Case Study - Sell or Continue Renting SoCal

[FireOnTheMuffin]

Hi, I should probably just read more prior case studies here to get ideas, but my brain is too foggy to think things through these days.  Should I sell or continue renting out?  What factors should I be considering? 

I’m recently FIREd, so have the time to manage the property, but every time something goes wrong I get stressed.  My current tenants are complainy/rude so it stresses me out more than prior tenants did.  And it has not been cash flow positive at least the last couple years, probs its entire rental life since 2017.  Approximately break even.  I have young kids.  Might they want to live here one day? 

Original Purchase price:  $509k
Original Mortgage Amount:  $458k
Down Payment Amount:  $51k
Interest Rate:  2.99%
Mortgage Term:  30yrs
Term remaining:  ends Jan 2051
Amount remaining on mortgage: $381k

Estimated market value:  $1.1M if I spend maybe $50k dolling it up.
Capital Gains Exemption?:  None, I don't qualify anymore.  We used to live here, but it's been too long.

Gross Rents:  Currently $3850/mo, but will raise in June to about $4200

Principal and Interest, Taxes and Insurance:  Total $2380/mo.  P&I portion is $1724/mo, and T&I portion is currently $656/mo but goes up slightly every year.
HOA costs:  $0

Deferred maintenance notes that are not included in the $50k cosmetic changes for sale: 
- Could use a new roof in next few years $18-25k
- Has a small pool (or large jacuzzi) that has some surfacing cracks/chips.  Not sure what this would cost to fix.
- These are not future expected costs, but as background over the last 2 years I have not even broken even with all of my maintenance/repair expenses compared to the rent I’ve taken in.

Anything else special or unique in regards to the numbers of the property (not the property itself; things such as city assessments, back taxes, special costs due to unique features of the property, etc. etc.):  Can’t think of much here.  Property is in SoCal.

[srad]

Seems like an easy one to me.

You apparently don't need the money from the rents, because you aren't getting any money from rents 
You are FIRE'd already so the long term play for real estate isn't that important. 
You don't like being a landlord.   

You have two options
1. Sell it, pay the taxes, invest the rest and live stress free.
2. Move back into it for two years, fix it up, then sell it. This will eliminate the cap gains tax and you'll only pay the depreciation recapture.

You have a nice win on your hands, your call if you want to cash out or not.  And I don't know anyone who can predict where their kids will want to live in 20 years.  I personally wouldn't keep something I dislike around just so the kids may use it decades from now. 

[Paper Chaser]

It stresses you out, you don't like the tenants, and it's cash flow negative. Why on Earth would you keep it?

[uniwelder]

Like everyone else is saying, if you don't like it and don't need it, then sell.  Who knows where your kids will want to live later on.  However, I am curious about digging into the numbers a bit and want to play devil's advocate.

Is there a lot of deferred maintenance?  Are the tenants really rough on things?  I'm wondering how you're not making any money on this house.  With the current rent of $3,850, you should pull in $1,470/month over the mortgage.  It doesn't sound like you've had a vacancy, so what is costing you so much for repairs and maintenance?  That's 35k for the past two years!  And you say it's been break even averaged over the past 6 years, so you've had to put in something like 100k in its relatively short rental life.  What's going on?

Also, it may not be money immediately in your pocket, but remember to include principal pay down in the profit calculation.  It seems like that should be somewhere around $700/month. 

As for appreciation, you've done really well and lucked out in the SoCal location, but I have no idea how that might pan out in the future. 

Also, depreciation works in your favor with taxes while you're a landlord and working a full time job.  If you waited to sell when your husband retires, assuming you file joint taxes, you'd probably come out ahead.  If interested in the numbers, you'd really have to talk to someone that actually knows what they're talking about--- not me.

edited to add--- I wonder when you say "as background over the last 2 years I have not even broken even with all of my maintenance/repair expenses compared to the rent I’ve taken in." that is considering the number that shows up when you do taxes.  In that case, it could be normal and fine.  It's entirely possible all the money going in your pocket might be negated on paper by the depreciation.  It would just be a paper loss, actually helping with your taxes.  Do you think this is the case?  Otherwise, I have no idea how you're spending 17k/year on repair/maintenance.

[BECABECA]

One thing that is unique to your situation is that the property tax is assessed much lower than the current value of your house due to California’s 2% cap on annual property tax increases. In the future, depending on the specific circumstances, if you wanted to buy a different house in California when you are of eligible age, you could have your property tax basis transferred from this house to the new one, potentially saving you thousands of dollars every year (at your current value, you’re probably paying ~$6,000 less every year in taxes from this). Or if there was a possibility you would live in it again for 2 years at any point, selling it after that point would save you capital gains taxes on $500,000 of gains (if married filing jointly), around $75,000 in federal taxes saved, plus whatever savings your state taxes might also be.

[FireOnTheMuffin]

Thanks all for responses so far!

@uniwelder, thanks for playing devil's advocate!  I do want to make sure I'm thinking through everything.

Is there a lot of deferred maintenance?  Are the tenants really rough on things?  I'm wondering how you're not making any money on this house.  With the current rent of $3,850, you should pull in $1,470/month over the mortgage.  It doesn't sound like you've had a vacancy, so what is costing you so much for repairs and maintenance?  That's 35k for the past two years!  And you say it's been break even averaged over the past 6 years, so you've had to put in something like 100k in its relatively short rental life.  What's going on?

