A recent, true-life client situation is the inspiration for this month’s post. Dr. Tony* and his wife, Sam*, had just made a bid on their “forever” home in California. We had prepared a plan scenario to determine the amount of home they could reasonably afford given their long-term goals and projected income and savings. After some expected haggling, they emailed to tell me their bid had been accepted! They were finally going to move from their original starter home, which had almost doubled in value since they purchased it two years ago. But now they had a dilemma – should they keep their original home to rent or should they sell it?

This is a common dilemma, especially for physician families a year or two out of training. Once you have your student loans under control and you’re finally making a reasonable salary and you add a baby or two you realize you’ve outgrown your starter house and want more space and a better school district. Isn’t this the perfect time to become landlords and start some of that passive income rolling in? Maybe, but probably not and here are my reasons why:

1. I first asked Tony and Sam if they didn’t own this particular house and they were looking for rental property, if they would buy it again. The immediate answer was “no”. But by deciding not to sell it, that is exactly what they would be doing – deciding to own this house over any other rental properties they could choose. Just because the property is convenient (you already own it) does not make it the best choice for rental property.
2. We then talked about the emotional attachment. This was their first real home and their babies were born during their time there. Was there an element of emotion in their interest in keeping the house? Yes, they admitted, there was. Mixing emotion and money is like putting a flame to gasoline – it’s a combustible combination. You should never let your feelings affect a financial decision.
3. What about being landlords – did they really have the time and energy to devote to keeping the house livable, finding acceptable tenants, and evicting unacceptable tenants? Of course, they could hire a management agency, which would take 10% off the top, reducing the owner’s profits.
4. Another point in favor of selling was the exclusion available to them on the proceeds of the sale of their house. They would have only 3 years to sell and be able to totally exclude the gain (the property must have been your main home for 2 of the last 5 years in order to qualify for the exclusion). This means that, if they decided to turn their home into rental property, they would be looking at either a short-term investment (which I never recommend) or need to be able to make up for the foregone gain exclusion of approximately $350k when they eventually sold the property. That’s a huge mountain to overcome. Which leads to my last point…
5. Real estate investment success cannot be assumed. Any investment should be kept for a minimum of 5 years or you are, quite simply, gambling. And a single-family home is not only an extremely concentrated investment position, it is illiquid, meaning that you may have to wait months or years before being able to liquidate (or sell). This is not a position that I believe a young, upwardly mobile family needs to put themselves in.
6. The final consideration was the obvious one: liquidity. After selling expenses and paying off their mortgage, Tony and Sam can reasonably expect to net ~$325k. Having a large downpayment will qualify them for better mortgage terms, allow them to front-load their children’s 529’s, even invest in a well-thought-out piece of real estate if that particular itch still needs to be scratched. In other words, having the proceeds will afford them many more opportunities than they will have by keeping the house.

Of course, there is one more way that Tony and Sam could have kept the property and gotten away with paying no taxes on it – they could keep it until they die. Then, they could pass it along to their heirs tax-free. Given that they are in their mid-30’s, planning to keep a property for decades and make a reasonable return on it is iffy at best – and we have no guarantee that the IRS will continue to allow the stepped-up basis exclusion in 6 or 7 decades. That’s a long planning window, too long for most people’s comfort zone.

When can you justify turning your home into rental property? See this month’s Vlog with Michelle to learn when we might recommend this course of action.

Because everybody’s situation and goals are different, be sure to discuss your real estate plans with your personal financial professional before you make a major decision. If you don’t currently use a financial planner and you’d like to learn what is involved, you can schedule time for a free, no-obligation initial consult here.

*These are real clients but we’d never use their real names!