Advice sought on renting out old house versus selling and taking the money

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Submitted by bibsoconner on April 7, 2014 - 5:01pm

Hi,

I'm hoping the analytic pigs here can offer some advice (or sarcasm, flames, insults) about my current happy dilemma. I own a house free and clear worth about 700,000. After prep/realtor fees I think I could net ~650,000. I bought for about $350K. I've done the research and believe I would have no problem renting it out for $3000. That's 3000 gross, before management fees (I believe I probably need a prop mgr), expenses, etc.

Should I sell and invest the cash, or rent it out? The money from the sale would be all tax free. It's not an easy decision. $3000 X 12 = 36,000 or 5.5% of 650,000. I'm not sure how I could invest 650,000 and get 5.5%. Sure, I could put it in the stock market and it may double. It could also go down by 1/2! CDs pay < 1%. I'm sure someone will point out that I'm not really getting 5.5% if I rent it out, so perhaps that should be my first specific question:
1. What is the expected earnings on a house renting for $3000/month that costs $650-700K and has management fees of 8-10%? I'm sure some experts here have a feel for repairs/disasters, etc.

And then my more general question would be:
2. What would you do? Take the money and run? If so, how would you invest it? More real estate? Stocks? CDs? Or would you rent it out?

For what it's worth, my own calculations and beliefs lead me to believe that renting it out, even allowing for a large amount of repairs provides a more attractive safe investment than CDs, T-bills, etc.

Thanks for the advice and finally, I realize this is a happy problem to have and appreciate my good fortune.

Dave

Submitted by an on April 7, 2014 - 5:17pm.

I depends on your age and if you need the rental income now for expenditure or if you're still in the wealth accumulation stage. If you're counting on the rental income to live, I'd rent it out. If you're in the wealth accumulation stage, I would refi, take some money out and buy more rentals. A loan will help reduce your taxes as well, how much savings depends on large your loan is. If you have a big enough loan, you can technically count it as a loss in the IRS's eyes because of the various deductions.

Submitted by CricketOnTheHearth on April 7, 2014 - 6:06pm.

Hi, Dave:

Fascinating to hear a property owner's side of the story. I rent and go around saying, "I wish all these people would sell their houses instead of renting them out, so I/other people could buy one."
But assuming you could really get that 5.5% return, yes, I can see your point that renting it out would be your best financial option.

But there are a lot of 'ifs'.
Several of them are mentioned in the comments thread of a Doctor Housing Bubble post:

1)"A simple issue such as someone flooding out your floor (it does happen) can wipe out an entire year (or more) of profits."
2) If you get a bad tenant, it could take you 6 to 12 months to push them out.
3) How much of a bite out of your profits will the property tax bill take? My rule of thumb here in San Diego is "about $100/month for every $100,000 of assessed house value" (so about $700/month in your case, assuming the house is here in San Diego.)
4) The aforementioned management company at 8-10% will be taking up to $300/month on a $3,000 rent nut.

One of the commentors on the above Dr. HB thread, "chris" on October 1 at 11:08 am, said he has been a landlord for 13 years. He had a lot of interesting comments, mostly about properties with mortgages on them, and the following which seems also relevant to you:

5) "You should budget at least 3% for capital expenditures and improvements."

So out of your $3,000 a month rent, I estimate you'd be taking home roughly $1910 of it, or about 3.5% annual return. That's if nothing drastic happens, like the water heater blowing a gasket and flooding the house, or a Tenant From Hell, or something.

Still better than market interest rates; up to you and whatever veteran landlords you can find for advice, if you/they think it is less risky than the markets.

One piece of advice I've gotten from house-landlords: DO NOT try to rent out a house that is in another city/state!!! Unless you get angels for tenants this can be a real pain, he told me.

Submitted by an on April 7, 2014 - 8:51pm.

Cricket, you point 1 & 2 are covered by property insurance. Since OP bought the house for $350k, his monthly property tax should be around $300. $300/month seems high for property management. Ive seen them around $100/month. 3% for improvement seems high. It's a rental, not a primary residence. I don't even spend that much on my primary. Keep in mind that 3&4 are deductible and so is home insurance.

Submitted by Coronita on April 7, 2014 - 10:00pm.

