In most cases>, moving means selling one's home. After all, it's usually a necessary step in affording a new home.
But for various reasons some people choose to rent out their homes instead. In some instances, people know that they'll be leaving only for a year or two perhaps while they pursue a graduate degree or take on a specific project at work. Sometimes the would-be seller simply can't sell at a price deemed acceptable, so he or she chooses to hang on until the market picks up. Or, if property values are rising, an owner may want to wait to be able to ask for a higher price later.
Whatever the reason, it's important to have a healthy grasp of the financial issues at play when weighing this decision. Here's what you need to consider.
The Tax Issues When You Sell
As you probably know, Uncle Sam provides a generous tax break for those who've lived in their home for at least two of the past five years. Married couples who file jointly can earn up to $500,000 in capital gains tax-free, while singles can enjoy $250,000 in tax-free gains. (For more on this, including exceptions to this rule, click here.)
Good news: Those who are planning on renting out their home for just a year or two will still be eligible for these breaks (provided they've lived in their home for at least two of the past five years). Should they sell more than three years later, however, they forgo the tax exemption, meaning their gain would be taxed as a capital gain.
Consequently, for those whose renting plans would turn a tax-free gain into a taxable one, it is probably wise to sell. The rule of thumb is if you have a large gain on your personal residence, you don't want to rent it out. There is an exception, however: If you're willing to move back into the house and live there for two years before you sell, you'll requalify for the exemption.
The Tax Issues When You Rent Out
Becoming a landlord also offers some handsome tax perks. While rental income is taxed as ordinary income, your tax bill could easily be eliminated thanks to the numerous deductions on expenses and depreciation. There is, however, one major exception: If you eventually sell the house and qualify for the capital-gains tax exemption discussed earlier, you'll be taxed on the amount you depreciate, which could make renting out your home considerably less attractive.
Let's talk expenses first. You can deduct pretty much any out-of-pocket expenses related to owning and managing the property. This includes your mortgage interest payments and property taxes (same as if this were your primary residence). It also includes other expenses, like advertising or broker fees, the costs of repairs to the property, maintenance expenses such as cleaning services, utilities and management company fees, the cost of fire and liability insurance, and even travel and local transportation expenses incurred for the maintenance of the property and collection of rent.
Then there's the "phantom deduction" called depreciation. Just divide the fair market value of the property at the time you start renting it out (excluding the cost of land) by its recovery period which is 27.5 years for residential rental property. Bingo! There's your annual depreciation. For example, if the home is worth $550,000, you divide that by 27.5 and get a $20,000 annual deduction. If you have another $10,000 in out-of-pocket expenses, which are also deductible, you can get $30,000 in rent tax-free.
Improvements can't be deducted, but you recover their cost by depreciation. The good news is, you typically depreciate the cost of any appliances, carpeting, furniture or plumbing over only five years. So if you buy a new $1,000 dishwasher for your rental, you can deduct $200 a year from your rental income for five years. (This is pretty complicated stuff, so be sure to talk with a CPA before you file your returns.)
|Keep property as it appreciates>||Possible damages to property>|
|Tax-breaks could offset income tax on rent>||Could be taxed on the whole profit if you sell>|
|Rent income covers mortgage, taxes and insurance payments>||Potential legal or financial problems with tenants>|
|Likely tax-free capital gain>||Could be priced out of market if you want to return>|
|Frees up equity that could be invested or rolled into new home>||Lose potential property appreciation>|
|Simplicity: Only one house to maintain>||Could have to sell at a bad time for real-estate market in your area>|
Can You Afford to Rent?
For many homeowners, renting out a home is simply not a viable option; they need to sell in order to raise the capital necessary to buy their next home. And owning two homes requires deep cash reserves. Consider, for example, that there may be periods in which you have no renter or when a tenant may skip one or two months of rent. You have to figure out whether you will be able to make mortgage payments anyway.
There's also the risk that a tenant could damage your property or cause problems that lead to an expensive eviction process. Frighteningly, an eviction could cost you several thousands of dollars, or more, and could last as long as 18 months, during which time the tenant is likely to refuse to pay rent. So you need to be financially prepared for the worst.Is the House Likely to Appreciate?
If you expect prices in your area to soar markedly over a three-year time span, you may want to rent it out. But keep in mind that, historically speaking, real estate tends to appreciate at the rate of inflation (roughly 3% annually), so even when property values are in an upswing, that doesn't mean they'll continue to be.Look at the house as an investment, and think of it as part of your overall portfolio. Ask yourself: Am I diversified enough? If the majority of your net worth would be tied up in your two houses, you need more diversification, and you could be better off selling the house and investing the profit.Is It a Hot Rental Market or a Hot Sales Market?
Sometimes the market is better for sellers than for landlords. Call your local board of Realtors or a real estate agent and have them appraise the house; get the numbers for the rental and the numbers for the sale. Generally speaking, it will make sense to rent the house out only if it's in a relatively stable market and the income from rent will cover your mortgage and other related expenses.Do You Ever Plan to Come Back to the Same Area?
If you want to return to the same area years from now, you could be priced out of the market if you sell your house. It would therefore make sense to rent it out.Strangers in Your Home
Consider how comfortable you are with tenants living in your home. If you have a deep personal connection with the property, you may see it as an invasion of your space. If you set out to rent it, you must be prepared to handle the process in a businesslike manner.
Are You Cut Out to Be a Landlord?
Becoming a landlord isn't for the faint of heart. What happens if a pipe breaks and you're out of state on vacation? Being an absentee landlord is impossibly difficult unless you have someone to oversee the property. If you're willing to part with 10% of the monthly rent, you could hire a property-management company to do it. Depending on your agreement, it could take care of everything related to the property from putting it on the market and screening your tenants to collecting rent, maintaining the property and even taking care of your mortgage.
Should you decide to seek the services of a management company, go through your local chapter of the National Association for Residential Property Managers, which represents managers of single-family homes, or through your state's or city's apartment owners association if you own an apartment.