So, you have outgrown your current home, and you are thinking about keeping it as a rental property. Converting your current house into a rental might not be a bad idea, but there are several things that you need to take into consideration. Depending on your situation, you might be better off selling the current house instead of keeping it.
Should You Convert Your Current House into a Rental?
First, look around and see how much a house like yours could make per month. If the monthly rent does not cover your mortgage plus the HOA payments, you should consider selling it. To ensure that you have a decent investment that does not put a strain on your budget, you need to have at least $200+ cash flow (i.e., that is rent minus mortgage minus HOA fee).
Cash Flow = Rent – Mortgage Payment – HOA Fee
Even with some cash flow, you will most likely lose a small sum of money each year. The reason for this are expenses that will inevitably show up, e.g.,
- Non-payment of rent and eviction expenses
- Marketing expenses (when you need to find a new tenant)
But losing a little bit of money at the beginning is not always a bad thing. You are likely to become profitable once the rental rate goes up over time.
Another reason to sell your house instead of keeping it as a rental is capital gains. Before you convert it to a rental, check with your Realtor to estimate how much capital gains you have accumulated over the years. You can calculate your capital gains as follow:
Capital Gains = Expected Sales Price (when you sell)
minus Original Purchase Price
minus Closing Costs (when you bought)
minus Closing Costs (when you sell)
minus Improvement Expenses
If you have a sizable gain, talk to your Tax Advisor about tax implication. In general, you do not have to pay any capital gains tax if you sell your house and buy another one, as long as you live in the current house at least 2 out of the last 5 years. The limit of this tax exemption is $250,000 in capital gains for an individual and $500,000 for a married couple.
Converting a house with a sizable gain into a rental could translate into a lot of taxes in the future.
There are Better Rental Property
When you bought your house, you were probably not thinking about how good it would be as a rental property. In most cases, the house you buy for yourself rarely makes a good rental property. Besides the cash flow issue which we already mentioned, here are some factors to consider:
- Large Yard – tenants rarely take care of the yard. If you have a large yard with beautiful landscaping, you can count on significant deterioration year after year.
- Expensive Components – tenants rarely care of cabinets, floorings, countertop, appliances, and other components as much as you do. If you have been putting a lot of money into your house, renting it out is usually not a good idea. The money you invested will likely turn into nothing over the years as these expensive pieces break down or wear out
- Large House – a larger house also makes a bad investment because it is so expensive to turn it over. For instance, a small 1200 sq ft townhouse will cost less than $2,000 to repaint, but a large 5000 sq ft luxury house with tw0-stories living room, and foyer will probably be close to $10,000 to repaint. This is also true with repairing/replacing floorings, roof, siding, etc.
If you’re thinking about getting into real estate investing with your current home, be sure to review these factors carefully before you commit to the plan. Your lovely first home might turn into a nightmare as a rental property if the house does not have the characteristics of a good investment property.