A common question for new homebuyers is whether they should rent out their old home. Even with the highest mortgage rates seen in the last few decades, there is a natural pull to turn previous homes into a rental investment. There are three main areas to evaluate: the time, money, and tax implications of renting out your home. Here are 5 factors you should consider before taking the next step in becoming a rental property manager.
Key Takeaways
- Becoming a landlord requires significant time and management, ranging from managing tenants and repairs to shopping for mortgages and insurance.
- If you are only making $100 to $200 a month, it may not be lucrative enough to pursue renting out your old home, especially if you are also pulling money away from savings or other investments to fund the purchase of your new home.
- Beware of the tax implications of owning a rental property: you will lose eligibility for the capital gains exclusion, and the IRS considers a rental property a source of passive income, so you can’t offset large income/expenses from the rest of your tax situation.
The Right Mindset
Anecdotally, people say they want to get into real estate because that is “what the wealthy people do”. They apply that concept to their new and former residences and want to start renting out their previous home. There is nothing inherently wrong with doing so, but it deserves more thought than simply asking whether it will make money. There are 5 main financial considerations for renting out your old home, all of which could be dealbreakers. After addressing each of these, you should have a decent understanding if this decision is right for you.
- Time is more important than Money.
Buying a rental property and/or renting out old homes is, by all means, very similar to running a business. There is a stark difference between a Real Estate Investment Trust (REIT) and the home-turned rental property you manage. The former is a single purchase and sale of a security, while the latter requires managing tenants, repairs, insurance, mortgages, etc.
The time required to become a landlord is worth considering before deciding to rent out your former home. Would you do the repairs yourself? Do you have a list of service professionals to call on? Will you market or search for a tenant? Are you going to hire a property manager? There are many more questions worth asking yourself before bringing another family into your old home.
2. Math Out The Investment
Many people naturally start with the numbers, but take the time to write out how renting your home will be profitable, and include everything. What is the mortgage, estimated rent, estimated repairs, insurance, utilities (if paid), property taxes, management services, and more? If you add all this up to find your profit is only $100-$200 a month, it may not be worth it to go through with. One negative event above your planned expenses could eliminate several years of projected profit.
3. Additional Money May Be Required
Most people, when moving from one house to the next, will roll their equity into the new location, generally at least covering a down payment if successful. Planning to purchase a new home without selling your former residence means that any down payment required must come from another source. Which means you are still taking funds to indirectly buy a rental property. That could come from a savings account, brokerage account, retirement account, etc. This is not necessarily a negative outcome, simply that you will pull away saving/investment money to “invest” in the new home/rental combo.
4. Capital Gain Exclusion
Hopefully, the old home had appreciated over the years and would be sold for a higher price than the original purchase price. This is a textbook capital gains investment, where once the asset is sold, generally the government requires a piece of the gain through the Capital Gains Tax system. However, there is a primary residence exclusion for the first $250,000 of gains for a single filer and $500,000 of gains for a couple. Any gain over this limit must still be taxed at your capital gains rate (0-20%).
Generally, to qualify for this exclusion, you must have owned and lived in the residence for any 2 of the last 5 years. For example, a couple rents out their old home for 5 years and then sells it. They recognize a $400,000 gain on their home, but since they haven’t lived in it in 2 of the last 5 years, it could be that all $400,000 would be subject to capital gains tax (at likely 15%, so possibly $60,000 in taxes). Many people do not factor this tax liability into the equation.
5. It’s Not One Big Write-Off
For most people, rental losses, however negative they become, likely cannot offset their wages or other active income. Having one long-term tenant in your former home is treated as a passive investment in the eyes of the IRS, which means you cannot offset large income/expenses from the rest of your tax situation. There are many rules and stipulations to become eligible, however, so do your research to better understand what is best for your rental. If it is possible to only do short-term rentals or reach Real Estate Professional Status, it could help from a tax planning perspective.
Is it a Good Investment?
Ultimately, it is worth considering all the facts before deciding to rent out a former residence. Getting into real estate can be a great financial decision, but it should not hinge on one single property. If the long-term goal is to own multiple properties, renting out an old home is a great first step. If this is the only property in the future, but it sounds like it could make you money, I would be cautious to jump in. You may find in the future that you’d rather have left your investments and bypassed the headaches. The goal, like any investment, is that it should fit into your overall financial plan and help towards the goals you have.
