Convert my primary residence to rental? How to analyze?

Question

New pro member here. We are under contract for our next primary residence - purchasing conventional and qualified with both new mtg pmt and current one. I have the cash for my new purchase 20% down plus some more in reserve. Originally, I was just going to sell my current home once we were all moved out and had a chance to finish a few repairs. But now I'm wondering if it makes sense to turn it into my first rental property or not. My original plan was to sell it and then start looking for a small multi family property to invest in.

How do I analyze the numbers with rental calc here since I already own the property and have an existing mortgage? I'm not sure what to put for purchase price and loan information. I have will have put in about a total of $15K in repairs and updates when complete.

Current numbers are:

PITI (fha loan so that includes pmi) $1038/mo

Loan balance $112K (30 yr ln - right at 23 years left on term)

ARV $158-160K

Expected rental income: $1700/mo

Expenses:

Vacancy:	$80.00	Repairs:	$80.00
CapEx:	$112.00	Garbage:	$20.00
		Management:	$144.00

Dave Foster · Answer

@Tim Heizer, the primary motivator behind your analysis has to be an opportunity cost evaluation. Which means you start with what you would net from a sale and has to include the taxable/tax free status of that money. Project your return using those net proceeds and then compare with a real time situation of rent with the associated expenses including mtg payment. Your comparison is what can I make if I sell vs what can I make holding.Fortunately time is on your side as far as taxability goes. If you've already lived in the house for 2 years prior to today then you could sell and the first $500K (the "we" means your married??) in gain is tax free. But the rule of sec 121 is that to get this exemption you must have lived in the house for 2 out of the last 5 years prior to sale. So you could actually move out fix up and rent out for an additional 3 years and still qualify as having lived in it for 2 out of the 5 prior to sale. The gain is still tax free and all you would have is depreciation recapture.This then becomes another calculation in the opportunity cost analysis. What cash flow, equity increase, appreciation, and tax benefit can you get over 36 months? if you go this route and happen to run past the 5 year look back so you no longer qualify for sec 121 you would still qualify for a 1031 tax deferred exchange. Not nearly as fun as tax free but still tax deferred.

Doug McLeod · Answer

I started out with my old house as my first rental, too. Since you don't have it as a rental now, you might think of it like you are "buying" a rental with the existing loan representing both your price and your financing (so you have 100% of purchase price financed and a 23 year note). Everything you paid in before was just your housing expense. Your repairs will be out of pocket and can be counted as either expenses or treated as capital expenditures adding to your basis (talk to CPA who knows rental real estate). You might think about a cash-out refi so you can drop the PMI, maybe lower your rate (might not be lower since investment property rates are higher than owner-occupant rates), and have some cash to offset some of the repairs. If you can find a local REIA (real estate investment association) you may find vendors who will do the repairs you need at better rates than you will get from "retail" contractors. Ask other investors for contractor referrals. Those that work with investors frequently will turn the repairs around quickly allowing you to get it rented sooner and minimize vacancy (your biggest expense when the property is actually vacant).If you want to capture all your capital gains now without tax and put that into a multifamily, that may also be a good option - but you can still get some favorable tax treatment later even if you go ahead and turn it into a rental - so long as you lived in it 2 of the last 5 years at the time you sell it.Hope it works out well for you!

Tim Heizer · Answer

Thank you everyone for chiming in! It's awesome to know i can bounce ideas and questions off all of you!

Tim Heizer · Answer

@Dave Foster Thanks Dave. That's a lot to digest. Some of the repairs and updates we (yes married!) have done were done with selling in mind. Would have probably done it differently if I had planned on renting from the beginning. I think I am going to stick with my original plan and sell. Then take those proceeds combined with my existing reserves and I will work to purchase a small multi-family where the numbers make clear sense. I'm still a newbie and am reading and studying this stuff as much as I can...but I AM going to purchase my first property this year!

Jessie Tetreault · Answer

If it were me, I would sell this property and take the tax free gain. Then take the money and leverage a multifamily with it. I think you would see a greater return on your money. I did a quick rundown of numbers with your property. This is how I run numbers and these might be slightly high but I mean I feel it can be challenging to really budget for repairs and vacancy because it's not a fixed expense so I would rather be safe than sorry. $1700.00 (Rent)-$1038.00 (PITI)-$170.00 (Vacancy) 10%-$170.00 (Property management) 10%-$170.00 (maintenance) 10%-$85.00 (cap ex) 5%-$20.00 (garbage)$47.00 (cash flow)I wouldn't say these numbers are set in stone at all and could definitely vary and maybe @Doug McLeod could give more feedback on these numbers. He definitely seems like he has more experience than me. I hope this helps.

Taylor Brugna · Answer

Tim Heizer Just going to give you a few things I would be thinking about: What did you pay for the property? One of the most valuable tax "breaks" is the section 121 exclusion, which allows you to exclude up to 250k of capital gain if you've lived in the property for 2 out of the past 5 years. If there is a gain, at some point in the near future I'd be looking to sell to take advantage of this. Analyzing the property can be done a variety of different ways, but for the "purchase price" I would definitely use the market value of the property. When the value increases, your return on equity is decreasing. Your original cost wouldn't really be a useful metric. Hope this helps

Dave Van Horn · Answer

Hi Tim, Smart move as I've done this same move 3 times over last 25yrs, as long as I cash flow a min. of $300-$400/mo. and the property is $150k or less it usually makes sense to keep it and you have more than that after your PITI. In this case you're not throwing away your closing cost money from your 1st purchase and because you're a few years into the loan more of your payment goes to principal and your future tenant will be paying off the rest of this mortgage for you. Also, repairs made after moving should be advantageous tax wise. Best of luck!! Dave