Moving--Rent or Sell Current Home

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davidlukewilcox
Posts: 117
Joined: Sat Dec 24, 2011 1:44 am

Moving--Rent or Sell Current Home

Post by davidlukewilcox »

I'm moving soon. I was going to ask if I should rent or sell my current home. But, I decided to spend a couple of hours and make a spreadsheet for it.

https://docs.google.com/spreadsheets/d/ ... sp=sharing

I assume a 8% discount rate (predicted stock market return). In my case, I eventually have positive NPV to rent instead of sell, but it takes 13 years. After 23 years, I have about $30,000 positive NPV to rent instead of sell. Also, I'm budgeting $3600/year of expenses (which is much more than I spend now, but probably less than a rental). Go ahead and validate my assumptions and let me know if anything is off.

I'm wondering if it's worth doing a rental for this many years for a shot at $1500/year of NPV after 20+ years, and negative NPV before 13 years.

Thoughts?
Lafder
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Location: East of the Rio Grande

Re: Moving--Rent or Sell Current Home

Post by Lafder »

If the financial benefit is equal to either rent the house out or sell and invest the proceeds in the market, which would you choose? How much more would renting have to make to be worth it? Do you like the idea of owning the house?

Your spread sheet makes me think you are most concerned about the $$ aspects of sell vs rent.

The immeasurable/unknown costs are the stress of having a rental even using a property management company, as well as the repairs and unrented periods.

There is no way to know what the stock market will actually do, or how much the house will go up or down in value.

If you keep the house as a rental, you will eventually have a paid for house to keep renting or sell.

Your life will be simpler if you sell it. So only keep it as a rental if you REALLY want a rental property.

((Sorry I am not commenting on your #s or years to be ahead on rent vs invest, that part hurts my head to think about and decide if the numbers you came up with seem correct))

NOLO Every Landlord's tax deduction guide may help you figure out some $ points you may have forgotten. Also, google Tenants from hell to toughen yourself to some possible rental problems.

In full disclosure I do have some residential rental property. One bought as an investment years ago and now paid off. The other by default after we moved and did not sell the house fast enough. SO for me I decided yes it is worth it. But I may sell them and be done with the hassle when my net worth is enough I no longer have to work and can retire.

Lafder
LeeMKE
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Re: Moving--Rent or Sell Current Home

Post by LeeMKE »

IMHO a 13 year breakeven is way too long a period to be reasonable.

Managing rental property is work. Coordinating repairs and maintenance with a tenant in place and from out of town is a challenge. And some tenants will cause problems. And I don't like putting renters in expensive SFR property as the wear and tear is more severe and depreciates the property substantially (use 15% discount as a rule of thumb). I don't see cost of sale in your spread sheet which will run 8% of current market value (if you are lucky and don't have to spend money to redecorate, landscape or otherwise spiff up the property before it hits the market)

Finally, I assume you are certain you can rent the home. Some HOAs have restrictions on rentals.
The mightiest Oak is just a nut who stayed the course.
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jimb_fromATL
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Re: Moving--Rent or Sell Current Home

Post by jimb_fromATL »

Before getting into the math, your mortgage numbers suggest that you have been in the home close to two years now. So before you decide to rent it out, you need to consider that you can avoid capital gains tax on the profit if you have lived in the home for 2 out of the last 5 years before you sell. If you put it into rental service and miss the requirement or deadline later, you’ll have to pay cap gains tax on that profit.

Here's a bunch more stuff to think about:

Whether to rent or sell also depends on your budget and income and debt-to-income ratio in addition to your temperament to be a landlord and your tolerance for risk. Most lenders will not consider potential rent as income in qualifying for a new mortgage. So your total debts including both mortgages plus taxes and insurance, possibly an allowance for maintenance and repairs, and any other debt obligations such as car payments, student loans, etc. would need to be no more than typically 30-35% of your income.

Plus you'd need to come up with 20% down for the next home without robbing too much from your emergency funds ... which IMO need to be enough to cover at least 6 months to a year of all living expenses and bills -- including both mortgages and other expenses of owning both homes even during vacancies on the rental.

