equity increase in the property or continuing to rent it out. If I sold the property, I've decided that I would likely invest the money into additional real estate and not into other ventures such as the stock market (I like to stay diversified by keeping real estate and the stock market separately and not taking money from one and putting it into the other). If I sold I could use a 1031 exchange and ostensibly not pay any taxes on the gain nor depreciation recapture (is this right?). I would get a mortgage in a more expensive property and repeat the process.

If I would continue to rent, I would have more years of depreciation as well as would continue to get appreciation from the value of the property plus whatever cash flow there is. The main problem with this is that I don't realize the equity in the property. However, couldn't I get a home equity loan at a low interest rate (maybe 6%?) and use the money to purchase a second property while using the cash flow from the first to make the mortgage payments on the second? While avoiding paying any taxes, I would be paying a relatively small amount to make use of a lot of equity while retaining appreciation from the property and positive cash flow.

Is my understanding of the situation correct? I don't see why anyone would sell looking at these issues but probably I have not looked at all the possibilities...

 

[toofrugalformycat]

I'm going to leap in, with only a little experience in real estate, but you asked why ANYONE would sell.
In my personal situation, where I've owned and lived in an old house for a long time, and want to test out living somewhere else but not sure I'm going to move there:
Reasons to sell:
1)Foreseeable problems with the economy/neighborhood/other factors that make appreciation of the property not a given;
2)Payment for management of the place (I don't want to be an absentee landlord, or really a landlord at all) sucks up part of the income;
3)Horror stories of getting a bad renter and then not being able to get rid of them in a timely manner or get enough money from them to repair the damage;
4)Maintenance of this older dwelling in this fierce climate may suck up any profits from rent;
5)Due to all of the above, no guarantee of positive cash flow even with depreciation.

I should say that even with all the above I haven't made up my mind yet to sell or rent. There are costs associated with selling, and property values in this town have fluctuated so wildly in the past, that if I do sell and then want to move back here there's no guarantee I could. I have rented this place successfully before for a year, and then moved back in, but it was to a trustworthy person that I knew.

 

[Nords]

First, let me trot out my usual recommendation for two most excellent landlording & rental-financial books:
(1) Investing in Real Estate, 4th edition or later, by Andrew McLean & Gary W. Eldred (who's taken over the new editions) and
(2) Landlording by Leigh Robinson (7th edition or later).

If I depreciate the property to the point that I sell it...

Doesn't matter to the IRS whether you depreciate it or not-- they assume that you've been depreciating it and you are taxed the depreciation recapture accordingly. So to save your own investment, you have to depreciate the structure for every rental day between the time you buy it and the day you sell it.

If I sold I could use a 1031 exchange and ostensibly not pay any taxes on the gain nor depreciation recapture (is this right?). I would get a mortgage in a more expensive property and repeat the process.

The timing is a tad complicated and critical to the success, and you essentially pay other people a bunch of commissions to hold your money for you, but that's how it works. Taxes are deferred but will someday be due, unless you die first and the property goes through probate.

Another option would be to invest your 1031 funds in a property partnership through tenants-in-common ownership. You'd essentially be a landlord (along with a bunch of partners) in an apartment building or a shopping mall with a property manager. You'd be entitled to a share of the net, just as if you owned shares in a REIT. This is very easy to accomplish as long as you're willing to pay commissions to every middleman between you and the actual rent-paying tenant. It's usually driven by elderly landlords who want out of the hands-on part of the job but who don't want to have to pay taxes yet and who are unhappy about the interest rates on CDs or bonds. It's also done by young investors who don't trust the stock market.

Spouse and I sold a primary residence in 1989 and rolled the cap gains over to a new primary residence. In 2000 we moved out of that primary residence, turned it into a rental, and bought another new primary residence. 21 years after that first sale, we're still deferring the cap gains on that sale (and I'm still holding on to the paperwork and the tax returns). I've told spouse that I plan to win this game by dying first. She assures me that's her plan for me too.

