What to do with rental income?

[onemorebike]

I'm not prepared yet to post all the gritty details of our budget, but hope to have that cleaned up over the holiday.

The short is, we owe about 33k (in a series of smaller loans ranging from 3-5 percent) in my wife's student loans, together make around $110,000 (pretax) a year. We have plenty of expenses I'm trying to trim to do some more saving and growing of the stache. (We were great savers until we had two kids, daycare is a drain and we upgraded from a 980 sq fter - now the rental - to a 1700 sq fter for the running of the children.)

Anyway, I own a small rental in Denver with $700~ mortgage (105,000 left on about 160,000 value) at %5 and $1250 rent so I manage to bring in about $6600 before any repairs, taxes or turnover costs - not to mention paying down the mortgage. (I've been renting for a little over a year and a half now and haven't incurred any major costs - yet.) A chunk will go to taxes, a smaller chunk will go to the house's emergency fund but a few grand of it (which pretty much is pay on being a landlord) is available. Should I use it to pay down the mortgage, my wife's educational fund, contribute to the 503b or my IRA? Also, while discussing the details, I have about a year to decide to sell or keep the rental before I'll have to pay a larger tax on the sale of the house. (if you've lived in the house 2 out of 5 years you can sell without paying capital gains). Is this making me enough money for the investment  that the profits from the sale of house wouldn't be better invested elsewhere (compared to being a landlord and slowly profiting off of renting this house?)?

[arebelspy]

a few grand of it (which pretty much is pay on being a landlord) is available.

Kudos to you for realizing this; most don't.

(if you've lived in the house 2 out of 5 years you can sell without paying capital gains).

I'm almost certain that's prorated, so if you lived there 2 out of the last 5 years, you don't pay cap gains on 40% of it, the whole thing doesn't suddenly become free.

That being said, you'll need to run the numbers much finer than given here.  I personally wouldn't purchase a rental for 160k that only grossed 1250.  It'd need to gross at least 600 more than that (and likely more like 1000 more).  Most of my rentals that rent in that range (1200) cost around half that.  Obviously a different area, but that's my point, if you want to invest in a rental, pick one that will be profitable.  I vote for selling, but again, that's based on two numbers (your estimated FMV and gross rent).  I'd think you could take the 35k or so you'd get from selling and either pay down debt or invest in equities or invest in a different rental if you like real estate right now.  But that one you're holding out of convenience (having lived there)?  Meh.

[onemorebike]

Yeah, I paid 110,000 for it. It was our first house and I invested another 15-20 in rehabbing it. (we did most of the work - with a little help from a windows and floor guy) I put the low end of what it is valued at just to give an idea of its value versus cost.

Selling isn't out of the question, I just have seen it as a long term investment - perhaps nest egg for the college educations. But I'm not opposed to a face punch on that one.

So far I'm pretty damn good at land lording - in that I am able to manage the property with minimal effort, choose and maintain tenants that pay their rent on time and don't trash the house.

[Another Reader]

In an appreciating market, it often makes sense to hold on to a house like this.  You would incur a lot of selling costs and net maybe $40k.  You would lose the tax sheltered income as well.  Since you only have your down payment and sweat equity costs into it, your yield on cost is not too bad.   In your shoes, I would look at refinancing the rental to see if I could drop the interest rate.  If I had that extra money on hand, I might try to drop the principal balance a little at the same time.  If you financed $100k at 4.25 percent for 30 years, your P&I are $492. 

If you have no problem being a landlord, I would probably follow through on the nest egg idea.  I would reduce the other expenses and cash flow the student loan payoff.  Any other money I could squeeze out would go to funding the various retirement accounts.

[Catbert]

I agree with Another Reader you should hang on to the rental and refi if possible.  Use some of that "landlord pay" to bring the loan balance down if necessary to get the best rate.  (You're right that if you occupy it 2 of 5 years before sale you won't pay cap gains if less than 500Kgain for a married couple.  It isn't pro-rated.)