I don't have an answer for you.. But here's some questions you should probably ask yourself...

1. If you keep it, you would rent it out $36000/year less insurance/taxes/hoa/management fee, less income taxes... How much would that be?

2. Are you leaving the state? If so, do you think you might return?

3. What are you going to do about housing? Do you have another home you are living in or will live in?

Submitted by CA renter on April 8, 2014 - 3:05am.

I vote for keeping it and renting it out. The current investment climate is pretty sketchy, IMO. Lots of reasons to think that we might have another crash in the near future (margin debt levels, the weakened position of the Fed and the US Govt to do anything should something bad happen, etc.). OTOH, asset prices might keep rising if everyone begins to fear that the USD will no longer be the world's reserve currency, in which case your house might be one of the best possible things to own, as opposed to stocks, IMO.

The other posters bring up good points for you to consider, so definitely take some time to run the numbers and do what feels right given your circumstances.

Good luck!

Submitted by livinincali on April 8, 2014 - 8:29am.

350,000*0.01125 = 3937.5/yr in taxes. Lets just say $4000 although it might be a bit higher than that. On the property management cost you usually assume 8-10% but for $3K a month maybe you get a discount. Let's just say $200/mo or $2400/yr. Vacancy/Maintenance tough to judge when you only have 1 property, but let's just assume 1 month of rent per year.

So 36000-4000-2400-3000 = $26,600/yr. Cap Rate tends to be based on the value of the house but let's calculate it both ways. For you the cap rate is 26,600/650,000 = 4.1%. For an investor it goes down a bunch because of the increase in the tax base. So a new investor that bought your property would have property taxes of nearly $8K a year putting the revenue down to 22,600. SO 22,600/700,000 = 3.2% Cap Rate. So there's no investor demand for your house. Your potential buyer pool is limited to owner users. An owner user that bought at $700K and put 20% down is looking at a monthly nut of about $3500/mo which isn't that much more than renting.

The problem you potentially face is that if/when interest rates go up and there's other investments that look more attractive the costs for potential buyers are going to go up at the same time. I.e. when you can get a safe 4% return at a bank the mortgage rates will be close to 7% which makes the monthly nut close to $4500. In order to keep the monthly nut close to the $3500 @ 7% interest the home's price would need to be around $500K rather than $700K.

If you're betting or guessing that rates should rise in the near future than it would make sense to sell now. If you bet that rates will stay low for a long time than it's better to keep the property and rent it out. If you use Japan as a guide than it's probably better to hang on to it.

Submitted by bibsoconner on April 8, 2014 - 9:43am.

Thanks for all the comments and advice so far. To answer some of the questions. Yes, I have another home to live in (in San Diego). As I said, I realize it's a lucky problem to have. I'm in my late 40s.

The decision to have a property manager is probably a good one for me. I'm not particularly handy, and my job takes up a great deal of my time. Quite frankly, I'd rather play catch with my kids than change a light bulb on my own house. I really don't want to deal with problems from renters. That might well be a point for selling, rather than renting.

I'm paying 8% to the property manager. Frankly, I thought that was a fair deal. Others were asking 10%.
We're going the renting route right now, but could easily change. I'm getting nervous that it is not renting after being on the market for about 20 days, although things seem to be heating up now (we did a price reduction from 3400 to 3100). My basic research indicates that there is not as much demand for 3+ bedroom houses in the >$3000 range. There's just a smaller segment of the population that needs that. And those folks that can afford >3000/month can entertain the ideas of owning something. That's why I was floating the idea of selling and perhaps getting a couple of small houses/condos. Although knowing myself, I probably would not get around to the buying part...

Property taxes are about $4000/yr by the way.
Dave

Submitted by plm on April 8, 2014 - 10:33am.

Had the same decision to make four years ago. Bought a new house and what do with the old one (doubled in value like yours)? Held on to it and rented because it was hard to sell homes at that time. In hindsight, I should have sold it so the income would have been tax free and I don't have to deal with being a landlord.

Missed the tax free capital gains window now so I'm stuck with it being a rental. It did appreciate nicely though so maybe its a wash now.