If I would continue to rent, I would have more years of depreciation as well as would continue to get appreciation from the value of the property plus whatever cash flow there is.

If you're using the most common depreciation schedule then that runs out after 27.5 years. The vocabulary, math, and details are a bit more complicated but that's the simple version. Of course you could continue collecting rents and appreciation (as long as they both lasted) but you'd no longer be deducting depreciation on Schedule E, so your taxable income would rise.

For years I used a library copy of "J.K. Lasser's Your Income Tax" to do these calculations (and tax forms) by hand. Now I pretty much punch whatever computer keys TurboTax tells me to punch. The advantage of Lasser's is that you learn the rules and how to apply them. Of course TurboTax is a lot faster and a lot less thinking.

The main problem with this is that I don't realize the equity in the property. However, couldn't I get a home equity loan at a low interest rate (maybe 6%?) and use the money to purchase a second property while using the cash flow from the first to make the mortgage payments on the second? While avoiding paying any taxes, I would be paying a relatively small amount to make use of a lot of equity while retaining appreciation from the property and positive cash flow.

The catchphrase is "dead equity". You could try for a HELOC or even a 30-year fixed-rate mortgage, but banks will treat you as a small business and will drag you though the wringer on the analysis of your rental accounting. They may assume conservative factors that you feel are ridiculous, too-- like 25% vacancy rates or thousands of dollars in repairs/maintenance. If you have a relationship (or contacts) with your financier then it works out well, but if you're cold-calling the local bank then it might be less successful.

I think you'd be fortunate to borrow up to 80% of value, and many financial institutions may throttle you down a good bit lower. The FHA (whose criteria almost all banks lend to these days) also limits the number of "investor mortgages" you can have. That's because you're essentially using leverage to maximize your returns while hoping that nothing bad happens in your market.

Another option would be to pull equity out of your primary residence, but many landlords are reluctant to take that step. Nothing good or bad about it, just an extra magnitude of personal risk if the rental market implodes overnight.

You really need to decide now whether or not you want to be a long-term landlord. Regardless of that decision, you should also have a "sell it now" contingency plan in case your life changes. Spouse and I never really wanted to be landlords-- it just worked out that way because at the time it was easier to landlord than to sell. Unfortunately that situation has persisted for most of the last two decades and will probably continue for a couple more. It usually feels pretty good when the rent is deposited to our checking account, but it sucks when I'm doing the yardwork or forced to contemplate an ugly repair. If you have the temperament for it, then you should do it for as long as it's not driving you crazy. If you have some talent for it, then it can easily grow to replace the income of your day job-- which may be driving you more crazy than landlording.

Oh, and landlording doesn't seem so bad now that CD rates are low and our rental's cash-on-cash returns are higher than CD rates. When any ol' bank or credit union was paying 5-6% for a three-year CD, though, I was seriously questioning my commitment to real estate.

 

[Purron]

As usual, Nords has provided excellent information and advice. I'd only add a couple of comments. I would do some research on your area and determine if the value of the property is expected to stay steady, decline or rise. Yup, I know, it's a difficult call. However, the bottom line is you are treating this property similiar to an investment.

As the song goes, "you gotta know when to hold 'em and know when to fold 'em". If you believe you can invest the funds better elsewhere, then it may be time to "fold 'em".

In addition, as Nords mentioned, you have to consider the "hassle factor". Being a landlord isn't for everyone. DH and I have a rental in an area that is likely to increase in value. We've been lucky with renters for the past 11 years, but just don't want to push our luck. Therefore, we plan to get out of the landlord business.

Good luck and let us know what you decide.

 

[Ronstar]

Being a landlord can be a full time job. I dont know where your investment property is in relation to where you live, but being an absentee landlord can be a disaster. Unforeseen costs, uncontrollable expenses (RE taxes), etc. Also, I don't many people in ER that want the hassle of essentially running a business

I dont see how the tax on a sale will be less in the future (unless after you die) than the tax would be now.

