Now that the housing market has picked up, does it still make sense to rent out your old home? In 2010, when it was very difficult to sell a home, renting out your home was a great alternative. Fast forward to 2015 and the housing market is rocking like it was 2006. My brother has been looking for a home in the San Jose area and he keeps getting outbid. The Portland housing market is also very hot right now. The inventory is low and it’s a sellers’ market. Mrs. RB40 just told me her coworker got outbid again.
The hot real estate market makes it easy to sell, but our rental market is also rising very fast. The Portland metropolitan area’s rent rose 20.45% over the last 5 years. That’s the sixth fastest rise in the US. We also have an apartment building boom in Portland. I see three big apartments in various stages of construction on our way to preschool. There are signs of construction everywhere in Portland.
Actually, this market is reminiscent of 2007 when we decided to move and then rented out our old home. There were several reasons why we moved. We wanted to live in the city and be closer to Mrs. RB40’s work. Our condo has a great view and it was perfect for a couple with no kids. The old house was too big for us. I think the primary reason we kept the house was because we weren’t sure if moving into the city was going to work out. We put a lot of time and effort into the old house and we didn’t want to let it go. If we didn’t like living in the city, we could move back into the home we liked. I also wanted to try being a landlord because I heard that it was a great way to make some extra money on the side. This was a couple of years before I started obsessing about Financial Independence so it wasn’t the main reason.
Knowing what we know now, would we rent out the house if we could do it again? Or would we just sell it? I’m sure many homeowners struggle with this dilemma. Let’s go over the pros and cons to see both sides of the story.
Pros of renting out your old home
Become a landlord – Real estate is one of the few proven ways to build wealth. I’m sure you have heard many stories of how various properties appreciated over the years. We purchased our old home for $209,000 in 2000 and sold it in 2014 for $346,000. (Keep in mind, our initial investment was 20% or about $40,000.) The tenants were paying down the mortgage for us from 2007 to 2014, that’s half of the time we owned it. If we kept the place, eventually it would have been paid off and we’d have a nice monthly positive cash flow. We sold it because we wanted a rental that’s in a better location and closer to where we live. I wanted to try being a landlord because I want to build our wealth and renting our old home was the easiest way to get started. You can see if you like being a landlord. If it’s not the right fit for you, then you can always sell the place and invest in the stock market.
You know the property – We lived in our old home for 7 years so we knew all the problematic areas. I knew we’d need an exterior paint job in a few years. The fence had some rotten spots. The carpet piled up in certain areas. In contrast, you never know what problem you’re going to get with a property you haven’t lived in. Our rental duplex had an antiquated electrical wiring system and we had to spend about $1,000 to bring it up to code. Well, we got the inspection report, but I still think it takes time to become familiar with a property.
Better chance to cash flow – Our old home generated positive cash flow as soon as we started to rent it out. It’s pretty difficult to generate positive cash flow in Portland because the purchase price is so high. We purchased the home in 2000 at a decent price so the mortgage and property tax was reasonable. We wouldn’t have been able to cash flow if we purchased the place in 2007 explicitly as a rental. This might change in the future at the rate rent is rising, though.
Build equity – The good thing about owning a home is you get to build equity. We pay $1,200 per month on our mortgage and a portion of that goes toward the principle every month. After 20 years, we’d have a big stake in our home. Having a rental home is even better because your tenants are helping you build equity. The more property you have, the more equity you’re building every month. That’s oversimplifying it a bit, but it’s the general idea.
Rent goes up every year – The Portland area is projected to see a population growth of up to 725,000 people in the next 20 years. However, the city only has the capacity for 15,000 new single family homes. I guess this is why rent is going up so much each year. However, your mortgage remains the same assuming you got a fixed rate loan. So your rental income increases while your mortgage cost remains the same. Actually, we refinanced to a lower rate so the mortgage could even decrease in some scenarios. Property tax, repair, utilities, and insurance usually increase, though.
The longer you hold property, the better it is for the cash flow. We lived in our old home for 7 years so the rent slowly increased over that time. Our purchase price was also locked in at a reasonable price and the mortgage wasn’t that high.
Appreciation – In the long term, real estate price will most likely appreciate. It depends on your local market, of course. I only lived in California and Oregon so my experience is limited. The housing price took a big tumble during the last recession and it just only recovered in some area. However, I still think real estate is a great investment for the long term. I’m sure in 30 years, the housing price in Portland will be sky high.
Tax deduction – A rental property is a great investment because the tax code was written by landlords. Rental properties provide many tax benefits and here are a few of them.
- Interest – We could deduct the interest payments on the mortgage.
- Depreciation – The cost of the building is depreciated yearly and deducted against the rental income.
- Repairs – The cost repairing the drainage can be deducted.
- Travel – The cost of travel associated with the rental can be deducted.
- Legal and professional fee – Accountants, HOA, property managers, and gardeners can all be deducted.