But it sucks to be a landlord. Renter is two months behind on rent now. Maybe should have gotten a property manager to demand rent. Its tough to demand rent when you know they are doing their best to make the payments. Income from being a landlord is not good. I get about 3 percent on investment. I think you need a mortgage to make the numbers work better.

Now with house prices so high, I don't see why you don't sell. Unless the capital gains tax rules change, it would be huge financial benefit to sell now.

Submitted by Coronita on April 8, 2014 - 12:25pm.

bibsoconner wrote:
Thanks for all the comments and advice so far. To answer some of the questions. Yes, I have another home to live in (in San Diego). As I said, I realize it's a lucky problem to have. I'm in my late 40s.

The decision to have a property manager is probably a good one for me. I'm not particularly handy, and my job takes up a great deal of my time. Quite frankly, I'd rather play catch with my kids than change a light bulb on my own house. I really don't want to deal with problems from renters. That might well be a point for selling, rather than renting.

I'm paying 8% to the property manager. Frankly, I thought that was a fair deal. Others were asking 10%.
We're going the renting route right now, but could easily change. I'm getting nervous that it is not renting after being on the market for about 20 days, although things seem to be heating up now (we did a price reduction from 3400 to 3100). My basic research indicates that there is not as much demand for 3+ bedroom houses in the >$3000 range. There's just a smaller segment of the population that needs that. And those folks that can afford >3000/month can entertain the ideas of owning something. That's why I was floating the idea of selling and perhaps getting a couple of small houses/condos. Although knowing myself, I probably would not get around to the buying part...

Property taxes are about $4000/yr by the way.
Dave

Given some of the additional details you provided..

If I was in your situation, most likely I would sell and pocket the $300k cash tax free, and put it to use for something else for a couple of reasons..

1. There's absolutely no chance you will move back into this home for nostalgic reasons. You already have a move-me-up primary home...

2. If you're worried about possibly losing out on more appreciation, well look at it this way..

a) If property values continue to go up, you have your current primary home to get another capital gains tax exemption on.
b) If property value goes down, you cashed out the first one, mitigating the "paper loss" on your newer primary. Besides, you can take comfort that your primary home isn't earning income anyway if you're living in it so you shouldn't care...

It's the nice thing about having a primary home now and being able to dispose of the old one.

As a wise RE guy once said to me.. "It's not about whether you win or lose. You already won.. It's about how much you are winning by..."

3. Where I might consider keeping the home is keeping it to let my kid(s) inherit it..But that's a long time out, and we don't know what our government is going to do with estate taxes moving forward both at the federal and state level.. If in doubt, just look at what's going on right now in New York...

http://www.cnbc.com/id/101561812

The headline is misleading, because it's not really 164% increase total... But the point is, taxman is coming to tax the crap out of your estate if not sooner, definitely later. So, maybe leaving everything in an estate isn't such a great idea.

4. If you're bent on being a landlord, and cashflow is what you want, maybe you can do some research into finding something like a 1/1 or 2/2 that cashflows comparable, but doesn't require you to put the entire $300k. You might then have something leftover to spread the risk to another asset class.

Disclaimer.. I'm doing this, others are doing this.. And finding good property in SD that cash flows well at this point (in the areas I want to do this in is getting really challenging)....

5. 4% is currently what some high quality companies are paying with a dividend yield. So while I don't recommend putting everything into stocks, it might not be such a bad idea to spread your money out among real estate, some stock, and something else, or just hold onto some emergency cash...

Altria for instance is paying around 5% dividend...
And there's plenty other "boring" companies that are doing 4-5%... My problem is that historically, I have the opposite problem. I'm way too heavy in stocks, around 80%+ allocated into stocks a few years ago.. I wanted to move money out of the stock market into cash and something else other than stocks..

My ultimate goal that I've been working out is to more readily distribute my net worth between 40% stock, 40% rental property and 20% cash.

Disclaimer: don't listen to me for financial advice. In fact, people usually find out doing the opposite of what I say works out better :)

Submitted by spdrun on April 8, 2014 - 1:42pm.

Assuming $4000/yr property tax, if you can rent it for $3000/mo, that's only a 4.5% cap rate. Before management costs and insurance.

I'd consider selling and buying other rental property at 6-7% cap, which is doable these days. Maybe condos where the HOA takes care of a lot of the lifting and a management firm is less necessary.

