QMy wife and I own a house in the city. We needed a larger home after our first child was born and bought one in the suburbs. It is tempting to sell our other house, especially because of the robust market and the favorable capital gains tax treatment. However, we have been leaning toward renting it out, at least for a few years. Do you have any suggestions?
AMuch will depend on your personal situation, both financial and psychological.
There are many issues that you, your family and your financial advisers should consider as you decide whether to rent or sell. Here are some of them:
* Tax considerations. No one likes to pay taxes to the federal government. If you sell your principal residence, will you have to pay capital gains tax? Perhaps not. Have you owned and lived in the house for two out of the five years before the sale? If so, if you are married and file a joint tax return, you can exclude up to $500,000 of your gain.
Gain is defined as the difference between the adjusted sales price and the adjusted purchase price. Let's take this example: You paid $100,000 for your house and made $10,000 of capital improvements. Your adjusted purchase price is $110,000. Then you sold your house for $400,000. You also had to pay a real estate commission of $24,000, and miscellaneous closing costs of $6,000. Your adjusted sales price is thus $370,000 ($400,000 minus $24,000 minus $6,000). When you subtract the adjusted purchase price from this latter figure, your profit (i.e., capital gain) is $260,000.
If you are married and file a joint tax return, you can keep all this profit. If you are single (or file an individual tax return), then you can shelter only $250,000. The remaining $10,000 profit will be taxed at the current capital gains rate of 15 percent, or $1,500. You also have to take into consideration any local or state tax on such gain.
* Rental headaches. Being a landlord is not easy. In some areas, such as the District, there are strong tenant rights laws. You must make sure you understand the rules and regulations that affect landlords before you decide to rent out your property.
There are other landlord concerns. Is the property in an area that will continue to appreciate? How old is your house? Will it need periodic maintenance? Is the roof on its last legs? What about the heating and air-conditioning system or other appliances? Keep in mind that with most rentals, you, as landlord, will be responsible for making sure everything is in working order, unless your tenant negligently caused the damage, which is difficult to prove.
* Long-range goals. Do you have any idea how long you will hold on to the property? While I recognize this is a difficult question, you should give serious thought to whether this property is to be included in your estate planning. It is never too early to start planning for your retirement and death. Will the rental property be a burden on your family or your budget?
* Management. If you decide to rent, will you self-manage or hire a professional property manager? Doing it yourself will save you the money you would have to pay a manager. But it will not save you from the midnight telephone calls from a distraught tenant who has locked himself out of the property or has a flooding toilet. If you decide to retain a manager, make sure you have a contract spelling out who is to do what and when -- including the cost of any such services. Your contract should not include a provision saying that if the property is sold to the tenant, the manager will get a commission.
There are different ways to work with a manager. Your manager can be given complete responsibility for handling the rental property. Under this arrangement, the manager will locate a tenant, determine if the tenant is financially capable of paying the rent, collect rent and pay all your bills. If you go this route, you should receive a monthly statement from the manager showing the income and expenses incurred during that reporting period.
Alternatively, you can give your manager selective tasks, such as finding a tenant for you.
All options should be discussed with your potential manager before you sign a contract.
You have suggested that you could manage the property for one year and see how you like it. Clearly, that is another option.
You also suggested that you could rent out the house for three years, and if you are not enjoying the rental process, you could sell it and take advantage of the capital gains tax savings.
That certainly makes sense, but watch your calendar carefully. As mentioned above, you must have lived in the property two out of the five years before the house is sold. If, for example, you lived in the house from July 1, 2002, through July 1, 2004, you must sell the house by June 30, 2007, to take advantage of the capital gains tax exclusion. If you rent out the house for three years, you may have trouble selling the property while the tenant is still there. Furthermore, no one knows what the market will be like in 2007.
Thus, if you decide to become a landlord, you should consider renting the house for only two years. Should you decide to sell after all, this will give you a full year in which to get the house ready for sale, find a buyer, and actually go to settlement within the required time.
Renting your house is clearly an option, but you should do your homework and understand the pros and the cons of this venture.
Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address.