A day may arrive when you find yourself having to choose between renting and selling your current property; for example, you might need to temporarily or permanently relocate for employment purposes.
In this situation, renting out your property is not necessarily preferable to selling it, and vice versa. Rather, the optimal choice for your current property will depend on various factors that we explore in this post.
Your future housing plans
Homeowners who leave town altogether typically opt to sell their home rather than rent it out. This is especially true for homeowners whose only reason to return to the city or town they leave behind is to check on the property.
Homeowners leaving the property for a few years with the intent of returning, on the other hand, may be more inclined to rent that property out to cover the mortgage cost until they return. This option appeals particularly to homeowners who feel attached to the property or the location. The only hitch is that homeowners in this category will need to act as a landlord in the interim or hire a property manager. The former can be a time-consuming process, while the latter can be expensive.
Considerations for selling
Homeowners interested in selling their home usually start by determining the amount they need to pay on their current loan compared to the current value of the house. Profits made on the purchase price will ideally be enough to cover the loan balance while leaving some money left over to fund the move and, if applicable, finance a down payment for a new property.
If you're in a difficult market, or have a new loan subject to prepayment penalties, you aren't necessarily stuck in that house. It may be worth exploring a land contract, which is a common path to "rent-to-own" a home.
This is where a homebuyer who is unable to secure financing through traditional means provides the seller (you) with a down payment on the house and then pays monthly rent. The seller may apply that rental income toward paying off an existing loan on the house. Either way, that rent gradually increases the buyer's equity in the home.
Sellers may want to look into rent-to-own because it widens the scope of potential buyers and gives homeowners who feel stuck in a tough market a means to sell their property. Should the buyer back out, the seller keeps the down payment and any rental income, meaning it's a relatively low-risk affair for sellers.
Considerations for renting
Homeowners may choose to rent out their current property for several reasons, including:
- With the intent of eventually returning to the house.
- To continue paying off the mortgage with the long-term goal of rental income and eventually profiting from capital gains.
Renters who intend to return to their property can continue paying off their mortgage and possibly profit from the passive income earned in the time spent away from their property. The extent of those profits depends on the price-to-rent ratio.
A low price-to-rent ratio means it's cheaper to buy than to rent in that area, so there's a good chance the rental income will yield a profit. A high price-to-rent ratio means that it is more expensive to own than to rent, which will yield narrower cash flows. These metrics can be useful for rental property owners, but it's also important to consider the market (e.g., is there actually any demand to rent in that area?).
The same price-to-rent rules apply to homeowners who decide to treat their current house like a permanent rental property. The main difference is that an investment property will be subject to capital gains taxes on the sale.
Be aware, too, that if you originally purchased a home with the expressed intent to rent it out, you might have to meet different lender criteria. Typically, rental properties require more cash on hand and a higher credit score than what you might expect relative to a conventional mortgage.
Interest rates could also be higher for non-primary residences. Plus, FHA and VA loans aren’t available for rental properties.
There’s also the issue of paying down a current mortgage via rental income while simultaneously purchasing a new primary residence. Maintaining the payments for two mortgages could be easier in some years than others based on market factors and employment conditions.
It is crucial to keep the conditions of your loan agreement in mind when planning to purchase a property as a primary or second home and then use it to generate rental income. A mortgage requires owners to live in a property for at least one year, whether as a primary or secondary residence. Violating this agreement could lead to a default, and your lender could call the note due and payable. Make sure to carefully review your agreements, and consider discussing your options with a trusted advisor, before making any major decisions around renting out a recently purchased property.
Can you rent your home for enough to cover the mortgage payment and expenses?
Whether or not you can cover both the mortgage payment and other expenses of ownership, along with the expenses of renting out a property, is a foundational concern when making a decision about renting or selling your current home and moving into a new one.
Differences between local real estate markets and personal financial needs, as well as the price-to-rent ratio in your area, could mean you will lose money renting in the long term. This may simply be due to the amount most renters in your area are willing to pay on a monthly basis for a property like yours, or the property management fee that comes with hiring a professional — often a necessity for absentee landlords — on top of the other costs that come with renting.
