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  What To Do With Your Old House...Sell It Or Rent It? - Back
Samantha and Tom are about to move into a new home and want to know if it's a good idea to keep their current home as a rental property.

The couple estimates that the rental on the house, which is situated five miles from a major university, would bring in an income that would exceed their monthly mortgage payment by about $75 to $125.

Before Samantha and Tom jump to a conclusion about renting their old home, they should give some careful thought to their overall investment situation, their desire to become landlords, and the income tax impacts of renting the home versus selling it. Below are some factors for Samantha and Tom to consider in each of these areas:

The Investment Situation

Samantha and Tom are relatively young and have a very long investment time horizon. They've accumulated some savings, own one home, and are in the process of finishing construction on a second home that they plan to move to.

Historically, over long time frames, real estate investments have provided substantial returns by way of price appreciation, but on average, they haven't performed as well as large capitalization U.S. stocks. If Samantha and Tom are confident that the old house will appreciate significantly over time, maintaining the home could make sense.

However, if Samantha and Todd aren't very confident about this, they'll likely be better off selling the old home and investing the net proceeds in a diversified portfolio that includes equities (large, small, and international stocks and/or mutual funds) and, possibly, fixed income.

If Samantha and Tom keep the old home, they need to be prepared to accept the higher level of risk associated with their concentrated real estate positions. Like all other pieces of real estate, Samantha and Tom's homes are subject to fluctuations in value caused by prevailing interest rates, the health of the local economy, general business conditions, zoning changes, and a host of other factors that are unique to each property.

On top of all of this, real estate is typically very illiquid, which means it could take several weeks or months for sales to occur and proceeds to be collected. Samantha and Tom are especially susceptible to value fluctuations caused by one or a combination of these factors because both of their real estate holdings are residential properties located in the same geographic region.

Furthermore, these factors are of particular concern with respect to the old house because Samantha and Tom would rely on rental income to cover the maintenance expenses associated with owning the home. In most cases, maintenance expenses, which include mortgage payments, property taxes, insurance, repairs, etc., are no small matter. If the local economy took a dive or some other factor caused negative pressure on the local rental market and the couple wasn't able to collect enough rent or otherwise cover the maintenance costs, they could be forced to sell the house in what would probably also be an unfavorable sales environment.

So, You Want to Be a Landlord?

Owning rental property can be financially rewarding, but it can require a lot of effort.

As landlords, Samantha and Tom need to be prepared to take on many responsibilities that they might not otherwise have the time or the desire to fulfill. These responsibilities include familiarizing themselves with local landlord and tenant laws to make sure they are aware of their rights and those of their tenants, carefully selecting tenants who will take of the home while they are living there and pay rent on time, collecting rent, addressing maintenance problems in a timely manner, keeping financial records related to the rental activity, and much more.

Being a landlord certainly isn't the most impossible job in the world, but it does require time and focus. Samantha and Tom should determine at the outset of the rental process which of them will be responsible for which tasks. This will help the couple alleviate unnecessary stress and agitation that might otherwise surface.

Income Taxes

If Samantha and Tom rent the old home, the house takes on a new income tax identity as "rental property." This means that Samantha and Tom still deduct mortgage interest and property taxes related to the home like they did when it was their residence, but they now get to deduct additional expenses like insurance, repairs, and depreciation.

The kicker for high-income people is that each year the deductions are limited to the amount of rental income collected. For instance, if the rental income exceeds the deductions, Samantha and Tom simply pay income taxes on the net rental income at their marginal tax rate. On the other hand, if Samantha and Tom end the year with a rental loss (e.g. the deductions exceed the rental income), the loss is suspended and carries forward to a future year when the income is greater than the deductions. In other words, Samantha and Tom wouldn't get the tax benefit of the current year loss until some future year.

That said, there is a provision that relaxes this somewhat and would allow Samantha and Tom to use up to $25,000 of a current year rental loss to offset other income (like salary) if their income before deductions was less than $150,000.

If Samantha and Tom instead decide to sell the old home, they may not have to pay any taxes if they realize a gain. The tax allows taxpayers to exclude up to $250,000 of gain from the sale of a home that was their principal residence for at least 2 of the 5 years prior to sale. Since Samantha and Tom are married, they can exclude a combined $500,000 of gain. Therefore, from a pure income tax point of Samantha and Tom might have an incentive to sell the old house immediately because they would have tax-free access to up to $500,000 of appreciation built-up in the home since they bought it.

The tax reductions passed by Congress earlier this year might give the couple further incentive to reinvest the proceeds in equities to get the benefit of the new 15 percent tax rate that applies to dividends and long-term capital gains, which is lower than the tax rate applied to rental income.

Although the tax treatment is seductive and could, on its own, lead Samantha and Tom to a particular conclusion, they should make the rent-vs.-sell decision based on what they expect the overall long-term financially optimal outcome to be.

Thinking It Over

When deciding whether to rent or sell the old house, Samantha and Tom should determine how best the value of the property would fit into their overall strategy. Does keeping the real estate provide enough upside potential to offset the risks the couple would be taking by owning two homes in the same geographic area? And, are they prepared to take on the added responsibility of being landlords?

If the answer to both questions is "yes," they should keep the house and hang the "for rent" sign soon. If they answer "no," they should sell the house and invest the proceeds elsewhere.

However, if they answer "maybe," they could explore a middle ground. Rather than sell the house immediately, Samantha and Tom could give the rental route a try. If they rent out the property and decide within three years that being landlords isn't financially or psychologically stimulating, they would still meet the two out of five years principal residence requirement necessary for the $500,000 gain exclusion on the sale of the house.

Regardless of which direction Samantha and Tom decide to go, they should be familiar with the tax implications involved.

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