Next, I don’t think your spreadsheet using NPV is accurately depicting your gain for the rental property. If I understand it correctly, the spreadsheet is showing a gain of only about $3322 for the rental in the first year. But it appears to me that your numbers for income, expenses, and inflation indicate your actual gain in net worth to be more in the range of $12,000 for the first year. So the rental may be giving you a lot more gain than your spreadsheet suggests.

Let's talk about how the return on a rental compares to selling and investing in a mutual fund in a taxable account.
  • If you sell the home and invest the proceeds in mutual funds in an after-tax account, you will receive dividends every year, and will experience the increase in net worth from the gain in value of the securities while you keep the account. You pay tax on the dividends every year but defer taxes on the gain in value until you actually sell the funds.

    For the rental, the amount to compare as your initial investment is the cash you’d receive at this time if you sold it. In this case the positive cash flow from the rent after all expenses is roughly equivalent to the dividends you would receive from an investment fund. (If you had a negative cash flow, it would be like investing a lump sum then contributing more to the fund every month.) Unless you pay the positive cash flow amount to reduce the mortgage balance, it's also equivalent to taking the dividends from a mutual fund in cash instead of reinvesting them.

    Your gain is your improvement in net worth in the form of cash flow received after expenses (if any);
    • ... plus reduced debt on the mortgage -- the principal that is being paid with OPM (Other Peoples’ Money);
      ... plus the gain in value of the property from appreciation.
    (An advantage of the rental with a mortgage compared to a normal taxable mutual fund is that you’re getting leverage of the yearly gain on the full market value of the property even though you don’t have that much of your money tied up in it.)

    Just like a mutual fund, you pay tax on the “dividends” (the reportable positive cash flow) every year, but don’t pay tax on the gain in value until you actually sell it.

    However, you pay regular income tax on the taxable portion of the positive cash flow from the rental, whereas you’d only pay the long term capital gains tax rate on dividends from the mutual fund being held for more than a year.

    Unlike a mutual fund, you also get to reduce your year-to-year rental income by a lot more expenses, including mortgage interest, taxes, insurance, maintenance and repairs, condo or HOA fees and other expenses, plus the phantom depreciation allowance. So you can have considerable rental income but still have no taxes from year to year. You will pay taxes on the depreciation recapture when you finally sell it, along with any gain in value from appreciation.


So the question is whether the cash flow ( whether positive as income or negative as contributions); plus the reduction of debt being paid with OPM; plus the appreciation in value on the property will give you a big enough total return at any given point in the future to make it worth the risk, hassle, work, and month-to-month expenses compared to just selling the place and investing the net you would receive at closing.

Another consideration is that while you may see a big increase if the home appreciates, you could have much less gain if it only holds steady or loses value. Plus, while you may be improving your net worth at a good rate of return –often better than the stock market-- you're in debt with the mortgageand the equity is tied up in the home; so you can't put your hands on it easily in an emergency.

Now let’s look at your numbers in view of these considerations:
  • If you can sell it now for $240,000 with perhaps 6% costs and commissions of $14,400, then after paying off the $160,000 mortgage balance you'd have $65,600 that you could invest elsewhere such as the stock market. That’s the value I think you should use as the starting point of comparison for the rental as a long term investment..

    If you can rent it for $1400 per month for 11/12ths of the time, your income from OPM would be $1,283 per month, $15,400 in 12 months.

    With a monthly payment of P&I of $725 + $30 insurance + $120 taxes + $300 average for expenses you'd be paying out a total of $1,175 per month. With average monthly rental income of $1283 per month you would have an average positive cash flow of $108 per month, $1300 per year.

    The $15,400 income -$5,147 mortgage interest -$360 insurance -$1,440 taxes -$3600 expenses and perhaps $7,591 depreciation allowance for the year gives you a reportable income of -$2,739. Since it’s negative, there’s no income tax due for the year.

    However, since you're reducing your debt and it is hopefully appreciating or recuperating in value, you may have considerable actual gain in net worth.

    For example If it's worth $240,000 now and appreciates 3% annually it will be worth $247,200 in 12 months, an increase in your net worth of $7,200. With a $160,000 balance with a payment for P&I of $725 per month you'll reduce the balance (increase your net worth) for the 12 months period by $3,553.