Submitted by The-Shoveler on April 8, 2014 - 2:04pm.

I think I would go with what flu said,
You have a primary so take the tax free money now (expensive homes don’t usually pencil out well as rentals anyway)

Put some of it in a 2/2 condo or even a smaller 3/2 rental grade home a little further away.
buy some silver etc..

I really in good conscience cannot recommend stocks to anyone I used to own kmart stock (hey they have assets don’t they LOL).

Anyway never follow stock advice from me.

Submitted by flyer on April 8, 2014 - 4:00pm.

Since we bought our investment properties in San Diego many years ago, our cash flow and costs, etc., pencil out a lot differently from yours, so it makes a lot of sense for us to keep our rentals long term. We did, however, sell a couple of our properties at the last peak, because the timing was right.

IMO, and this is not advice, I don't think you can go wrong holding onto investment property in San Diego. That said, given the volatility of the current economic climate, this would hold as long as you know you can afford to do so, even if there is another downturn in the real estate market, and, if you know you will not need the cash for any other of life's many surprises.

Submitted by The-Shoveler on April 8, 2014 - 4:06pm.

I think what flyer said makes sense as well, but to me unless you are thinking really really long term (20-40 years) or maybe to pass down to your children etc...

I think that once you turn it into a rental for 5 years you can kiss your tax free money away and you could also pass the new rental and assets as well.

There are buy and "NEVER SELL" types that do extremely well over a long term time frame as well.

Will we see the same appreciation in coastal SD over the next 30 years as the last 30 years ?

Not so sure IMO, some other areas may do some catching up.

Submitted by an on April 8, 2014 - 4:12pm.

The-Shoveler wrote:

I think that once you turn it into a rental for 5 years you can kiss your tax free money away and you could also pass the new rental and assets as well.

Not entirely true. You can move back in for 2 years and then sell.

Submitted by spdrun on April 8, 2014 - 4:53pm.

IMO, and this is not advice, I don't think you can go wrong holding onto investment property in San Diego. That said, given the volatility of the current economic climate, this would hold as long as you know you can afford to do so, even if there is another downturn in the real estate market, and, if you know you will not need the cash for any other of life's many surprises.

If this holds true for the house, it will also hold true for something returning closer to 6%. So selling and buying other things in CA may not be a bad idea.

Submitted by an on April 8, 2014 - 5:02pm.

spdrun wrote:

IMO, and this is not advice, I don't think you can go wrong holding onto investment property in San Diego. That said, given the volatility of the current economic climate, this would hold as long as you know you can afford to do so, even if there is another downturn in the real estate market, and, if you know you will not need the cash for any other of life's many surprises.

If this holds true for the house, it will also hold true for something returning closer to 6%. So selling and buying other things in CA may not be a bad idea.

If you sell, you have to pay RE fees. That 5-6% on a $700k house is $35-42k. So, if you sell one $700k house that's making you 3.5% and buy 2 places ($350k each) that make you 6% (normally) wouldn't be 6% if you count in the $35-42k RE fee. Now, if you refi out and buy more properties, that might make more sense.

Submitted by spdrun on April 8, 2014 - 5:49pm.

^^^

The OP doesn't NEED to sell. Why not just list it in the newspaper, on Craigslist, and put a "FSBO, Brokers Not Protected (619)555-3453" sign outside?

If he manages to sell, he'll still owe the usual transaction costs, but not a 5-6% broker fee. Remember that the logistics of the closing are done by an escrow/title firm in CA, not by a broker, and an escrow/title firm will still be involved (but for a much lower price).

Submitted by The-Shoveler on April 8, 2014 - 5:51pm.

just list it 50K over market,

who knows you may get lucky.

just kidding sort of.

But really I think right now the prime coastal areas are selling at a high premium (over peak in a lot of cases) compared to more inland and/or pedestrian areas that are still 20/30% below peak.

I am not sure that differential will hold up so now may be a good time to sell there and buy in the other area's.

Submitted by exsdgal on April 8, 2014 - 6:24pm.

We rented the old residence when we bought our current house. The carrying cost was low, and rental depreciation was a factor. Following may not apply, generating passive income held a greater value to us than the rate of return from maintaining the property as a rental.

