Real estate is often a big part of an individual’s net worth, whether by accident or design. In the last 10 years, we’ve seen a tremendous comeback in the real estate market across the country. Buyers today generally enjoy low (but increasing) interest rates and relaxed lending requirements. These benefits are partially offset by continued low inventory which has resulted in bidding wars in many areas. Whether you are looking to buy, own a rental property, inherited a home, or are planning on selling your house at some point, you have likely noticed the state of the housing market and perhaps have even adjusted your financial plan as a result.
As some economists contemplate how long this over-confidence in the real estate market can continue, homeowners and real estate investors should be careful not to get too hung up in the value of their property today, unless of course they’re planning on selling it and realizing those gains in the near future.
As with any investment, you generally need to have a well thought out strategy before putting any money down. Real estate is a volatile industry, some get lucky while others wind up getting crushed. Throughout this article, we’ll discuss a variety of ownership scenarios, whether as an investment or for personal use, and some strategies to consider when holding real estate as an investment.
Owning real estate as your primary residence
Whether you own a home already or are looking to buy your first house, you may already be thinking about what to do with the property when you no longer wish to use it as your primary residence. A few of the most common options are:
- Sell the home before buying a new house (traditional method)
- Buy a new house before selling your old one
- Keep the home as an investment property
- Use the house as a vacation home or to help a family member
- Donate the property to charity or leave an inheritance to your children or other family members
What’s your home worth?
Although your home may be your largest asset, not everyone considers it an investment. Some homeowners don’t see their house as an investment because they never plan to move or because they wouldn’t move simply because the value of their home had increased. Calculating the true return on investment for your home can be tricky, and it is important to keep in mind that price appreciation does not mean ROI.
Professional real estate investors are dedicated to their cash flow models and making the numbers “work” – an exercise any new real estate investor or landlord should also practice before making an investment or deciding to rent vs sell your home.
Should I rent or sell my house?
Before converting your home into a rental property, it is very important to think about your sell or rent decision in context with your bigger goals. Even if you’ve only lived in the home a short time, moving can be bittersweet and emotional. Try not to let your attachment to the property cloud your judgment on whether to keep the property. Many homeowners find that once they’ve settled into their new home, much of the attachment to the old house has already faded. When considering renting vs selling a house, it is highly encouraged to first take an objective look at your overall financial picture and crunch some numbers.
Renting your house
If you don’t need to sell your house to buy a new home, you may be considering renting it out. Depending on your monthly overhead and potential rental income, it may be very wise to diversify your income streams. If you are moving out of state for a temporary relocation, you may wish to keep the house and return to it one day, assuming you feel it will fit your needs in the future. In general, it may make sense to hold onto the property as an investment if you have all of the following: time, money, cash flows.
Time. Being a landlord isn’t for everyone. Unless you have multiple rental properties, hiring a property manager is probably cost-prohibitive. This presents a significant challenge for landlords that do not live near the property, travel frequently, or have young kids or a busy schedule. Some repairs can wait but others require you to drop everything and find a solution. Having good tenants can also make or break your landlord experience. For example, if a renter doesn’t alert you of a leak, what could have been a $5 fix you could have done yourself, now involves an insurance claim and a new floor.
Money. Real estate is an illiquid and cash-intensive asset. If you have a rental property, you’ll need to have much stronger cash reserves than your personal emergency fund. If you own a condo, there are pros and cons. Your monthly dues will typically go to the association’s reserves and later be used to repair common areas like the roof. And if you’re in a larger building the daily maintenance may be taken care of. However, HOAs may also issue special assessments if the reserves are inadequate. While less common, special assessments can be $10,000 or more, making it hard for homeowners and landlords alike to come up with the cash. Keep in mind that holding too much cash will eat into your returns over time, so the opportunity cost is something to consider in your modeling.
Cash flows. What is your expected net rental income? How comfortable are your margins? You may find an extra $200 per month in pre-tax rental income isn’t worth the headache of keeping the property. Consider working with a CPA to run the numbers for you on an after-tax basis, including depreciation and other potentially tax-deductible expenses.
Note on the tax benefits of owning real estate as a landlord or a homeowner
The recent tax reform legislation has made dramatic changes to the benefits of holding real estate as a primary residence and as a landlord. Although it will likely take months for CPAs and accountants to release more concrete guidance on how the legislation will ultimately impact taxpayers, we do have a sense on what is to come. For specific guidance on the new tax code and how it may impact your tax situation, please consult your tax advisor or CPA.
Some of the major changes that will negatively impact homeowners are: state and local tax deductions (including property tax) are capped at $10,000 and interest paid on home equity debt may still be tax deductible, provided that the proceeds of the loan are used to “buy, build or substantially improve the taxpayer’s home that secures the loan.” Further, beginning in 2018, mortgage interest and qualified home equity debt interest may only be tax deductible on new home loans up to $750,000.
Where homeowners may have lost out in the Tax Cuts and Jobs Act, real estate investors have gained. Although it will likely take months for CPAs and accountants to release more concrete guidance on how the legislation will ultimately impact landlords, we do have a sense on what is to come.
Assuming the rental activity is considered a business not an investment by the IRS, landlords of residential property will likely not be subject to the same limits as homeowners regarding the deductibility of property taxes and mortgage interest. Further, the new tax bill also included a provision where landlords may be entitled to a tax deduction of up to 20% on their “pass through” income. While these changes could equal big savings for landlords, if you decide to rent out your home instead of selling it, consulting a CPA to prepare your 2018 tax returns is strongly advised.