I'd probably take the remaining extra money and pay off student loans.  Or split between extra loan payments and retirement accounts.

[arebelspy]

Another Reader, I usually agree with you on real estate stuff, but on this one I'm curious why you'd stick with an investment made accidentally just because it's "not too bad." (I'd personally be empahsizing the too if saying it out loud.)   You don't think that 40k could produce a better return elsewhere? 

I see it as: you have 40k.

You can use it to invest into the property you have now.  You can use it to pay off debt.  You can use it to invest in the stock market.  You can use it to buy blow and hookers.  You can use it to buy rental property elsewhere.  Whatever, basically.

I don't see option 1 as the best use, personally.  If you like rentals as a type of investment, sell and use that 40k as a down payment on a good rental! (Say one that costs the same, 160k, but rents for 2k.. Or one that costs half as much, but rents for the same.)  The only reason to keep it, IMO, is because it's less work.. Which isn't a great reason, in my mind.

Again YMMV, but I'm just curious why you're thinking that holding it is the best solution.

[arebelspy]

(You're right that if you occupy it 2 of 5 years before sale you won't pay cap gains if less than 500Kgain for a married couple.  It isn't pro-rated.)

Are you sure? 

If you aren't certain, please don't talk with such certainty, especially when giving tax or legal advice. :)

AFAIK, (and again, I could be wrong, laws change all the time) this was changed back in 2009.

From this site: www.groco.com/readingroom/real_helpforhomeowners.aspx

“Non Qualified Use” Provision
There is another new provision in a bill passed by Congress that will take effect January 1, 2009 that you need to know about. This involves rental properties that revert back to owner-occupied properties.

Old Rule: Rental > Owner-Occupied > Live in 2 out of 5 years > Sell and get $250,000 capital gains tax free if single, $500,000 if married.

New Rule: Rental (let’s say for 3 years) > Owner-Occupied > Live 2 out of 5 years > Sell – now the government says the 3 years of rental were “non-qualified” use so you will only get credit for the years that were owner occupied, or in this example: 2/5th of the gain is tax free. There is a formula: the top number is the amount of time it was owner-occupied and the bottom number is the time of total ownership of the property, this fraction then determines the amount of tax free gain and the balance that will be taxable up to the $250,000 or $500,000 limit.

Why is this important? If you own a rental or plan to buy one and then plan to revert it back to a principal residence at some point in time, you need to be aware that you will not be getting 100% of the taxable gain credit up to the $250,000 or $500,000 limit. You will only be entitled to a portion of it tax free, with the balance being taxed. Have a CPA help you with this if you are thinking of doing this or are in this situation.

That was just the first google hit.  I'm sure there's more.

If you know otherwise though, please let us know!  :)

[Another Reader]

Because of the transaction costs of two transactions if he buys another rental.  I don't think he's going to do a lot better in yield by taking $40,000 net and reinvesting it in his local market from what I know of Denver.  He will incur management costs if he buys outside his local market.  This one has just been renovated, minimizing rehab costs.  He's getting tax sheltered income today.  Denver is an appreciating market.  I would rather set and forget this one, especially if I could refi and decrease the payment.  Now if he could get $250k for it with the same rent, I would be all over selling it.  Sell and buy two or three.

In addition, his income is pretty solid.  By trimming his expenses and focusing, he can start to fund the retirement accounts from cash flow.  The student loans can also be cash flowed.  He's also got kids that need to be educated.  In his situation, I would take the conservative "wait and see" approach with this house. 

[arebelspy]

The transaction costs would be calculated in total returns, and become irrelevant, basically.  If another investment is better after transaction costs, then what does it matter what the costs were?  Ditto management expenses.

I think you're right if he wants to have investment property, and keep it local (Denver).  If either aren't true (i.e. have better uses for the capital than mediocre investment property or is willing to invest elsewhere), I think he can easily, easily beat that return.