    So your actual gain for 12 months is $1,300 cash flow + $3,553 less debt + $7,200 appreciation = $12,053.

This makes the gain for the rental about 18.4% in the first year for an investment of $65,600. Since the cash flow is incremental, the gain of $12,053 is an APY of 17.13% compounded monthly for comparison to investing in a mutual fund.

If you sold the house and invested the lump sum of $65,600 and earned an APY of 8% while taking out $108 cash per month, then after 12 months you'd have $69,696 in the account plus the $1300 cash for a total gain of $5,396. Not nearly as good as the rental.

There are also a number of details that I think need to be addressed in your spreadsheet.
  • One minor point is that the depreciation allowance is based on the lesser of your actual cost or its basis when it’s put into rental service, which you appear to be using. But you can only depreciate the structure, not the land, so the depreciable amount will be less than its market value or purchase price. Many tax records separate the component values of the structure and the land.

    Another minor detail is that you appear to be using 28 as the number of years for the depreciation allowance instead of 27.5. It’s no biggie, but you are carrying the calculations out to many decimal places, which implies more accuracy.

    Another perhaps bigger issue is that only the mortgage interest is deducted from the rental income for tax purposes from year to year -- not the principal. The interest is a deductible expense. The principal is reducing your debt, increasing your net worth, so is part of your gain in value for the investment.

    IMO the expenses of $300 seem very high for maintenance and repairs. If it were really going to cost that much, that could a good reason to sell it rather than rent it out. It would be comparable to an investment in a mutual fund that had very high management fees. Or is it possible that expense estimate also includes any HOA fees in addition to maintenance and repairs?

    Another detail to consider is that the mortgage interest accrues on the unpaid balance every month. So the ratio of interest to principal changes in your favor from month to month and year to year with less interest and more principal in every payment. You can use the FV function to calculate the mortgage balance and the total principal and interest every year. It's not quite the same as the average for each year, so your balance – and thus your return on the investment and the tax deduction will probably be off by several hundred dollars after a few years.

    For example, the balance the first year will be:
    =FV(0.0325/12, 12, 725, -160000) … which is $156,447.39
    For the next year:
    =FV(0.0325/12, 12, 725, -156447.39) … which is $152,777.59

    Another point to consider is that the depreciated value affects the income tax you pay from year to year on the rental income, but it does not really change the actual market value of the home from year to year

    Speaking of income taxes, I think you’re over-estimating that cost.

    You do pay regular income tax in your highest bracket on the taxable portion ... which in this case is $1300 in the first year. But when you do finally sell, you will be paying the lower long-term capital gains tax rate on your gain. Currently in your 33% marginal tax bracket, the cap gains tax rate is 15%. You will pay income tax on the depreciation recapture when you sell, but it’s lower than your marginal rate too. (I think it’s currently 25%.)

    Don’t forget state tax if it’s applicable in your state. It could help make the rental more viable if you can deduct it too. The more income tax you can defer by deducting expenses and the phantom depreciation allowance, the better the rental is likely to work.
All things considered, and assuming you can afford it and qualify for both mortgages, I think the first thing is to determine how much gain you actually have that would be taxed later if you don’t excluded it by selling now. That may make a big difference in your total profit after taxes at some point when you sell.

Then do some research on how much the property is likely to appreciate. If it might keep up with the historical average of around 4-5% (before the crash of 2008) you stand to have a very, very good return for the money. If the expenses are actually less than the $300 per month you estimated, even better. If the rent is likely to go up, even better yet.

Then think long and hard about whether you really want the risk and hassle of being a landlord. Your mutual fund is not going to call you in the middle of the night about a clogged toilet. It is not going to pack up and move in the dead of night to avoid paying you a monthly dividend; it's not going to require you to make payments if you don't have a tenant; and it’s not going to be trashed requiring you to spend a lot of money on it before you can start earning those dividends again.

jimb
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Watty
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Re: Moving--Rent or Sell Current Home

Post by Watty »

How does the market values of the homes compare to your net worth?

Assuming that you are buying another house with another mortgage that could mean that the houses market value(not home equity) is many times your net worth. If the two houses are 200% of your net worth then even a 25% real estate market slump could cut your net worth in half.
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