Many people get into landlording because they decide to buy a new house and rent out their old one. This can be a profitable rental strategy with low barriers to entry, good cash flow, and ease of management. Seems like a great strategy, right?
It is, except many people overlook one very important aspect: the capital gains tax exemption.
Time and time again people tell me they plan on keeping the property forever. Who wouldn’t want a paid off house that cash flows every month? That’s nice, however, forever is a long time, and it could come at the expense of holding back greater cash flow investment potential.
Before we jump into that, let’s examine the upside to turning your house into a rental.
BENEFITS OF TURNING YOUR HOUSE INTO A RENTAL
- Low barrier to entry – In this strategy you don’t have to compete with other investors or the market to find and acquire another rental property. This can save a lot of time, energy, and effort.
- Good cash flow – Depending on how long you lived in the house and how much the mortgage payment is, you could receive a nice monthly cash flow from the house. Time can do amazing things for property owners in terms of appreciation and inflation, and if your committed mortgage payment is well below current rental rates then you could be cash flowing nicely each month.
- Ease of management – No one knows the house better than you do. You know all the quirks, you know the annual maintenance schedule, the areas to keep an eye on, and you know all the neighbors. If there is ever a time to get your feet wet as a landlord, then this is it. If you just need to manage one single family house and you don’t move far away from the area, then this will be the easiest rental property one can have. Do some research on lease forms, inspection forms, and current landlord tenant laws and you can be off to the races with a handmade “For Rent” sign in the front yard.
CON OF TURNING YOUR HOUSE INTO A RENTAL
For as many benefits as there are to turning your house into a rental property, there is one HUGE caveat that many people tend to overlook: Homeowners do not have to pay capital gains.
Well, that’s not entirely true, but to an extent it is. The government, in an effort to promote homeownership, gives homeowners exemptions from paying taxes on the profit they make from selling their home. There are some rules to this:
- A single person is exempt from paying taxes on gains of up to $250,000 of profit.
- A married couple is exempt from paying taxes on gains of up to $500,000 of profit.
- To be eligible for this exemption, the owner must have resided in the property for two out of the last five years.
These are huge savings and this is a great way to add serious wealth to your nest egg! If you have significant equity in your house and are able to sell it without having to pay your State and Federal capital gains taxes, then you have just saved yourself a ton of money.
Depending on your tax bracket, you could be paying upwards of 15-20% on Federal capital gains, and then you have to factor in your State’s capital gains tax rate. In Oregon where I live, for example, the capital gains tax rate is the same as your regular income tax bracket. In total we are talking about a sizable pot of money that the government takes from the sale of investment properties.
Before you turn your house into a rental, or in the opposite case, put it on the market, there are a couple things that you should do to help yourself create an action plan:
- Determine how much equity you have in the property, how much the cash flow the rental would yield, and how much capital gains you would have if you were to keep the property.
- Determine your goals: Do you want to scale an investment portfolio with multiple passive investment streams, or are you looking to simplify?
- Determine where the market is heading. If your market is softening and vacancies are on the rise, this could set you back more than if you sold the property.
- Come up with a timeline: If you plan on keeping the property, potentially consider holding it for two to three years and then selling. You squeeze out good cash flow while it’s a rental AND you save on capital gains taxes.
- If you decide to sell the house, use the proceeds to purchase another investment property!
Good luck on your investing endeavors. If you have any questions or comments, please leave them in the comments section below or send me an email at Neal@ChooseLatitude.com
-- Neal Collins