Selling your house
There are a number of reasons why a homeowner would decide to sell their house. Perhaps the most common reason is cash flows – either you need the proceeds from the sale to buy your next home or the anticipated rental income isn’t sufficient to cover your expenses and time. Just like an investment property can have financial benefits, selling your home can pay off big too. Here are a few of the scenarios where it may be advantageous to sell vs rent the house:
Cash windfall. If you bought your home at a good time or have a low mortgage balance, you could stand to pocket a lot of cash from the sale of your home. If you can avoid plowing all of the proceeds from the sale of your home into your next property, the windfall could make a meaningful impact on your other goals. Consider getting caught up on your retirement savings by putting the proceeds in a brokerage account or funding the kids’ 529 college savings plans.
Tax benefits. If you own the home and have lived in it as your primary residence for at least two of the last five years, you may be able to exclude all – or a portion of – the gains from capital gains taxes. Single filers may exclude gains up to $250,000 ($500,000 if married filing jointly) from their taxable income. Although this provision was on the chopping block in earlier versions of the recent tax reform legislation, it managed to survive the final bill. However, the next administration could change the tax code again. The key takeaway is that the tax laws can change at any time, even radically as we have just seen. If the success of your strategy hinges on the continuation of any favorable treatment of real estate in the tax code, proceed with extreme caution.
Diversifying your assets. Depending on your other investments, your home may already be a large part of your net worth. If this is the case, it may not be wise to substantially increase the proportion of real estate in your overall investment mix by renting the property and buying another home to use as a primary residence. Selling the home can allow you to use some of the proceeds to diversify your investments.
Depending on your situation, a financial model may be advisable to analyze the trade-offs and cash flows to help determine the best financial outcome for you. Contact us to learn more about the benefits of a financial plan.
Inheriting a house
If you have inherited a home either by yourself or with siblings, you may be wondering what to do with the property. If the home was not held in a trust, it will likely go through probate, which is time-consuming and costly. As you face the difficult practical and emotional decisions at hand, try to remain as objective as possible when evaluating your options. In most situations, the beneficiaries of newly inherited real estate will have the following options for the house:
- Sell the house
- Keep the home for your own use, whether as a vacation home or a new primary residence
- Keep the home as a rental property
- Donate the house
If you have inherited the home with siblings or other family members, you may want to be prepared for differing opinions about how to move forward. Whether you agree about what to do with the inherited house or not, there are numerous logistical and financial issues at play should you decide to keep the home or rent it out.
How inherited real estate is taxed
The tax treatment of an inheritance is complex. Inherited real estate such as a house or vacation home receives a “stepped-up” basis for tax purposes. This stepped-up cost basis is the market value of the property on the date the decedent (the person you inherited the home from) passed.
The tax benefits can be significant if the property has appreciated considerably since the decedent purchased it. Further, the stepped up value is always considered “long term” for capital gains taxes. If you sell the property for more than the cost basis, the gain will be taxed at long term capital gains rates.
If the property is sold for less than your stepped-up basis, it will likely be considered a capital loss. Only $3,000 in capital losses may be deducted against your income each year. However, the balance may be carried forward to future years. These calculations can be complex; consulting a tax professional for specific advice is advisable.
What should you do with an inherited home?
Usually, when adult children inherit their parents’ primary residence, they do not wish to keep the property for a number of reasons. Perhaps they do not wish to relocate or they already have a home of their own.
Deciding what to do with a vacation home or rental property may be more difficult, especially if the home has been in the family for a long time. Similar to the rent or sell analysis above, it is best to try and be objective about your next steps. Ask yourself: what would you do if you had no personal ties to the property?
Affordability. Even if the property doesn’t have a mortgage, keeping the home needs to be financially feasible without stretching you too thin. Costs like insurance, maintenance, property taxes, and so on will never go away. If the home is seasonal, rental income could help make the financials work, but this could mean you’re no longer able to use the house yourself during peak season.
Cash windfall. Since you did not purchase the property and will receive favorable tax treatment upon sale, selling the house and using the proceeds to fund other goals may be in your best interest. An unexpected windfall could really change your financial picture. Consider getting caught up on your retirement savings by putting the proceeds in a brokerage account.
Feasibility. To keep the home as a vacation house or a rental property, consider how feasible it will be to maintain the home as a landlord or during the off-season, especially if you do not live nearby. Do you like to travel to new places on vacation or is the house somewhere you can see your family using frequently enough to justify the cost? If you’ve inherited the property with other family members, discuss the details first. Who is going to be primarily responsible for maintenance? Will you split these costs equally? Does each family member have funds set aside to share unexpected expenses? Who is willing to be the landlord for renters? Who gets to use the house on school vacation week? Ironing out these seemingly minor details in advance can help avoid disagreements and frustrations among family members.
Real estate can be a great investment. You can enjoy a property in ways very unlike a traditional investment portfolio with stocks and bonds. Unfortunately, also unlike an investment portfolio, you may have little control over how much money and time you’re required to spend on keeping your investment in good order. When properly vetted, holding real estate as an investment can still be a good way to build wealth over time and add diversification to your portfolio as a component of your overall net worth.