Maybe you’re moving into a bigger house to fit a growing family, maybe you want to downsize, or maybe you’re relocating for work. Luckily, you’ve done such a good job planning that you have plenty in savings to cover the move and don’t have to sell your current house. Now you’re at a crossroads, though. What should you do — sell your house or rent it out?

There’s a lot of information on the internet about real estate investing vs. investing in stocks. Real estate professionals have one perspective, where the answer is almost always “purchase more real estate.” On the flip side, I’ve seen plenty of other non fee-only financial advisors suggest that all of your investments should be in stocks or bonds. Neither of these professionals takes a very holistic view on the matter.

The actual right answer is highly personal and dependent on your goals as well as your current financial situation. So let’s figure out how you can make that determination for yourself.

Questions you need to answer when deciding whether to sell vs. rent out:

Sit down with yourself (or with your partner) and work through the questions below, based on what you want out of life and your money. Be brutally honest — you do yourself a disservice by not answering them truthfully.

1) Is It Worth Being a Landlord?

Under the right circumstances, renting out your property can be lucrative, but that doesn’t mean being a landlord is for everyone.

There are numerous responsibilities that arise when managing a property. When you’re the landlord, it’s up to you to deal with them. They can drain your time, sanity, and money.

For example, you’ll need to manage tenants, which might include finding and screening them to fill vacancies, evicting them when necessary, collecting rents, and handling other complaints. There might be other unforeseen hassles that you’ll need to take care of too, like bug infestations, broken garage doors, and appliances that need to be replaced/fixed, just to name a few possibilities. Between tenants, you might need to spend money on property improvements (i.e., new roof, replace carpets, paint). You might even have prolonged periods of vacancy or times when you’ll have to lower rent to meet market rates, potentially cutting into (or eliminating) your profits.

Some people find being a landlord exciting. You take a much more active role in the management of the investment than if you were to buy an index fund. Others see these tasks as headaches. At the end of the day, only you can decide whether the potential income is worth the extra work and cost to you.

Hiring a property manager to do what you don’t want to

If you’re not inclined to manage the property yourself, you could also hire a property manager. Doing so would save you from much of the day-to-day hassles of dealing with tenants or the property. It will not alleviate the financial burdens that are a part of rental property ownership (like vacancies). In fact, it will cut into your bottom-line even more, as property managers typically charge somewhere between 8-12% of the rental value of the property.

This will be a critical expense that will need to be included in determine whether your property will be cash flow positive (more on that below).

2) Will My House Appreciate in Value?

Wouldn’t it be great if we knew exactly what was going to happen in the future? We’d be able to choose the best stocks year-over-year, protect ourselves from losses when (not if) markets crash, and know exactly when to buy/sell our real estate. Unfortunately, we don’t. So instead, we have to use history to make assumptions about what will happen in the future.

On average, house prices have gone up over time — an average of 3.9% across the nation over the last 25 years to be exact. (Not so coincidently, this is also very close to the inflation rate over the same period of time.) Of course, there are periods, like 2008-2009, were values dropped. Likewise, there are times where house prices rise at faster rates. (Helpful, right?)

We do know that location matters when it comes to real estate, and it matters a lot. That means local appreciation rates can be very different than the national average, so you’ll need to do your homework on your specific area. Zillow makes estimates using their home value index tool, so that might be a good place for you to start your research.

3) How Much Has My House Already Appreciated?

What we’re trying to understand here is how much of a capital gain you’d have if you were to sell your property today. It’s a relatively simple calculation: make an educated guess at what you’d be able to sell the property for today and subtract your cost basis (which is usually what you paid for it).

This is what you’ve gained on the property, and if you were to sell today, what you might be taxed on (less any closing costs and selling expenses).

Let’s see an example. You purchased your property in 2010 for $150,000. Today, you could sell it for $425,532. After paying 6% in realtor fees and closing costs, you’re left with $400,000. That’s $250,000 in appreciation that you’d be able to net from the sale of your house and on which you might be subject to capital gains taxes (see taxes below)!

4) How Much Would I Pay in Taxes If I Sell My House?

I’m sure many of you have heard Benjamin Franklin’s quote, “in this world nothing can be said to be certain, except death and taxes.” While this might be true, the IRS does give some pretty sweet tax relief to home sellers whose property was also recently their residence (sorry real estate investors, they don’t give you the same benefit).

Depending on how much your property has appreciated (question #3), this may or may not matter to you. If you have a significant amount of appreciation in the property and are thinking about turning the property into a rental (which I’m sure you are since you’re reading this), though, you’ll want to pay special attention.

Selling immediately after moving out

If you’ve owned the property and lived in it for 2 years out of the last 5, the IRS lets you exclude up to $250,000 if your single ($500,000 if your married filing jointly) of capital gains on the house that you do not need to pay federal taxes on. That could save you 15% – 23.8% on the appreciation (as the tax code stands in 2020), which could be used to increase your net worth in other ways.

Renting out your house for a few years and then selling

However, if you decide to rent out your house for 3+ years before you sell, you’ll likely no longer be eligible to receive the tax-free capital gains. Instead, you would need to pay taxes as if it were an investment property at the capital gains tax bracket you’re in when you sell. Right now, that would range from 15% – 23.8% federal, plus state taxes (if you live in a state that has an income tax), depending on your overall income.