On the income side, yes I currently pull in $1470/mo but it wasn't always this good.  Here's an annual run-down because I think people often make this sort of comment, but this will show some reality, and the nature of the expenses more detailed below:
2017, I was negative just based on market rents compared to my mortgage at the time (only refinanced to current rate in 2020), and on top of that I had expenses getting the house ready for rental after we moved out.  Overall, negative by thousands.
2018, I raised rents and had a little cash flow over my mortgage, but expenses got me negative by thousands. 
2019, left rent same and expenses got me negative by thousands. 
2020, raised rent a little but had 10 days of vacancy; expenses were low so was positive by $740 for the year, Yay! 
2021, raised rent a little more and my refinancing reduced mortgage effective at beginning of year, plus in the refinancing I got to skip the first month payment?  I actually haven't thought through where that money comes from to skip the payment, but i've put it as $0 for the month on my spreadsheet.  Managed to be positive for the year by several thousands, but not enough to cancel out prior losses. 
2022, raised rent a ton but took a 1 month vacancy to do upgrades and had some other expenses, positive by under $500 for the year. 
2023, raised rent more, and had ridiculous expenses, positive by $2750 for the year.
2024, so far rent is the same, but have just had major expenses.  Currently, down $3500 for the year.

The house is just kind of old, built in the 50's.  Just this week I had over $6k in expenses to replace some cast iron sewage piping that was rusting completely closed and backing up a bathtub.  If these tenants weren't so fussy and hard to schedule around, I might have saved some by getting more quotes on the work.  In 2023, I had major expenses due to a mold issue from exterior walls that had never been insulated accumulating condensation on the interior from the temperature differential, which required me to put the tenants up in an AirBnB.  Then again in 2023, I had to tent the house for termites and put them up in an AirBnB.  This second AirBnB probably could have been avoided if the tenants hadn't been unreasonably freaking out about a few termites, and could just have waited until they were on vacation or something.  Prior to these tenants moving in in mid-2022, I put in quartz kitchen counters which was more thousands.  And in years past, there were 3 other moderate to major expenses/upgrades installing heat pump HVAC, tiling a shower, replacing a patio cover, plus replacing various appliances over the years. 

I've been lucky in that none of my tenants have been rough on things.  I keep thinking after every major expense, this has GOT to be it for a long time now, right??  I didn't have to do some of these upgrades, but they have probably helped me increase rent at the rate that I did.  In theory, if the major expenses stop, this property should be a great income generator...  But that roof, though...
 

Also, depreciation works in your favor with taxes while you're a landlord and working a full time job.  If you waited to sell when your husband retires, assuming you file joint taxes, you'd probably come out ahead.  If interested in the numbers, you'd really have to talk to someone that actually knows what they're talking about--- not me.

I'm not working anymore and my partner and I are not legally married, so it doesn't help him.  Also, he makes too much to deduct losses, and when I was working, I also made too much.  So, there are a bunch of tax losses in the property that have not yet been taken, I guess that could help on sale cap gains.

edited to add--- I wonder when you say "as background over the last 2 years I have not even broken even with all of my maintenance/repair expenses compared to the rent I’ve taken in." that is considering the number that shows up when you do taxes.  In that case, it could be normal and fine.  It's entirely possible all the money going in your pocket might be negated on paper by the depreciation.  It would just be a paper loss, actually helping with your taxes.  Do you think this is the case?  Otherwise, I have no idea how you're spending 17k/year on repair/maintenance.

Nah, it's not this.

@BECABECA, I'll have to look into this property tax basis transfer stuff more.  I don't really understand it, but I'm guessing it wouldn't work out for us.  We have other homes we are living in/going to live in already. 

Question for @srad & @BECABECA, I thought if we move back in for 2 years, it will still only be like some pro-rated portion of the cap gains exclusion?  I've always thought there was a pro-ration and have always been confused why nobody talks about it.  Am I wrong?  Also, I own this property in my name alone, so would max get $250k exclusion.  I don't think we would do it, in the end.

[FINate]

Question for @srad & @BECABECA, I thought if we move back in for 2 years, it will still only be like some pro-rated portion of the cap gains exclusion?  I've always thought there was a pro-ration and have always been confused why nobody talks about it.  Am I wrong?  Also, I own this property in my name alone, so would max get $250k exclusion.  I don't think we would do it, in the end.

You are correct, it would be pro-rated based on the number of years you lived there divided by the number of years owned. This changed 10-15 years ago because too many people were gaming the system as is being suggested here.

[FireOnTheMuffin]

I think my situation is similar to @Villanelle 's thread a few months ago, to which @Nords replied, the following, which I am now trying to wrap my brain around to properly calculate what my net would be.  Is there an easy spreadsheet around for this, or just my tax software?

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.

[Nords]

I’m recently FIREd, so have the time to manage the property, but every time something goes wrong I get stressed.  My current tenants are complainy/rude so it stresses me out more than prior tenants did.  And it has not been cash flow positive at least the last couple years, probs its entire rental life since 2017.  Approximately break even.  I have young kids.  Might they want to live here one day? 

We could dig into the finances of keeping your rental property, @FireOnTheMuffin, but this paragraph is exactly why you should sell.  Nobody needs to have a stressful investment, and you're even more at risk of misery when you're a landlord in an excessively tenant-friendly state like California. 

I've never run across a family whose kids took over Mom&Dad's properties, either the family home or a rental.  (I've had the discussion with over a dozen landlords who've tried that approach, and their kids were not at all interested because they were too busy with their own lives.)  I think most young adults want to make a clean break from home and choose their own living arrangements for a few years.

I'm not aware of an easy spreadsheet that handles all of the factors in selling a rental property-- but most tax software can account for all of them.  This year when we finish our income-tax returns, I'm going to run a separate TurboTax return (starting with our same 2023 numbers) to simulate the sale of our rental property.  The difference between the two tax bills will give us a good idea of what we'd have left (after selling and paying the taxes) to invest in a total stock market index fund.

And then we'd enjoy many more months of hassle-free slow travel.