Chances are, your current home will not meet your needs indefinitely. If you live in a small starter house or a condo, you may want to upgrade to a larger house as your family grows. If you’re already in a large residence, you might want to downsize your home when your kids move in. In addition, there is always the possibility that you or a member of your family will have to move for work, in which case it is time to say goodbye to your current address.
The big question is what to do with the property when you move in. Is it better to keep your old home for rent or does it make more sense to sell it? While leasing allows you to pay off your mortgage or earn a little extra money each month, it also comes with a lot of risk and additional tax complications.
Why rent your house?
When a tenant pays your 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. After the mortgage is paid off, you can keep the monthly rent as income.
Renting your home can diversify your investments and sources of income, which can help reduce your financial risk. For example, if you lost your job, you would still have rental income. Or, if you think you have insufficient retirement savings, you have real estate that you can sell.
When calculating the cost of renting a home, consider the following potential expenses:
- Mortgage payment. Consider both interest payments and principal payments.
- Property taxes. These vary by region, 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 the value of your home, expect to pay your mortgage insurance premiums.
- Home insurance. This covers tenant damage and protects you if someone is injured on your rental property. Home insurance is typically 15-20% higher than home insurance, according to HouseLogic.
- HOA fees. These payments are necessary if your house or condo belongs to an association.
- Repairs and replacements. Windows, doors, walls, carpets, ceilings and major appliances need to be repaired or replaced.
- Maintenance. After a tenant leaves, common costs include exterior painting, interior painting and carpet cleaning. You will almost always need to clean the carpet between tenants and you may also need to touch up interior paint. Exterior painting is less common; expect to paint every five years or so.
- Renter Advertising and Rental History Checks You can advertise on websites like Craigslist for free, but expect to pay around $ 100 if you want to advertise in a newspaper. VeriFirst reports that an eviction case rental history and rent payment history cost between $ 5 and $ 10.
- Accounting and property management fees. Property management companies typically charge around 10% of your rental income. Also, expect to pay a minimum of $ 200 annually for a CPA to prepare your personal and rental taxes.
HouseLogic provides a free worksheet to help you estimate the cost of renting your home.
You can get a fairly accurate estimate of potential rental income by looking at the stations in your neighborhood. Zillow’s online real estate market uses MLS data and a proprietary formula to estimate rental values for specific homes. Rentometer offers a similar service. You can also talk to a local real estate agent or property management company, or check Craigslist for the current rate in your area.
Also consider historical rental trends in your area: if you are in a city experiencing rental price increases, your rental income could soon exceed your expenses. Services such as Rent Jungle can show you specific rental price trends for your area.
As with any business, your income must exceed your costs if you want to be profitable. Fortunately, the costs you incur to rent the house are tax deductible, which reduces the amount of income tax you have to pay on the rents collected and increases the money you bring home.
If your rental income immediately exceeds your charges, that’s a good sign. However, even if you don’t make a profit right away, don’t worry. Rental rates may be low right now or you may still be paying a large mortgage. According to Reuters, Jerry Gross, a chartered accountant from Maryland, estimates that you usually have a solid investment if the initial rental income covers at least 80% of the immediate rental costs.
A rental calculator like All Property Management’s can provide insight into the long-term profitability of your rental. Simply enter details about the rental price, mortgage interest rates, mortgage balance, payments, property taxes, insurance, association fees, and how long you plan to own the property. . The calculator then provides a detailed graph of expected cash flows. It takes into account all the small variable costs like vacancies, property management fees, maintenance costs, selling costs and tax rates.
In addition to profitability, the calculator also projects the future value of your home or rental property. When evaluating the results of the calculator, consider the time value of money. It may be exciting to think that your house could be worth millions in 30 years, but $ 1 million in 30 years is not $ 1 million today. In fact, assuming an inflation rate of 2%, a present value calculator estimates that $ 1 million in 2045 is only worth $ 552,000 in 2015.
Rental versus sale: considerations
Before pulling the trigger in any 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. Sale price and capital gains
If you are unhappy with the current value of your home, renting the home can provide you with some income while you wait for your home to rise in value. If homes are appreciating quickly in your area, it may be a good idea to wait.