Research can go a long way toward helping you determine if your property will provide some type of financial return should you rent it. Every rental property is different. However, you can examine properties with similar square footage, amenities and location to develop an idea of acceptable rent levels. You do not need to limit your search to online information from rental listings and real estate databases. Walking or driving past similar properties, or even taking tours, if available, can reveal more valuable information than is possible through a digital-only approach.
The costs and opportunities of owning a rental property
Be sure to keep all the costs of turning your home into a rental property in mind, and don’t limit your calculation to only the direct financial considerations. You will want to weigh the passive income that renting generates and the value of eventually paying off the property’s mortgage with the price of maintaining the living space, taxes on your income, insurance, hiring someone to manage the property if needed and similar obligations.
That cost column should also take your personal time and effort into account. Even though you may choose to pay an individual or property management company to oversee your former home, you may still have to make important and potentially complex decisions, like replacing large appliances and addressing certain aspects of repairing damage in the wake of a natural disaster or other incident. You will also need to at least occasionally engage in some due diligence to ensure your management company is acting in your best interests.
For some homeowners, these added duties might be seen as valuable, providing early experience in becoming a landlord and leveraging passive income to their advantage. Homeowners may appreciate the experience and even enjoy it, finding that the work aligns with personal and professional interests. Others, however, may find the complexities and costs of owning an investment property to be a significant burden. Consider your own personal feelings, interests and work experience as part of the larger equation — with finances remaining the most important factor — as you make your decision about renting versus selling your home.
Will you be able to buy or rent a new home without selling your current property first?
Some homeowners are in a financially advantageous position when making a decision about renting versus selling their home: They have either plenty of money in their savings, a dependable, high income or both factors in their favor. This circumstance means you can be more flexible in how you make your final decision, but it still requires careful planning and oversight to realize substantial benefits.
If it isn’t an imminent financial priority to sell or rent your current home before moving into a new one, you can take more time to explore your options. You may decide you want to see what potential rewards — and difficulties — come with generating passive income through renting. This approach can help you learn more about the big picture and day-to-day needs of managing your property.
If you have the funds available, you could also consider renovations that make your property more attractive to potential tenants and allow you to maximize potential income. A large, freestanding home could potentially be divided and upgraded to provide more than one complete living space, for example.
Should renting prove to be a success in broad terms, you may decide to maintain your former home as a source of income, or eventually sell it and use the proceeds to purchase another investment property. In the latter scenario, you will have to address the additional expense of capital gains tax.
What are the tax benefits for selling vs. renting a house?
Turning your current home into a rental property and selling your home are very different approaches to reaching a common goal: Earning some type of income from a property that you no longer plan to reside in. When it comes to taxes, it shouldn’t be a surprise that there are very distinct considerations to make in each of the two scenarios.
When selling your home, you pay taxes on a singular transaction. And, unless you’re selling a luxury home or a house in an especially expensive real estate market, you may not have to pay anything at all. Capital gains tax applies to home sales, but an IRS rule allows individuals who have owned and lived in the home being sold for at least two of the previous five years to avoid paying taxes on the first $250,000 in capital gains. For married couples, the limit is $500,000. It’s important to note that the capital gains tax only applies to the profit earned, not the total sale price.
When it comes to renting a home, the tax structure is vastly different. The passive income you earn from a rental property is exactly that. Rental profit is categorized as income and taxed according to your income bracket. Many expenses related to the property, from your mortgage to the property management fee, may be used to lower the tax burden. Because real estate also depreciates over time and offers tax savings in this regard, the combined benefits can make renting out a home a financially rewarding choice even when costs by themselves are high.
The bottom line
The decision to rent or sell your house depends predominantly on your priorities, such as whether you're attempting to find, or retain, the home of your dreams, or profit from an investment property. Contact Comerica Bank to begin discussing your options.
