Trying to decide if we should keep our rental when the lease is up this summer, or continue to rent. I like the diversification it has added to our portfolio, but that's only worth so much. (I won't try to quantify that unless it is a close decision.)
We have 8 years left on an 18 year loan, which was a refinance. Have owned it since 2004 and was our residence until 2010. I have to look at the tax rules to see how specific the cap gains exclusion is, but I think we don't qualify, even with the additional 10 years added for military to the 2/5. (Is it based on the exact months you moved out, or just the fiscal year? We left in May or June of 2010 and lease goes though July of '24.)
I'm having trouble figuring out how to run the numbers. Could sell for roughly $900k today (and of course that could be more or less by July) and rent for maybe as much as $3900 today (+/-).
If I base the numbers on what we owe, this is the deal of a century. But that ignore the opportunity cost of the hundreds of thousands of dollars in equity. I feel like I should be able to figure this out, but my brain keeps stumbling. I looked at the pinned google sheet, but didn't see how to apply that to an existing property and calculate for the opportunity costs on the equity.
If the question is "would you buy today with a $900k price and $3900 in rent" the answer is a firm no. But I'm not buying today (or at today's interests rates). If I look at the amount we owe (very, very roughly $150k at 5%) compared to the income, it's amazing. But I think the reality is somewhere in the middle.
Your brain might be stumbling, but this is a complicated spreadsheet. Capitalization rates can be used for
lying different ways in determining your opportunity costs.
When you bought the place, you would have looked at your return on the cash that you invested in it. That formula considers the mortgage payment as an expense on your net profits, but it was mostly interest and not much equity.
Now that you’ve grown a bunch of dead equity through appreciation (and some mortgage amortization), you could choose to borrow on that equity (HELOC or cash-out refi) to buy another property or invest it in the stock market. At today’s interest rates that’s not much fun (it can practically kill the BRRRR tactics that real-estate investors have used for nearly 20 years) and it’s also not much fun leveraging a 6%-7% mortgage to invest in a 6%-7% stock market.
However you could calculate the opportunity cost of your after-tax cash you’d have left over after selling the place. That’s the capitalization rate using your net annual landlording profits divided by your after-tax equity.
You’d use the after-tax equity because that’s what you’d have left to invest in the stock market after you sell the place. You’d use tax software to figure it out to the last nickel on your income-tax returns, but you can estimate those numbers for your cap rate spreadsheet.
You’d start with the cost basis of your place. That’s the purchase price, the closing costs as a buyer, and the capital improvements you put into it (as your owner-occupied residence) up until the day you became a landlord. You use the date of the closing as the date you owned the place.
Then you started depreciating the house when you began landlording (you probably picked the mid-month convention for the start date of the depreciation) until the date you sell it. (You don’t depreciate the land.) The closing date of the sale is the end of the depreciation (probably the mid-month convention again, but I’d have to research the reference) and that’s the total months of depreciation you’ve taken. You can check your calculation against the depreciation you’ve already taken in your old income-tax returns to make sure that’s the correct number.
The basis of the sale is the sale price minus the costs of selling the place, and as of the date of the closing of the sale. The difference between the cost basis and the sale basis is the capital gain, but some of that capital gain is considered depreciation for recapture.
As a landlord you deducted your repairs & maintenance, and you also depreciated your capital improvements. You’ve already taken the repairs & maintenance deductions on your income-tax returns (as a landlord) but you’d add the depreciation of the improvements (carpeting, major appliances) to the house’s depreciation as part of your total depreciation for recapture.
Paul Allen at Redeployment Wealth Strategies wrote a good post for Kate Horrell on depreciation recapture:
https://www.katehorrell.com/favorable-tax-rules-for-military-when-excluding-capital-gain-from-sale-of-principal-residence/Now you add up a honkin’ big tax bill:
- capital gains from the sale of the house
- capital gains tax at the federal, state, & local levels
- net investment income tax for really big capital gains (I haven’t looked up the NIIT math yet but I think it’s about 3%)
- depreciation recapture at the federal, state, & local levels
There’s probably still the issue of Alternative Minimum Tax, which I do not understand well but which might be applied instead of capital gains & depreciation recapture.
The money your spreadsheet leaves you with is the net equity (the opportunity cost that you could invest in the stock market), and your net annual gain from landlording tells you the capitalization rate.
It’s perfectly reasonable to check your emotional happiness of landlording. If you’re not happy then the numbers don’t matter (or will be derailed by your emotions) and you should sell the place.
As an investor you could also sell the place with a 1031 exchange into a syndicated real estate investment. (You’re a limited partner with a general partner.) That gives you some tax deferral (along with hypothetical truly passive income) but now you’re at the mercy of a GP. When the GP cashes out the investment property a few years later then you’re faced with the same taxpayer situation.
We’ve landlorded for 25 of the last 28 years. Houses are fully deprecated at 27.5 years. When I did our 2022 income-tax returns I dug through our old returns to check our depreciation recapture, and our TurboTax numbers didn’t add up for the house. I dug through our 2022 return to find the place where TT was calculating the total depreciation, fixed that number, and should now have the full depreciation taken by the end of 2025.
When I run the sale of our rental property through our tax software and put the numbers in our spreadsheet, it’s pretty annoying to see how much it costs (in taxes and in depreciation recapture) to cash out. For example, as a landlord you’re depreciating and taking the deduction in the 12% or 22% income-tax bracket, but you might pay the recapture at as high a rate as 25%. Your capital gains quickly end up in the 20% rate, and the NIIT just adds insult to injury.
Our rental’s cap rate on our after-tax equity is also annoying at about 3%. (This is all too typical of Oahu.) We look pretty smart when interest rates are 2%, but otherwise we’d do better putting that equity in the stock market for at least 10 years. We have the reliable inflation-fighting pension income to handle that aggressive asset allocation, and after 40 years of investing we’re comfortable with stock-market volatility.
When I show those numbers to my spouse, she plays the diversification card and tells me that we’re keeping the rental. She does 99% of the work (I just show up for heavy lifting, casualty assistance, and tax returns) so she gets to make that decision on her own. For her it’s the emotional security (from behavioral financial psychology) of diversification and the landlording skills she grew up with.
That’s not much emotional comfort when the tenant texts you— 48 hours before you leave the island to start your long-term travel— the news that their refrigerator has a broken defrost heater.
My spouse tells me that the equity in our rental property is part of our fund for paying our long-term care expenses (if necessary), and after that her long-term landlording strategy for avoiding depreciation recapture is… probate.
