Why Converting Your Home into a Rental May Be a Bad Idea:
Many homeowners, when moving out of their primary residence, consider turning it into a rental property instead of selling it. On the surface, this may seem like a great idea, especially in high-appreciation markets. However, there are several financial and legal factors to consider before making this decision.
The Legal Considerations:
Before turning your home into a rental, it’s important to understand some potential legal implications. If you have a mortgage on your home, the terms of your loan specify its intended use. So, if you claimed the home as your primary residence for the mortgage, you may not be able to rent it out immediately without violating the terms of your loan. Violating the terms of the loan could be considered bank fraud, which carries severe legal consequences, including potential jail time.
However, if you have lived in the home for a while (i.e. – the home was actually used as your primary residence) and then you later decide to rent it out, the legality depends on your lender’s policies. To avoid legal trouble, you should check with your current lender to determine what their policies are. Another option is to refinance your home with an investment property mortgage, instead of a primary residence mortgage. This ensures that you comply with your loan’s terms while renting out the property legally.
The Financial Considerations:
One of the biggest factors in deciding whether to rent out your home or sell it is the financial impact. Just because a property is located in a high-appreciation market does not necessarily mean it is a good rental investment. Many homeowners hold onto properties based on speculation rather than actual returns. Even if a property has rental income that exceeds its expenses and the property is consistently cash flow positive, it doesn’t always make sense to keep it.
One major advantage of selling your primary residence is the home sale tax exclusion rule, which allows you to exclude a significant portion of your capital gains from taxation on the sale of your primary residence. To qualify for the exclusion, you must have owned the home and used it as your primary residence for 2 out of the past 5 years (although the 2 year of residency don’t have to be consecutive). If you qualify for this exclusion, the amount of gain from the sale of your house that you can exclude is as follows:
- Single/Head of Household Filers: up to $250,000
- Married Filing Jointly filers: up to $500,000
Using these sale proceeds (and the money you saved in taxes due to the home sale tax exclusion) to invest in other assets with higher returns might be a better financial strategy than collecting modest rental income over time.
While selling is often the better financial decision, there are certain scenarios where keeping the property as a rental could be beneficial. For instance, if you continue to live in part of the home while renting out a portion, you could reduce or eliminate your housing expenses. Or, if your long-term goal is to pass the home down to your children, inheritance tax laws may allow them to inherit the property without incurring significant tax liabilities (although your heirs will eventually pay capital gains tax when they decide to sell). A third scenario where it might make sense is if your rental income would provide a substantial amount of income, after accounting for expenses for upkeep of the property.
As you can see, converting your home into a rental sounds great in theory, but might not be the best course of action for your situation. Thus, you should take the time to analyze the pros and cons for all the options. Make sure to consider the home sale tax exclusion rule, the opportunity cost of tying up your capital in a rental, and any legal implications. If your rental property has a strong profit margin, it may still be a viable option to convert it to a rental instead of selling…but is it the best option? That answer depends entirely on your unique financial situation. Before making a decision, consult with a financial advisor to determine the best course of action for your property.