Primary residence has better mortgage terms – It’s much easier to obtain a mortgage for a primary residence than a rental property. In my experience, the requirement is much less strict than when you’re getting a mortgage for an investment property. You can also put less money down on a primary residence. The last time I got a rental property, the bank wanted 25% down and required quite a bit of extra documents. Mortgage insurance won’t cover investment property so you need at least 20%. The interest rate is also a little bit better with primary residence mortgage.
Con of renting out your old home
Renting out your old home is a great way to build wealth, but nothing in life is free. There are quite a few big disadvantages to it as well. I didn’t know any of this before I converted our home to a rental in 2007.
Being a landlord – If rental property is such a great way to build wealth, why doesn’t every investor own rental properties? Being a landlord takes time and energy. You know your old home best so the repair and maintenance is less problematic than a newly acquired rental, but there are many other problems a landlord has to deal with.
- Vacancy – How long can you carry two mortgages?
- Bad tenants – I have dealt with late rent, damaged property, unauthorized alteration of the home, and more. I hope I never have to do an eviction. That sounds like a nightmare.
- Insurance – As a landlord you need to get additional insurance.
- Emergency repair calls – I got one call in the evening about some electricity going out. Luckily, it was just the GFI and was easily fixed. The water heater is bound to go at some point and I’m not looking forward to that at all. There will still be repairs even if you know the home well.
Some people never want to be a landlord and I can understand why. It can be a lot of work. Of course, you can hire a property manager if you don’t want to deal with it, but that can be problematic as well. A property manager takes about 10% of the rent and usually a month rent when they sign a new tenant. It is also difficult to find a good property manager. They manage many homes and they won’t have time to pay a lot of attention to your property. I tried 4 property managers and wasn’t 100% satisfied with any of them.
Less money for down payment – When we moved in 2007, we didn’t take any money out from the old house via refinancing. We had some cash saving and sold stocks to cover the down payment on our new condo. Most regular households couldn’t afford to do that. They usually need to sell the old house so they can use the money as a down payment for the next home.
Primary residence capital gain tax exclusion – If you have a gain from the sale of your primary residence, you may qualify to exclude up to $250,000 of that gain ($500,000 if you file a joint return.) This is one of the best tax breaks available to regular people. When you convert your old home to a rental, you will lose this tax break.
In order to qualify for this tax break, the homeowners must use the home as a primary residence for at least 2 of the past 5 years. You could move into your old home for two years and sell it to get some of the tax break back. You won’t get the whole tax break because depreciation recapture will still be taxed. In 2008, Congress further limited the exclusion of capital gain on properties that was converted from a rental to a primary residence. You will get a just a fraction of the tax exclusion if you turn your home into a rental. The size of the fraction depends on how many years the home was rented vs. used as a main home.
We did a 1031 exchange when we sold our old rental home in 2014. This deferred the capital gain tax until we sell the acquired duplex. To get back a portion of the capital gain exclusion, we’d need to keep the duplex as a rental for 2 years and then make it our primary residence for at least 5 years.
This whole thing can get complicated very quickly and will require its own big article. Suffice to say, you need to talk to a good tax accountant when you sell a rental (and a big bottle of Advil.)
Real estate price could go down – I’m sure we all know this after the last housing bubble burst. Zillow shows that our home price peaked in 2007 and only recovered recently. Theoretically, we could have sold the old home in 2007 and get the same price as what we got in 2014.
If I had a crystal ball, I would have sold the home outright and buy a new rental property at the bottom of the market. In reality, I don’t like have a big chuck of cash in my saving account so I would have invested it in the stock market which also took a big tumble in that time frame. Anyway, real estate price can and will drop. I still believe it’s a guarantee win over the long term, though.
Harder to get a mortgage – Unless your income is strong, it could be more difficult to get a mortgage for a new home while carrying a mortgage for the old home. You don’t have proven rental income from the old home yet so some banks don’t take the rental income into consideration when they look at your mortgage application. Actually, the rules change all the time so I’m not sure if it’s different now. Our income was very good in 2007 so it wasn’t a problem for us.
Would you rent out your old home?
Would I rent out our old home if I could do it over again? Absolutely! I wanted to gain some experience as a landlord and this is the easiest way to do it. If I hadn’t rented out our old home, I don’t know if I would have the gut to jump into a new rental property. The experience was invaluable. I strongly believe that rental property is a great way to build your wealth over time and I’d hate to miss out on that. I don’t have a crystal ball so I still don’t know how to time the market.
There are quite a few disadvantages to renting out your old home, but I still urge you to consider it if financial independence is your goal. You can always sell it within 3 years of converting it to a rental and get the capital gain tax exclusion. Two of the last five years as a primary residence mean it can be any two years.
Would you rent out your old home when you move? If you’ve already done it, do you think it was the right choice?
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