Nancy and Joe’s New Home
Nancy and Joe are moving to a new home an hour away and must decide to sell or keep their old house as a rental property. They are in their thirties with two young children. (Note: I’ve rounded some of the numbers to make it a little easier to follow, but the evidence below is roughly true.)
- New Home: $500,000
- Old Home: $400,000 (appreciated by $200,000)
- Cash/Savings: $100,000
- 401k/Retirement Savings: $100,000
- They both have steady employment, $120k net income.
- They’re planning on saving $1000/month towards retirement.
- New Home Mortgage: $400,000 (after $100k savings down), 4.90% interest
- Old Home Mortgage: $100,000, 3.50% interest
- Their marginal tax rate is around 33%
Nancy and Joe can use their savings for a down payment on the new home that will avoid PMI, and they’d like to keep the old house as a rental since it has increased in value so much in the past decade: The sky’s the limit.
Or so they think. I’ll show you why the decision to keep the rental property might be a perilous one.
If they sell the old house now, or anytime in the next three years, they’ll avoid all taxes on the appreciated value because of the IRS rules on capital gains from the sale of a primary residence. That’s an extra $66k in their pocket right now! If they keep the old house, eventually taxes will be due on this appreciation.
When you put a big chunk of your retirement savings into owning the entire stock market, you own a tiny slice of every public company out there. One of these companies could see a bad actor that burns down her business (metaphorically), and you might just see the slightest dip in your portfolio from this unexpected news.
If instead you put a big chunk of your retirement savings into owning a rental property, you own one big slice. One awful tenant could burn down your portfolio (literally, this time), and you might see your retirement plans go up in smoke overnight (sure, metaphorically and literally).
If this rental property was a small part of Joe and Nancy’s retirement portfolio, it would make more sense. However, it’s about 40% of their total assets, and a whopping 80% of their current net worth. They’re putting a whole bunch of eggs in one basket of real estate. With a bit of bad fortune, that could end very badly. And if it does end badly, it may become very difficult to find workable contingency plans.
Another issue they face is liquidity. Perhaps the new home gets flooded or they have a medical emergency. If they are invested in the whole stock market and need to extract $50,000, they’ll be able to do so pretty quickly and without too much hassle. If instead their net worth is tied up in these two houses, they can’t very well sell off just $50,000 of the rental. They’ll have to sell the whole thing, and face the tax burden described above whether they like it or not. Further bad news: Rentals tend to be harder to sell than primary residences. In an emergency, cash is king.
They want to hold the rental property for the long term, so let’s project the next 30 years if they keep the rental and if they sell the rental.
We have a model for stocks and bonds, so what’s a reasonable approach for a single rental home? These were the fairest assumptions I could come up with:
- Similar properties in the area rent for $1600/month
- Occupancy Rate of 90%.
- Maintenance and Taxes Budget of 2% of home value per year.
- Nancy and Joe have an extra $1000 toward the houses/retirement each month.
- They will sell the rental at the end of 30 years, paying their marginal tax rate (33%) on the appreciation.
- Value of the property appreciates an average of 7% per year, with the same volatility as the historical stock market.
The last point is tricky. Maybe they should expect higher appreciation; but so too they might expect higher volatility. Caveat emptor.
They can sell their old house (blue) or keep their old house (red):
I calculated the value at each point after taxes, so you see a big dip in the red lines at Age 33 when they would no longer avoid capital gains on the rental house. Otherwise, they’re borrowing money to invest with which is good when it works and awful when it doesn’t. You can see in Figure 1 above that the upside scenario with the rental is better than the upside without the rental. The expected (median) case breaks even around two decades into the plan.
“Only when the tide goes out do you discover who’s been swimming naked.” -Warren Buffett
I’m more concerned about the downside. Here’s all the time between now and when the baby is in college in the 10% worst case scenario:
The worst case scenario in their new home with no rental is merely tepid growth in net wealth. Probably the couple will have to work a bit longer or cut back on spending in retirement. However, the worst case scenario with the rental is a loss that will take 18 years to get back to ZERO! And we haven’t yet included the emotional and financial costs of a badly behaved tenant’s eviction, or the myriad other unfortunate events that can befall a single property. We talked earlier about the advantages of liquidity in a crisis: What do you do if you need cash and your rental property is worth less than you owe?
Selling their old house immediately nets them $66,000 in saved taxes, and they can put all of the proceeds into the new mortgage for an effective guaranteed interest rate of 4.90%. They could also keep a share of the old house proceeds to ensure they are fully funding their IRA and 401k accounts in the next few years (or ESA accounts for their children). They’ll have less risk, more liquidity, AND more money, and their new home will almost be paid off!
If they’re determined to be landlords, it’s still better to sell! Buy a rental house in the new neighborhood and they’ll reap the tax savings from the old home AND have a shorter drive to manage the property. Also, they should look for real estate opportunities that are closer to the One Percent Rule. With two young children in their new home, Nancy and Joe will probably be happier and more secure selling their old home and waiting for the right time and place to purchase a rental property.