Chances are, your current home won’t suit your needs indefinitely. If you’re living in a small starter home or a condominium, you may want to upgrade to a larger house as your family grows. If you’re already in a large residence, you may want to downsize your home when your children move out. Also, there’s always a chance you or a family member may need to relocate for work, in which case it’s time to say goodbye to your current address.
The big question is what to do with the property when you move. Are you better off keeping your old place as a rental, or does selling it make more sense? While renting allows you to either pay off your mortgage or make a little money every month, it also comes with a fair amount of risk and added tax complications.
Why Rent Your Home?
When a tenant pays you rent, you can use the check to cover your monthly mortgage. In a sense, your tenant is paying for you to earn equity in your home. Once the mortgage is paid off, you can keep any monthly rent as income.
Renting out your home can diversify your investments and income streams, enabling you to reduce your financial risk. For example, if you lost your job, you would still have some income from the rental. Or, if you find your retirement savings are insufficient, you’ve got a piece of real estate you can sell.
Costs of Renting
When calculating the cost of renting a house, consider these potential expenses:
- Mortgage Payment. Consider both interest payments and principle payments.
- Property Taxes. These vary by area, but expect to pay up to 2% of your home’s value per year.
- Mortgage Insurance Premiums. If your down payment is less than 20% of your home’s value, expect to pay mortgage insurance premiums.
- Landlord Insurance. This covers tenant damages and protects you if someone is injured on your rental property. According to HouseLogic, landlord’s insurance is typically 15% to 20% more than homeowners insurance.
- HOA Fees. These payments are required if your house or condo belongs to an association.
- Repairs and Replacements. Windows, doors, walls, carpeting, roofs, and major appliances must be repaired or replaced.
- Maintenance. After a tenant leaves, common costs include exterior paint, interior paint, and carpet cleaning. You’ll almost always need to clean the carpet between tenants, and you may need to touch up interior paint as well. Exterior painting is more infrequent – expect to paint every five years or so.
- Advertising and Rental History Checks on Tenants. You can advertise on websites like Craigslist for free, but expect to pay around $100 if you want to run a newspaper ad. VeriFirst reports that a rental history of eviction records and a rental payment history both cost between $5 and $10.
- Accounting and Property Management Fees. Property management firms typically charge around 10% of your rental revenue. Also, expect to pay a minimum of $200 annually for a CPA to prepare your personal and rental tax return.
HouseLogic provides a free worksheet to help you estimate the cost of renting your home.
You can get a fairly accurate estimate of potential rent revenues by checking out postings in your neighborhood. The online real estate marketplace Zillow uses MLS data and a proprietary formula to estimate rent values on specific homes. Rentometer provides a similar service. You can also talk to a local real estate agent or property management company, or check Craigslist to see the going rate in your area.
Also, consider historical rental trends for your region – if you’re in a city that’s experiencing rental price increases, your rental revenue may soon outpace your expenses. Services like Rent Jungle can show you specific rental price trends for your area.
As with any business, your revenue must exceed your costs if you are to be profitable. Thankfully, the costs you incur to rent the home are tax-deductible, which decreases the amount of income tax you have to pay on rents received and increases your take-home cash.
If your rental revenues immediately exceed your expenses, that’s a good sign. However, even if you’re not immediately turning a profit, don’t fret. It may be that rental rates are low at the moment or you’re still paying a hefty mortgage. According to Reuters, Maryland CPA Jerry Gross estimates that you usually have a solid investment if initial rent revenue covers at least 80% of immediate rental costs.
A rental calculator like the one at All Property Management can offer insight into long-term profitability of your rental. Just enter details on rent price, mortgage interest rates, mortgage balance, payments, property taxes, insurance, association fees, and how long you plan to own the property. Then, the calculator provides a detailed chart of expected cash flows. It accounts for all the little costs and variables such as vacancies, property management fees, maintenance costs, selling costs, and tax rates.
Along with profitability, the calculator also projects the future value of your home or rental property. When evaluating the calculator results, be aware of the time value of money. It may be exciting to think that your home could be worth millions in 30 years, but $1 million 30 years from now isn’t $1 million today. In fact, assuming a 2% rate of inflation, a present value calculator estimates that $1 million in 2045 is worth just $552,000 in 2015.
Rent vs. Sell – Considerations
Before you pull the trigger either way, consider your financial situation, the state of the housing market, and any state or local ordinances that affect your rights as a landlord.
