Question: My wife and I own a house in the city. With the addition of our first child, we needed a larger home and bought one in the suburbs. It is tempting to sell our other house, especially since the market is so robust, and given the favorable capital gains tax treatment currently in existence. However, we have been leaning toward renting it — at least for a few years. Do you have any suggestions?
Answer: You have posed a difficult question, and there are no solid answers. Much will depend on your personal situation — both financial as well as psychological. There are many issues which you — and your family and your financial advisors — should consider before you take the plunge into those murky waters called “rental” or “sale.” Here are some of the various matters which you should investigate:
Tax Considerations: No one wants to pay Uncle Sam any tax money. If you sell your principal residence, will you have any capital gains tax to pay? Have you owned and lived in the house for a period of two years out of the five years before it will be sold? If so, and assuming you are married and file a joint tax return, you can completely exclude up to $500,000 of your gain. Oversimplified, gain is defined as the difference between the adjusted sales price and the adjusted purchase price. Let’s take this example: You paid $100,000 for your house, and made $10,000 of capital improvements. Your adjusted purchase price is $110,000. Now you have sold your house for $400,000. You also had to pay a real estate commission of $24,000, and miscellaneous closing costs of $6,000. Your adjusted sales price is thus $370,000 ($400,000 – 24,000 – 6,000). When you subtract the adjusted purchase price from this latter figure, your profit (i.e. capital gain) is $260,000. If you are married and file a joint tax return, you can keep all of this profit. On the other hand, if you are single (or file an individual tax return) then you can only shelter $250,000. The remaining $10,000 profit will be taxed at the current rate of 15 percent — or $1,500.00. You also have to take into consideration any local or state tax which is imposed on such gain. Of course all this needs to be discussed with an account and/or financial advisor.
Rental Headaches: Being a landlord is not an easy task. In some areas there are strong tenant rights laws. You must make sure that you fully understand all of the applicable rules and regulations which impact on landlords before you decide to rent out your property. Is the property in an area which will continue to appreciate? How old is your house? Will it need periodic, expensive maintenance? Is the roof on its last legs? What about the heating and air conditioning system — as well as all other appliances. Keep in mind that with most rentals, you — as landlord — will be responsible to make sure they are all in working order, unless of course your tenant negligently caused the damage (which is difficult to prove).
Long Range Goals: Do you have any idea how long you will hold on to the property? While I recognize this is a difficult question, you really should give serious thought to whether this property is to be included in your estate planning. Regardless how old you are, it is never too early to start planning for your retirement — and your ultimate demise. Will the rental property be a burden on your family? Will it be a burden on your budget?
Management: If you decide to rent, will you self-manage or hire a professional property manager? Doing it yourself will save you the money you would have to pay to a manager. But it will not save you from the midnight telephone calls from a distraught tenant who has locked himself out of the property or has a flooding toilet. If you decide to retain a manager, make sure that you interview him or her, and have a comprehensive contract spelling out who is to do what and when — including the cost of any such services. Your contract should not include a provision that if the property is sold to the tenant, the manager will get a real estate commission. There are different ways that you can hire a manager. Your manager can be given complete responsibility for handling the rental property. Under this arrangement, the manager will advertise and locate a tenant, determine if the tenant is financially capable of paying the rent, collect the monthly rent and pay all of your bills. If you go this route, you should receive a monthly statement from the manager, showing the income and expenses incurred during that reporting period. Alternatively, you can give your manager selective tasks — such as only finding a tenant for you. All options should be discussed with your potential manager before you sign a contract. You have suggested that you could manage the property for one year and see how you like it. Clearly, that is yet another option for consideration. You also suggested that you could rent out the house for three years, and if you are not “enjoying” the rental process, you could then sell the house and take advantage of the capital gains tax savings. That certainly makes sense, but watch your calendar very carefully. As discussed above, you must have lived in the property two out of the five years before the house is sold. If, for example, you lived in the house from July 1, 2002 through July 1, 2004, you must sell the house by June 30, 2007, in order to capitalize on the capital gains tax exclusion. If you rent the house for three years, you may have trouble selling the property while the tenant is still on the premises. Furthermore, no one knows what the market will be in 2007. Thus, if you decide to try the rental process, you should consider renting it out for only two years. This will give you a full year in which to get it ready for sale, find a buyer, and actually go to settlement within the statutorily mandated time frames. Renting you house is clearly an option for you to consider, but you must do your homework, and understand the pros and the cons of this venture.