Case Study: Sell rental to avoid tax on high appreciation?

[oneglowingfinger]

My wife and I moved out of our first home late last year and converted it to a rental. It seemed like the obvious choice because we bought the house as a foreclosure in 2010, and it's in a small, walkable town where property values are booming, buying competition is high, and rentals are relatively few and far between. Having a positive cash flow came easily with this house.

This is our first rental, and things are going well so far. We live about 20 minutes away and manage and maintain the property ourselves, and our tenants are great. Cash-flow positive, easy tenants--seems simple, right? Keep the house!

Well, I'm doing my income taxes and wrapping my head around the ideas of adjusted cost basis, depreciation, and capital gains for the first time, and this has me wondering if maybe there's a better way to put our equity to work. Here are the numbers:

Market Value: $270,000
Original Purchase price: $102,000
Original Mortgage Amount: $81,600
Interest Rate: 4.625%
Mortgage Term: 30 years
Term remaining: 22 years, 8 months
Amount remaining on mortgage: $71,531.72
Gross Rents: $1600
Principal and Interest: $427.76
Taxes and Insurance: $448.82
HOA costs: none
Deferred maintenance notes: Probably need a new furnace within 1-2 years and a roof in 5-8 years.

If I sell and end up walking away with $180,000 that I invest in the market, a 7% return would provide higher annual returns. I'd also avoid capital gains tax on the significant appreciation we've seen, and I'd have no responsibility for maintaining the property.

So what am I not thinking about here? Thanks!

[MDM]

Depreciation?

That saves you money now, at the cost of depreciation recapture when you sell....

[marty998]

If I sell and end up walking away with $180,000 that I invest in the market, a 7% return would provide higher annual returns. I'd also avoid capital gains tax on the significant appreciation we've seen, and I'd have no responsibility for maintaining the property.

So what am I not thinking about here? Thanks!

You are not thinking about the fact that your returns have been much greater than 7% p.a. over the period of time you have owned this house.

I mean... jesus look at the numbers... 170% capital appreciation return over 7 years...., before factoring in income returns.

Why the hell would you want to sell and only get your 7% p.a., instead of borrow against the house to rinse and repeat and buy more properties like that???

[tralfamadorian]

There's an argument to be made for either side. Fortunately for you, both are a win.

On one hand, you can keep the money making rental whose income is nearly/totally tax free. It's also an inflation hedge and a wonderful foil for index investing (see The Rate of Return on Everything posted here before for a dense but data driven explanation of this- https://www.frbsf.org/economic-research/files/wp2017-25.pdf)

On the other hand, you can cash out the equity for 100% passive index funds.

[LightStache]

Taxes are extremely favorable for rental properties, especially ones that have been owner occupied since you get the primary residence deduction as a pro-rata portion when you sell. Cap gains on your investments will be equivalent to the RE, but you won't have the leverage, at least not a 4.x%. So if your rationale for selling is tax, I strongly consider that you model the alternatives. To be clear, tax considerations should lead you to hold it.

But you do mention that it would be a plus not to have to manage the property. It can totally suck (SUCK!!) being a landlord, so if you're not ready to commit for the long term then you should sell. I say the long term because if the market takes a little dip, you see your equity erode, and you already hate being a landlord, that's the time you'll fold and sell. If you decide to keep the rental, then you need to commit to working through any market dips to come out the other side.

Congrats on an amazing purchase! Either way you chose, you've done really well.