With the usual disclaimer - not an advice - in case you decide to rent your old house… and if the numbers work one can consider pulling equivalent of the 'tax-free' money from the old house to purchase a second rental (house/condo?).

Regarding the rental process it is typical to have 30-45 day turn over between tenants, unless the prospective tenant is from out of state and can move immediately. If the cash-flow supports, renting $300-$500 below market also helps in keeping the tenants for > 1 year.

Good luck with your decision.

Submitted by joec on April 8, 2014 - 6:28pm.

A lot of good general advice. My thoughts are that it really depends on what else you hold and what are you doing with your other assets.

Some things to think about for you from what I've seen so far:

1) You own a primary already so you will be hedged if housing goes crazy...your existing place will go up too and is a good inflation hedge.

2) You probably won't want to keep this house considering your current place is nicer so for the wife/kids/etc, you probably won't want to move back in for the tax free gains so you have a limited time if you want the tax free gain from selling. If you plan to sell later, I'd probably move to sell now since the tax benefit may change and houses are near peak levels right now. It can go higher, but tax free gains may change and it can go down too.

3) It doesn't sound like you want to be a landlord and most people who keep it probably are more looking to build assets and manage the rental themselves to save on the mostly useless management companies. If you don't want to deal with a headache, it seems like selling is the less stressful way to go.

4) Your rental is pretty high cost so it's mostly going to probably turn over annually from families coming and going yearly. That's sorta a pain to find tenants if the manager isn't good and as mentioned, with the tax break, someone BUYING your home will save money vs. renting your place. I see a few in my hood where there's a new tenant every 1-2 years since the rentals are more than buying.

5) You have no mortgage on the home to write off...This makes it so if you got a mortgage, you can have your cake and eat it too. If you sold, got the cash, get another rental with a loan, get some rental income and cash flow, but still have the left over cash to invest/do things with and write off more against your income.

Good luck with your choice...If you invest for income and don't care if a stock moves a lot, you can do ok too...I have some intc bought for just that reason and get 3.4% yield and oh, the stock is at all time highs too.

At the end, I think the best solution is to look at all your assets/retirement holdings/pensions/real estate, etc...and fill in the hole that is lacking to diversify against anything the guv'ment and tax guys do.

Submitted by HLS on April 9, 2014 - 7:28am.

1. Take the tax free gain NOW, before the option is taken away.
2. Buy newer property elsewhere (multi units, or 3-4 SFR)either all cash or 50% down and get $5k+ a month income.
3. Use a good property manager.

Part of the benefit of rentals is depreciation AND doing 1031 exchanges.
Your current cost basis is low. Establish a higher cost basis with the same equity.

I think it's silly to rent out a $700K house.
You generally get more income (and potential appreciation) from 2x $325K houses.
Do not count/expect any appreciation.

When interest rates go up, it's going to be harder to qualify for financing.
I think we're in a bubble inflated by low interest rates.
Most people do not care what they pay for a house, they only care about their monthly payment.
If they cannot qualify for a loan they cannot buy.

Submitted by Coronita on April 9, 2014 - 7:47am.

One thing I didn't consider all is the income taxes... Maybe someone could chime in on this, because I'm too lazy to look things up.

Suppose someone has a household income (couple) of
$150k in W2 salary
$40k in long term capital gains from stock sales

Person is now considering selling primary home for $300k profit...

What are the tax implications?

1. I think the W2 salary income $150k still gets taxed the same regardless of one sells the home or not.

2. The $300k gain from the primary home sales is tax free, due to primary home capital gains exclusion of up to $500k for a couple

However,
3. Would $40k long term capital gains from the the stock sales end up being taxed at 20% instead of 15% ( since the household's AGI > $450k) ? Someone correct me if I'm wrong...

4. Would the $40k in investment income then be subject to the 3.8% medicare tax surcharge (which kicks in on the any "net invest income" for folks with an AGI >$250k/household)?....

If #3 and #4 is true, then I guess the solution would be don't sell any stock that year if your normal AGI isn't already hitting those thresholds...

Submitted by bibsoconner on April 9, 2014 - 9:18am.