Overall, I would prefer my $ to be in a balanced portfolio as opposed to real estate at this point of my life.

Good luck!

 

[JOHNNIE36]

I'm into a situation now where I rented out my previous house for a year and getting settled in to the new one. I would have preferred selling but in this economy, just couldn't get it done. For explanation: my previous residence is a manufactured home in a park where you pay lot rent monthly. These are not your normal double wides, etc. but 2000 sq ft really nice homes with textured dry walls and ceilings. I've got about $140k invested in it but was asking $125K just to get out of it. Couldn't sell but got it rented for $1000/month for a year and the renters may be interested in buying if they like the neighborhood, etc. The rent covers all my expenses plus puts about $500 in my pocket for a 4.8% return on investment less taxes and depreciation which I haven't gotten into yet. That's not a bad return. I also told them I would sell it to them for $25k down and carry the $100k mortgage. I'm thinking of charging them 6% with a payoff in 7 years. I think this is a good deal for both parties as it's hard to get a mortgage on mobile homes and manufactured homes right now. In this economy does any of this sound good to you?

 

[jimnjana]

I would recommend you sell and roll over gains into another property if that is what you want. As you move up in property value, your rental rates will be higher and you may not have as many issues with irresponsible tenants, providing you are screening them.

 

[KM]

We were faced with a similar situation about 9 years ago when my father-in-law passed away and we inherited the house. DH wanted to sell it - I thought we should rent it.

Anyway, we kept it and rented it. We went through one bad tenant after another and DH hated every minute of having to deal with the late rent, damages, phone calls, etc. etc. Yet, because we owned the house with no mortgage - we made a nice profit each year. Certainly as much, if not more, than if we had sold it and conservatively invested the money. And the house has since appreciated in value.

We eventually decided to turn it over to an real estate agency to manage. Now they find the tenant, deal with the late rent, handle damages, notice to evict, etc, etc. Yes, there are still issues, but we are much further removed and somehow they always seem to get our rent money, albeit a few months late sometimes. It has been well-worth the 9% they take. They have most of the headaches and we stil make a profit.

I, personally, would never do this if I had to carry a mortgage for the property, though (ie I would not sell this real estate and buy up a more valuable one with a mortgage). I understand the concept - but to do it and be profitable - I think you need to be the landlord. Frankly, not everyone is cut out to do that.

I guess this is my way of saying that most people do not realize how tough it is to be a landlord until they become a landlord.....for many, all of a sudden the money doesnt look so good.

 

[kcowan]

I guess the real question for most people is: If I am taking on the job of being a landlord, is the 9% I am saving worth the aggravation.

As for Johhnie36, it seems that you are taking the path of least resistance. With luck, you might sell the property anyway. I would ask the question: why do mortgage lenders avoid doublewides?

 

[inquisitive]

Bringing back an old thread as someone asked for an update above.

Have decided to keep it at least for the next year since I don't really have a better investment that I would put the money in and since I live in 1 of the bedrooms it has been easy being a landlord (it also helps that they are around my age). I do screen people exceptionally well and have paid thousands to improve or fix any possible issues but I have had a couple expensive repairs as well. If I have a reason to raise money I would consider selling it but if I am going to get a 2nd property I might first see if I could keep the first as a rental since it has been going well so far.

 

[kcowan]

Glad to hear it is working out for you Inq. Is this consistent with your asset allocation?

 

[inquisitive]

I've never really thought about how real estate fits into asset allocation. Depending on the real estate market, there is a certain price for a property so I couldn't have decided what % to put into real estate vs. stock investments but it is a mortgage anyway.

I have decided to keep real estate and stock investments separate and not mix the 2 monies, so this is a kind of protection, and I'm happy with being diversified in this way. Right now I have 100% equity in my stock investments but I am rethinking this and am planning on getting a REIT as well, and probably commodities.