Case Study : Sell or Continue to Rent this house?

[Lowerbills]

Long post, I'll apologize in advance :)

For reasons I'll explain below, I've been dead set on selling this house next Spring, but have started to reconsider.  I appreciate your comments!  I considered selling my previous primary residence in 2013, but decided to rent it instead.  Been rented since Jan 2014 to great tenants!  Lease runs through Spring 2016.

Current Market Value ~ $375k-$395k
Original Purchase Price = $250,000, with $25,000 cash at closing.  About $30k in remodeling since.
Interest Rate = 2.49%
Mortgage Terms : 5/1 ARM, fixed @ 2.49% until early 2017, initiated in 2012.
Amount Remaining on Mortgage = $184K
Equity = ($375k-$184k - closing costs and fees ) = approx $170K? **I am a licensed real estate agent, can save a little there).

Gross Rents = $2,100
Principal and Interest payment of $790 / month
Taxes and Insurance = $600 / month (Property taxes high in Texas, but no state income tax

No HOA

House has a pool, pretty much the main reason I want to sell it.  Pool maintenance averages about $200 / month which I "pay", but priced into the rent.

Numbers:

Cash flow of about $400-$450 per month. (roughly $5k year)
Principal Payments of about $5k / year
Straight line depreciation of $7,300, which leaves me with only paying taxes on about $1,500 each year.

Kicker - Appreciation*** been pretty solid in this neighborhood and city as a whole.  When I considered selling in late 2013, market value was approx $330k-$340k.

Cash flow alone based on the equity if sold looks paltry if you consider $5k income / $170k equity = 3%
But then I figure about another 3% in principal paydown...
And another 4-5% in appreciation (I know I can't count on this, but our market is scorching right now with multiple offers, low inventory and homes selling for over list price).

My main reason for wanting to sell is:  If I sell before the end of 2016, my understanding is I pay no capital gains tax under the "primary residence for 2 of the last 5 years", which I qualify for as my last two years I lived there were 2012 and 2013.  Rented for 2014, 2015 and 1/3 of 2016 (plan at least).  I know I can address capital gains via a 1031 exchange if I sell later, however it seems foolish not to take advantage of this now, and the recent appreciation.  Thoughts?

2nd Reason for wanting to sell is the pool.  As much as I want to own rental properties, I don't want to deal with the pool long-term for obvious reasons (maintenance, liability, etc...)  I've considered removing (filling in) the pool if I consider keeping this as a rental.  Thoughts?  I've heard anywhere between $5000 and $10000 to do this.

3rd Reason for wanting to sell is the ARM.  The first interest rate increase which would be in Spring of 2017 would still be lower than rates that I can currently refi at, but still, rising rates will eat into cash flow, and I can't get anything near the 2.5% I have now.

My general thinking over the last year has been 100%, I'm going to sell in 2016, but I've started to reconsider.  The main reason is, I want to accumulate more rental properties, and it's difficult to buy anything with even these numbers in my home area right now.  I also have great tenants, and if they are considering staying, I'd be happy to have them.  In my opinion, there is further upside as far as appreciation.  Relative to other nice neighborhoods, this area is still relatively affordable and feeds into the best schools.


Thoughts?

[skunkfunk]

I vote sell. Disclaimer - I don't know what I'm talking about, really. That said I wouldn't keep it, I'd want more in rent for a 370K home and I don't think you'll get that in Texas. Do you have much in stocks and such? You could certainly talk yourself into keeping it as part of your investment strategy.

[Another Reader]

Your understanding of the capital gains provision is outdated.  Since 2009, the 5 years is prorated.  If you lived there 2 of the last 5 years, 40 percent of the gain is excluded.  You would pay capital gains on 60 percent of the gain.  You would also pay income taxes on the recaptured depreciation for the time it was leased.

Pools suck in rentals.  I know because I own a couple in Phoenix.  You can't trust tenants to maintain them, they have a lot of mechanical parts that require repair and replacement, in Arizona they must be fenced for safety reasons, and they increase your insurance costs.  The increase in rent is far outweighed by the increase in expenses.  I will likely be selling mine over the next few years.

You have $225k + 30k + closing costs in this investment.  Say $260k.  This property does not meet the 1 percent rule, even on your initial purchase numbers.  As you say, your cash flow does not provide much of a return.  If you consider all costs over a long holding period, your capital improvements, the occasional vacancy, and higher maintenance mean that long term you will likely be cash flow negative.  When you look at your cash return on the current value, it's a lot worse.  Add a much higher interest rate into the mix and your cash return on equity is definitely negative.

On the surface, this property is a "sell."  However, the problem that I am struggling with on my appreciated properties is finding replacement properties or other investments that will cash flow and provide the tax shelter that I currently have.  I think that's your problem as well.