Let’s go back to our appreciation example above where you (conveniently) had a capital gain of exactly $250,000. If you’re required to pay capital gains taxes on that appreciation, it could cost you between $37,500 – $59,500, plus state taxes! (Double those amounts if you’re married and have $500,000 of appreciation.)

The more appreciation you have (up to the stated limits), the more valuable the exclusion becomes.

5) If I Were To Rent Out My House, Would It Produce Positive Cash Flow?

Owning a rental property is very similar to owning a business. Both produce returns in a couple of ways:

  • through appreciation (in property value or stock price)
  • through positive year-to-year cash flow (net rental income or dividends)

For rental properties, having net rental income is accomplished by having rents in excess of expenses.

You’ll need to make some assumptions about how much you could rent the property for, as well as what expenses you might need to pay. Make sure to include some wiggle room in the total expenses for the unforeseen expenditures (like property repair or maintenance) that always pop up and periods of time where the property will go unrented. If you’re opting to use a management company, that will need to be included in the expenses as well.

If, after running the numbers, you see that the property will be costing you money every year rather than generating a positive cash flow, it’s probably not a viable rental. On the other hand, if it looks like you’ll be able to make extra income through renting out your property, then you have the hard choice to make. You’ll need to decide whether the income (and expected appreciation) is enough for you when compared to other investment choices (like stocks, bonds, and REITs).

6) How Much of My Net Worth is in Real Estate?

Diversification is at the heart of any prudent investment strategy to protect the investor from risks associated with too much exposure to any single type of investment. In recent history, we saw this with tech stocks in the dot com bubble of the early 2000s and in real estate in 2008-2009. If all of your investments were in either of those types of investments during that time, you would’ve been a very unhappy camper.

Net Worth Allocation Targets

Generally, it’s recommended to have about 33% of your net worth in real estate, 33% in equities (stocks), and 33% in bonds and cash/cash equivalents. Of course, these targets can change with age (i.e., you’re likely to have a higher % in real estate when you buy your first house). However, they’re good allocations to aim for.

If keeping your house and renting it out will move you significantly away from those targets, you’ll want to go into that decision with eyes wide open to the potential risks you’re taking.

7) Will I Eventually Want to Cash Out on The Property?

I’ve seen clients, on numerous occasions, who have wanted to tap into the equity they’d built up in their rental properties because the cash flow they were receiving from the property wasn’t enough. Unfortunately, one of the tax benefits of owning a property for cash flow purposes (depreciation) can become a tax burden when you do try to sell.

When you sell a property that has previously been depreciated, you need to pay a depreciation recapture tax. Currently at 25%, depreciation recapture is at a higher rate than the current long-term capital gains rates.

If you do plan on investing in real estate, this would be another reason to stick with your targeted net worth allocation (Question #6 above). By maintaining a balanced net worth, you’re less likely to need to tap into the equity of your properties for cash flow purposes.

TLDR; Should I Sell My House or Rent It Out?

When to Rent Out Your House

  • You want to be a landlord
  • The property will produce positive cash flow
  • The property hasn’t appreciated much since you bought it
  • You expect that there will be lots of appreciation in the future
  • There won’t be much of a tax benefit to selling
  • A fairly balanced part of your net worth is in real estate
  • You have no plan of selling the property in the future

When to Sell

  • You don’t want to be a landlord
    • If this is the case, it doesn’t really matter what the numbers shake out to be. There’s no reason to rent out the property unless you’re underwater on it and need to wait for it to appreciate before selling.
  • The property will not produce positive cash flow
  • The property already has a good amount of appreciation that you can get out of it tax free by selling
  • You expect that appreciation will be slower in the future and you’d likely get better returns in the stock market or another type of investment
  • You could get a lot of money out of the house tax free
  • Most of your net worth is already in real estate
  • You might sell the property in the future and depreciation recapture could be too much of a burden to make it worthwhile

The Best of Both Worlds: When to Sell and Buy an Investment Property with the Proceeds

For this to make sense, you’d want to pass the checks of “when to rent out your house” section above, with the exception of the taxes. Here, you’d have a decent amount of appreciation in your home, making the tax savings just too good to pass up.

In instances like this, one idea is to sell your house and use the proceeds as a downpayment for a pure investment property (no muddying the waters by having previously lived there).

One thing you’ll need to be careful of here is that your property taxes, mortgage, insurance, and other expenses could change. So you’ll want to make sure you’re using income/expenses from the new property to determine whether purchasing that property still makes sense for you.

Can’t Decide or Need Help?

If you’re still struggling to figure out what’s best for you, you should really talk to an unbiased, fee-only financial advisor who can help make the decision with you while keeping your big picture in sight. We’re happy to help here at LifeSighted, or you can find others through NAPFA or XY Planning Network.

Work With LifeSighted

Are you are looking to make positive steps forward with your finances? And are ready to do what it takes to acheive the freedom and flexibility you want in life? Awesome! We may be a good fit for each other.