1. Sales Price and Capital Gains
If you’re not satisfied with your current home value, renting out the house can provide some income while you wait for your home value to rise. If homes are appreciating rapidly in your area, it may be smart to wait.
Unfortunately, this tactic can backfire if you wait too long to sell. After you rent out the home for more than three years, you can no longer claim it as your primary residence. This means you’re liable for tax on the sale of the residence. When selling a home that is not your primary residence, you must pay capital gains taxes on any profit, which vary from 0% to 20%, depending on your tax bracket. When selling your primary residence, however, you can exclude $250,000 of capital gains (or $500,000 if you’re a married couple) when you sell.
In order for your home to qualify as a primary residence, you must have lived there for two of the last five years. If you time your sale wrong, you could end up owing tens of thousands of dollars in capital gains after selling your rental.
2. Tax on Rental Income
Just like wages from a job or dividends from stock, you’re assessed income tax on any income you derive from your rental, at your ordinary tax rate. Thankfully, you can write off all the costs associated with renting the house. For example, if your gross rental income for the year is $40,000 but you incurred $30,000 in rental expenses, you’re only assessed tax on $10,000.
Along with deducting cash expenses, you can also claim a deduction for depreciation expenses. This non-cash expense allows you to slowly deduct the amount you paid to purchase the house. Also, if you have a rental loss, you may be able to use the loss to offset some of your income if your adjusted gross income is less than $150,000. Ask a CPA for more details on deducting any losses or depreciation.
The only way many homeowners can come up with a down payment for their next home is to cash out the equity they’ve put into the one that they already own. Can your family scrape up enough to put down 20% on your next home without selling your existing one? Consider this carefully before you decide to rent.
Hopefully you can keep your home rented most of the time and cover most or all of the mortgage payments. However, you should be prepared for a worst case scenario: paying double mortgages for your rental and your personal residence. Even without a tenant, you still incur some rental expenses including insurance, maintenance, advertising, legal, and accounting fees.
In many areas, it’s quite difficult and time-consuming to evict a tenant who isn’t paying rent. If you have a tenant who won’t pay or causes significant damage to the home, it’s possible that your rental could fail to make a profit for several months. With court fees, attorney fees, repairs, cleaning expenses, and lost rent, Star Point Tenant Screening estimates that evicting a tenant costs an average of approximately $3,000.
If you’re buying another residence, the lender for your future home factors this risk into its calculations. Lending Tree reports that lenders only consider 75% of predicted rental income when determining debt-to-income ratios. If renting out the home raises your debt-to-income ratio, you may not qualify for as large of a loan on your new home as you’d hoped.
5. Time and Stress
Being a landlord can be time-consuming and emotionally draining. You’re responsible for advertising, showing the home, and running background checks to get the home rented. You have to field calls from tenants, handle maintenance and repairs, and deal with any emergencies that come up. Although you can hire a property management firm to do this for you, expect it to charge at least 10% of your rental revenue.
6. Distance Issues
You may be able to manage a rental home yourself if you’re in the same city or county, but managing a remote rental is another story. Although travel costs to visit your rental – such as mileage expense, plane tickets, taxi fare, hotel, and food costs – are tax-deductible, they quickly cut into your rental profit. It makes more sense to hire a property management company to deal with day-to-day issues and potential emergencies. You must also hire repair and maintenance staff for minor jobs (such as carpet cleaning and painting) that you otherwise might have completed yourself.
7. Tenant Rights and Renting Restrictions
Each state has its own set of landlord-tenant laws, and some cities also have local ordinances. These rules can govern how and when you can evict tenants, when you can access the rental property, how much you can increase rents, and when you must return deposits. You can find state rules on your state consumer affairs website and look for city municipal codes via Municode.
These regulations can seriously affect the profitability of your rental investment. Some areas favor landlords, while others give extensive rights to tenants. For example, San Francisco rent control prohibits landlords from increasing rents more than 1% or 2% per year.
If you’re looking to rent out your condo, check with your homeowner’s association first about any restrictions. A low number of owner-occupied units can reduce a condo association’s value, so many boards limit the amount of units rented at any given time.
Renting a house, like many investment strategies, is a risk. If your home value appreciates over time, rents continue to rise, and you can keep the home rented, your property can provide a fantastic return on investment. However, if rents decline in your area, your home value doesn’t grow as fast as you expected, or you get tenants who don’t pay, it may not be a great investment. Make sure you have a fair amount of available cash to cover emergency situations, and speak with a financial planner before you make your decision.
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