In your shoes, I would start evaluating all your alternative investments.  You just missed the boat on refinancing - rates appear headed up.  Follow the rents in your area closely.  Consider how your investment would fit into your overall portfolio if rents stalled, your financing costs increased significantly, and the market value went down as part of the real estate cycle.  If you cannot find better investment alternatives, is it better to sell and hold cash, or is it better to hold an illiquid asset for the long term.

[Lowerbills]

Your understanding of the capital gains provision is outdated.  Since 2009, the 5 years is prorated.  If you lived there 2 of the last 5 years, 40 percent of the gain is excluded.  You would pay capital gains on 60 percent of the gain.  You would also pay income taxes on the recaptured depreciation for the time it was leased.

I'm with you on the recaptured depreciation, but can you provide a link explaining the current capital gains provision?  I'd like more clarification on this.

Pools suck in rentals.  I know because I own a couple in Phoenix.  You can't trust tenants to maintain them, they have a lot of mechanical parts that require repair and replacement, in Arizona they must be fenced for safety reasons, and they increase your insurance costs.  The increase in rent is far outweighed by the increase in expenses.  I will likely be selling mine over the next few years.

Agree!  I maintained this one for about 6 years.  Have a good company doing weekly maintenance during the summer season, bi-monthly for the rest of the year, and so far I've been pleased with the service, and whenever I stop by, the pool looks great.  I occasionally swing by (not far at all from my office) after big storm to check on things.  Have you considered filling in the pools on your rentals in Phoenix, or would you just sell the properties instead?

In your shoes, I would start evaluating all your alternative investments.  You just missed the boat on refinancing - rates appear headed up.  Follow the rents in your area closely.  Consider how your investment would fit into your overall portfolio if rents stalled, your financing costs increased significantly, and the market value went down as part of the real estate cycle.  If you cannot find better investment alternatives, is it better to sell and hold cash, or is it better to hold an illiquid asset for the long term.

Just refinanced my personal residence at 3.625% a couple months ago and considered doing something about the rental, but again, my plan all along has been to sell it next Spring, so I passed.  I would love to find a suitable replacement property, but chances seem slim unless things slow down a little here.  I am interested in duplexes, triplexes or quads, or other SFR, but other than that the other alternatives would just be more equities, which I feel like I have enough of right now...  Actually like the prospects of my local real estate market for next (1-3 years) more than the S&P.

[Another Reader]

http://www.irs.gov/pub/irs-pdf/p523.pdf

The publication is misleading, because on pages 2-3 it discusses qualifying for the maximum exclusion.

The worksheet for figuring out how much of the gain is taxable starts on page 15.  The introduction on "How Much is Taxable" starts on Page 14.  The rules were revised for 2009 forward.  Call your CPA if you have questions.

[Another Reader]

You probably do want to talk to your CPA because this article by Michael Kitces contradicts what I have been told and what the publication appears to say. 

https://www.kitces.com/blog/limits-to-converting-rental-property-into-a-primary-residence-to-plan-for-irc-section-121-capital-gains-exclusion/

This is a minefield.  Perhaps one of the CPA forum participants with experience in this area could provide more definitive guidance.  A sticky post at the top of the category would be very helpful.

[sunday]

The universal exclusion (250k/500k) for living in a home 2 of last 5 years is for your principal residence. For your second home/rental property, the exclusion is reduced proportionally by the time that it was not used as the principal place of residence.

[CashFlowDiaries]

What it ultimately comes down to is, if you sell, are you going to use that money to invest in something that will provide you greater returns then what you are currently receiving with renting that house out?

If yes, then sell and get yourself a better investment property.

If not, then keep the house and be happy with what youre making!

:)

[Lowerbills]

Thanks for the responses.  I'll follow up with my CPA regarding the conversion of a primary residence to a rental.

Using the worksheet AnotherReader linked, I would get credit for the almost 7 years I lived in the home prior to converting to a rental, which appears it would reduce the tax liability to roughly 25% of the gains, based on # days used as a primary residence and number of days as a rental.

What it ultimately comes down to is, if you sell, are you going to use that money to invest in something that will provide you greater returns then what you are currently receiving with renting that house out?

If yes, then sell and get yourself a better investment property.

If not, then keep the house and be happy with what youre making!

:)

I checked out your blog CashFlow!  Those are some nice out of state rentals you have.  I don't think I'm comfortable with that right now, but am willing to look in a radius of an hour's drive.

I'd prefer to use these funds (equity) for RE investment as opposed to more equities, and am 99% sure I'll sell next Spring.

Some of this second guessing came from a conversation with someone who's financial advice I generally respect, who basically said "never sell a house here unless you have to, hold onto them as long as you can".   Made me think twice...

[vermospan]

Thanks for the responses.  I'll follow up with my CPA regarding the conversion of a primary residence to a rental.

Would you please report back on what your CPA says, Lowerbills? I'm interested in knowing the answer to this, as well.  Thanks in advance!