Unfortunately, this tactic can backfire if you wait too long to sell. After having rented the accommodation for more than three years, you will no longer be able to claim it as your main residence. This means that you have to pay taxes on the sale of the residence. When selling a house that is not your primary residence, you must pay capital gains tax on any profit, which ranges from 0% to 20%, depending on your tax bracket. However, by selling your primary residence, you can exclude $ 250,000 in capital gains (or $ 500,000 if you are a married couple) from the sale.
For your home to be considered a primary residence, you must have lived there for two of the last five years. If you miscalculate your sale, you could owe tens of thousands of dollars in capital gains after your rental is sold.
2. Income tax
Like wages from a job or dividends from stocks, income tax is levied on any income you earn from your rent, at your regular tax rate. Fortunately, 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 costs, you are only taxed on $ 10,000.
In addition to deducting out-of-pocket expenses, you can also claim a depreciation expense deduction. This non-cash expense allows you to gradually deduct the amount you paid to buy the house. Additionally, if you have a rental loss, you may be able to use the loss to offset a portion of your income if your adjusted gross income is less than $ 150,000. Ask a CPA for details on deducting losses or depreciation.
The only way many homeowners can put down a down payment on their next home is to get back the equity they’ve invested in the one they already own. Can your family earn enough to put 20% on their next home without selling the one they currently own? Consider this carefully before deciding to rent.
Hopefully, you can keep your home rented most of the time and cover most or all of your mortgage payments. However, you need to prepare for the worst-case scenario: paying double mortgages on your rent and personal residence. Even without a tenant, you will still have to incur rental expenses, including insurance, maintenance, advertising, legal and accounting costs.
In many areas, it is quite difficult and time consuming to evict a tenant who does not pay rent. If you have a tenant who doesn’t pay or causes significant damage to the house, your rent may not pay off for several months. With court costs, attorney fees, repairs, cleaning costs, and lost rent, Star Point Tenant Screening estimates that an eviction of a tenant costs on average about $ 3,000.
If you buy another home, the lender of your future home takes this risk into account in its calculations. Lending Tree reports that lenders only consider 75% of expected rental income when determining debt-to-income ratios. If renting your home increases your debt ratio, you may not qualify for as large a loan as expected for your new home.
5. Time and stress
Owning can be time consuming and emotionally draining. You are responsible for the advertising, posting of the house, and the background check for renting the house. You have to take calls from tenants, take care of maintenance and repairs, and deal with emergencies that arise. While you can hire a property management company to do this for you, expect them to charge at least 10% of your rental income.
6. Distance issues
You may be able to manage a rental home on your own if you are in the same city or county, but managing a rental remotely is another story. While travel expenses to visit your rental, such as mileage, airfare, taxi, hotel, and food expenses are tax deductible, they quickly reduce your rental income. It makes more sense to hire a property management company to take care of day-to-day issues and potential emergencies. You should also hire repair and maintenance staff for minor jobs (like carpet cleaning and painting) that you might otherwise have done on your own.
7. Lessee’s rights and rental restrictions
Each state has its own set of laws for landlords and tenants, and some cities have local ordinances as well. These rules can govern how and when you can evict tenants, when you can access rental property, how much you can increase rents, and when you must return deposits. You can find state rules on your state’s consumer website and search for city municipal codes through Municode.
These regulations can seriously affect the profitability of your rental investment. Some areas favor landlords, while others grant extended rights to tenants. For example, the San Francisco rent control prohibits landlords from increasing rents by more than 1% or 2% per year.
If you are looking to rent out your condo, check with the Homeowners Association first for restrictions. A low number of owner-occupied units can reduce the value of a condo association, so many tips limit the number of units rented at any one time.
Renting a home, like many investment strategies, is risky. If the value of your home appreciates over time, rents continue to rise, and you can keep the home for rent, your property can provide a fantastic return on your investment. However, if rents are going down in your area, your home’s value isn’t going up as quickly as you might expect, or if you get tenants who don’t pay, it might not be a good investment. . Make sure you have enough cash on hand to cover emergencies and talk to a financial planner before making a decision.
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