Should we sell? Keeping renting it out? First-time landlords

Question

Hi Biggerpockets! First time poster, recent podcast subscriber here.

I write this post as my wife and I have been trying to figure out the appropriate course of action to do with a property she bought back in 2013 as a primary residence (in the Central Valley, CA area). She bought a home at a great value (estate sale from the original owner that hadn't done all that much improvement to the home since it was built back in the 70's), and it's appreciated well in the past 5 years as the economy has improved. At that point my wife was my girlfriend; we fixed up the home over the next year or so (replaced the older carpet/vinyl floors with hardwood/tile/laminate, painted all the interior walls, added improved lighting/trim, etc.). It's a 4 bedroom, 2.5 bath home, about 2100 sq. ft purchased for $237.500. We rented out few of the bedrooms to a couple friends of our that were working with my wife at the time. Life was great!

Fast forward a few years, and our careers take us to the SF bay area (east bay, to be specific). We ended up buying a second home in 2016 (and got married shortly thereafter), and were fortunate enough fund-wise to be able to do purchase our second home without selling the home in the central valley. We have rented out the previous property, with tenants (4 local schoolteachers) that have been great over the past few years, with calls to come and fix things few and far between.

One of the tenants is looking to move out this summer, and the lease that the tenants are under effectively goes to a month-to-month on 8/1/2018. We're planning on keeping remaining 3 tenants on a month-to-month lease from that point forward, until we come to the right financial decision as to what to do next.

We're now getting close to a crossroads with what to do with the property; we can increase rents year over year to get better cashflow (we're about $300 under market value right now), or we can sell the property if we find a home to can cashflow better (and potentially still have some cash in hand from the sale that can be used for other real estate deals).

If we sell, we're aware of the capital gains exemption available on primary residences, where it states that the home must have been occupied as a primary residence for at least two of the previous 5 years. I believe we still qualify for this, although we'd ask a tax accountant for details on this. The tax savings may be great for this home, as it's valued at least 50% higher ($360k) than the price my wife purchased the home at in 2013.

I hope this is clear, we're just looking for some advice as to the right "next step" for a couple looking to potentially grow our real estate portfolio if we find the right opportunity.

Thoughts? Questions? Comments?

Thank you for any advice you're willing to share with us newbies :)

Bjorn Ahlblad · Answer

To me it is in this order: Does it have a good positive cash flow? Will it be taxable income at top rate if I sell? Can I move it into a 1031x so that in the future I can sell and replace within the same 1031x. When I sold rental property in Ca I was able to buy quite a bit more rental property in Wa all in my 1031x with no tax ramifications. Go over your options with your accountant and make sure you understand the rules before you do anything. Take notes; the devil is in the details.

Zachary L. · Answer

Thanks for all the information, everybody. After talking it over with my wife, we decided that, given the rental is in a great location and very low maintenance, we've decided to keep the house and increase rent to get better cash flow. The existing tenants were able to find a replacement tenant, such that the increase in rent isn't all that harsh on everybody. We're also looking at refinancing the mortgage on this property to decrease the monthly payment, adding to the principal that we can pay ahead on the loan every month.

It's good to have all this input and see that either decision is a good one, we really appreciate all the input.

Jim K. · Answer

It's wonderful to be able to make decisions between only good and better alternatives. Wish I had more of that in my life.

I think the core qualification here is how committed you are to real estate investing as a lifestyle. If this is a one-property decision, don't trade the devil you know for tbe one you don't. If, however, you plan to get into this, by all means, sell at the best possible time after a discussion with your CPA.

Tom Bertz · Answer

Make sure you talk with your cpa.  Pay attention to the depreciation recapture rules.  If everything was reported properly on your (or wife's) tax return the original home was allocated between personal and rental.   Therefore it is possible that the personal residence exlcusion will only apply to the personal residence portion of the initial home.

Assuming you had someone prepare your taxes in the past they should be able to estimate since they have all the details.

Dave Foster · Answer

@Zachary L., I'm always a fan of tax free first and having the option to redeploy funds where and when I want - even though I also live in the world to tax deferred and 1031.  Your ability to not have to carry forward a low basis is huge for future strategic moves.

Don't forget that it is possible to combine sec 121 and 1031 so that all tax including the depreciation taken can be either tax free or deferred.

Jeff Zimmerman · Answer

Hey @Zachary L.  Great questions, I know a number of people that have come to similar crossroads as well.  I think it really depends on your goals for your real estate portfolio.  It sounds like your property is cash flowing really well so it may be best to ask yourself:  if I did sell it and did a tax-deferred exchange, could I get an average cash flow, over the next 5 years or so, that was greater than I'm getting now?  Will my percentage of returns go up as well?  If not, you probably have your answer.  If you can get greater cash flow by exchanging than it may be worth the trouble of selling and exchanging.

What would you want to exchange into and where would you want to buy?

Rachel H. · Answer

@Zachary L. It depends on your comfort level. Buying in a new market will mean it will take time to learn it. Do you need the cash from the sale right away? If not, you may want to start learning your new market to see what the values are rents are compared to the home you currently rent out. Compare the expenses and cash flow. Good luck!!

Marc Winter · Answer

Interesting situation you have here.  Keeping and renting with a positive cf, or selling, whether with a 1031 or straight sale leaves out an option I think you might be overlooking:  cash out refi of the rental or heloc.

Why 'kill' the 'golden goose', when you could possibly keep taking the eggs and perhaps leverage it up to another property or other cash-flowing investment.

Since your post sounds like you are in growth stage, how much do you think your existing rental will be worth in 5 or 10 years down the road?  How much of the current mortgage will be paid down?  How much stress/time is it taking for you to manage it?

Teachers, nurses and grad students often refer other qualified friends in the same fields to become new tenants.

If everything is running according to plan (an you are keeping your contingency/replacement funds growing to deal with the occasional emergency) I'd suggest you think long and hard before selling or trading this known entity for the next unknown one.

Good luck.

Jo-Ann Lapin · Answer

The Central Valley has always been a softer market. Sounds to me that you are playing your cards correct. Get some calification  from a cpa on your exemption as this is key.

Should we sell? Keeping renting it out? First-time landlords

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