Thanks for your latest comments flu. Not sure I quite followed them though. Our household income is roughly $220K/yr gross. We have no stock dividend/interest income to speak of. We sold all the stock to buy the new house. Our mortgage+taxes+insureance on the new house is around $5500 which is quite a bit more than $0 on the old house, and does keep me up at nights.

I've taken all the comments here to heart but it looks like we're leaning towards renting because the boss (wife) thinks it's a good idea. She might be right. She's much smarter than me. It concerns me that the cap rate is only 4.3% or so. I based this on $650,000 price, and took into account monthly rent, management fees, prop taxes/insurance, gardener BUT NOT maintenance or down time (time between tenants, etc.). As I said before, it's by no means clear that one can get 4.3% in other investments. Certainly I have dividend stocks in my retirement account that pay well now, and they may even go up by 100%. Or they may do what my GM and WAMU stock did a while back and go to 0.

To answer another question, no we don't need the money right away. So if prices went down a lot, we could ride it out. Of course if house prices dropped 25%, I'd expect to see rents drop too! Given the huge capital gains advantage of selling right away, it sure seems like we better be willing and able to rent for a long time. Realistically, I don't see us moving back in for 2 years to lock in new tax advantages.

Thanks to all,
Dave

Submitted by Coronita on April 9, 2014 - 10:44am.

bibsoconner wrote:
Thanks for your latest comments flu. Not sure I quite followed them though. Our household income is roughly $220K/yr gross. We have no stock dividend/interest income to speak of. We sold all the stock to buy the new house. Our mortgage+taxes+insureance on the new house is around $5500 which is quite a bit more than $0 on the old house, and does keep me up at nights.

I've taken all the comments here to heart but it looks like we're leaning towards renting because the boss (wife) thinks it's a good idea. She might be right. She's much smarter than me. It concerns me that the cap rate is only 4.3% or so. I based this on $650,000 price, and took into account monthly rent, management fees, prop taxes/insurance, gardener BUT NOT maintenance or down time (time between tenants, etc.). As I said before, it's by no means clear that one can get 4.3% in other investments. Certainly I have dividend stocks in my retirement account that pay well now, and they may even go up by 100%. Or they may do what my GM and WAMU stock did a while back and go to 0.

To answer another question, no we don't need the money right away. So if prices went down a lot, we could ride it out. Of course if house prices dropped 25%, I'd expect to see rents drop too! Given the huge capital gains advantage of selling right away, it sure seems like we better be willing and able to rent for a long time. Realistically, I don't see us moving back in for 2 years to lock in new tax advantages.

Thanks to all,
Dave

I think you can ignore what I said about taxes. Never mind....Brain fart..,.

Please ask someone who is an accountant.

..But I think the exempted portion of capital gains from sale of primary residence I don't think counts toward what is used to calculate the 3.8% tax surcharge....

This I think explains it..
http://www.realtor.org/small_business_health_coverage.nsf/docfiles/government_affairs_invest_inc_tax_broch.pdf/$FILE/government_affairs_invest_inc_tax_broch.pdf

Even more reason why from a tax efficiency standpoint, there is a huge advantage of selling a primary home versus any other sort of investments..

Also, the new 20% capital gains tax rate also I don't think applies to you either, if you don't have any all capital gains elsewhere...

http://www.marketwatch.com/story/taxmage...

Anyway, do some research on the 3.8% medicare tax surcharge and the 20% capital gains tax rate... If it's not applicable to you now, it's very possible it's very applicable to you in the future, if you don't plan on selling your primary home, which gets special treatments....

Gee. I'm jealous

Submitted by FormerSanDiegan on April 9, 2014 - 1:02pm.

bibsoconner wrote:

So if prices went down a lot, we could ride it out. Of course if house prices dropped 25%, I'd expect to see rents drop too!

When prices dropped 25% + in the last downturn, rents barely declined.

Submitted by The-Shoveler on April 9, 2014 - 2:36pm.

FormerSanDiegan wrote:
bibsoconner wrote:

So if prices went down a lot, we could ride it out. Of course if house prices dropped 25%, I'd expect to see rents drop too!

When prices dropped 25% + in the last downturn, rents barely declined.

That's what happens I guess when you have CPI tied to rents instead of owning.

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