This past week, I did an analysis for a client on a sell-versus-rent situation. We run a lot of financial analyses for clients that let the math lead the way in making informed decisions. Real estate transactions impact many other parts of a person's financial plan—from taxes, return on capital/equity, and cash flow, to legal considerations, estate planning, risk tolerance, and time constraints, just to name a few. Many of the strategies we use can take months or even years to set in motion, which is why we like to have an open dialogue early.
In this client’s case, they had moved up to a larger home and were deciding whether to rent out or sell their previous home. They didn’t need to use the equity from their old home to buy the new one. They have significant equity, a low cost basis, a very low fixed-rate mortgage, and the market rent would cover their total costs—a lot of good reasons to keep the property.
However, in running the numbers, their return on equity from renting would be close to zero. If they had any major repairs, it would be negative. That’s fine if markets are appreciating quickly, but not ideal if they’re flat or barely keeping up with inflation.
Since this is a primary residence, they would get the money they’ve put into the home plus the $500,000 tax-free exemption—freeing up well over $1,300,000 in cash after paying about $70,000 in capital gains taxes. They could then invest that into low-risk or no-risk vehicles like CDs, Treasuries, or Money Markets and make about 4.5%—roughly $58,000 in annual income—with very little or no risk and no headaches. They would also have the liquidity to take advantage of other opportunities when they arise.
If they kept the property as a rental, they’d still have a few years to sell and qualify for that tax-free exemption, but they’d miss out on nearly $116,000 in income and take on market risk for a property they may not want to own long term.
In this case, even with the emotional attachment to the home and the fact that they “don’t need to sell,” it was clear that selling now is likely the right move.
There are many other times when the math comes out differently. For example, if this home were worth $5,000,000 and they had bought it 25 years ago for $1,500,000, they’d have a $3 million taxable gain. In that case, they might consider converting it to a rental property for two years before selling. This way, they could take the $500,000 exemption and roll the rest into a 1031 exchange for income. We have different strategies for this depending on how hands-on they want to be.
Reach out to us today if you are ready to start having these big picture conversations, we are here for you.
