Captial Gains - Primary residence/rental property - Sell or Refi?

Question

BP Nation - As a rookie real estate investor, I'm seeking advice on our first investment property in the Nashville area that my wife and I previously called our primary residence (2017-Jan 2021), and began renting it at the start of 2021. We have up until end of 2023 where we could sell the home and not pay capital gains (we meet the IRS' ownership and use test having it been our main home at least two of the past five years). This house has given us great momentum that we want to keep going and some emotional attachment - so we're uncertain on the best approach with this property that is currently making 9% C/C and has continued to appreciate. SEE DETAILS BELOW. Bottom line -- torn on whether to sell the home to avoid capital gains costs, or keep it for a longer haul in a hot market and do some type of Refi to take cash out and put towards an additional property.
Deal Deep Dive >>
Purchased Home Price: $420K
Remaining Mortgage: $300K (3.85% APR)
Home Value today: $700K
Mortgage Payment (includes taxes + insurance): $2,200
Rental Income: $3,350

Scenario 1: Sell the home in the next 1-2 years to be able to exclude the capital gains from our income, and find another property to purchase with the proceeds
Scenario 2: Keep the home and Refi. What would this process look like? Would you recommend a Heloc or Cash out Refi?

Any help or thoughts are welcomed and appreciated.

Thank you in advance!

Evan Polaski · Answer

@Kallie Cornett, what is the age and condition of the major items in the house?  There are a lot more expenses that go into your cash flow than rent less PITI. Roofs, HVAC, exterior paint, decks, kitchen and bath remodels, etc.

I feel differently about markets than others.  If you don't have a clear path (read: renovations) to push that $700k up, my personal stance is it will still be worth $700k in a decade, maybe $750k, but I believe we are through the crazy appreciation.  I am selling most of my real estate and redeploying into real estate that has forced appreciation: flips, value-add syndications, etc.

But let's look at the numbers: assuming you don't have any large unforeseen issues (unlikely, but for arguments sake).  You keep the house, hire a manager, collect $3350/mo and pay $2200 in PITI.  Cash flow roughly $800/mo or 9600 per year.  Or you take $350k now (700 sale less mortgage and some closing costs).  You would have to rent the house for another 35 years to make that type of cash.  And in reality, in 35 years, you will have 1-2 more roofs, a few HVAC systems, a new kitchen and baths or two, repainting many times over, etc.

Taylor L. · Answer

I was recently making this decision for a primary and here are things I considered:

- Will it cash flow with a property manager? (looks like yours will)

- Since it will involve my time to some degree, what approximate &/hr do I expect to receive for my time? (the answer for me was unacceptably low)

- How many $ in capital gains taxes would I get to wipe out, vs how long would it take me to cash flow to make up the difference? Using round numbers, let's say there would be $50k in capital gains taxes and the property was cash flowing $250/mo. That's 200 months to make up the difference, over 16 years!!

I decided to sell and invest the equity in other properties.

Taylor L. · Answer

I'd say that's a decision only you can make, my friend!

Luka Milicevic · Answer

@Kallie Cornett

I was in this exact same situation in 2021.

I decided to sell. There's no way to pay no taxes, unless it's a primary. 1031 is cool, but it's a deferral.

In my case, and yours the property had appreciated so much that the tax bill would have been too high for me....

The primary I sold had appreciated 37% from Sept 2020-Aug 2021. While I believe Nashville is going to continue appreciating, I don't see another year like we just had.

My advice would be to sell and take the tax free gains, as that is what I did. This is just the advice of one person though...

Reid Chauvin · Answer

Hi @Kallie Cornett - an important thing to consider is how doing a cash-out refinance will affect your numbers. Because this is no longer your primary residence, you will be refinancing this house as an investment property. Your new rate will likely be a bit higher and, depending upon how much money you cash out, your principal balance will be a bit higher too. Both of these factors will bring your mortgage payment up.

As far as cash you will be eligible to take out, you can get a loan for up to 75% of the appraised value. If the home appraises for $700k, you can get a loan up to $525,000. That leaves about $225,000 after payoff of your current loan, and after the upfront costs and prepaid taxes/insurance associated with the transaction (ballpark of $10k), you could be looking at around $215,000 or so. Not bad!

Good luck with whatever you decide to do. I am more than happy to answer follow-up questions.

David Goodman · Answer

Hey Kallie -

My wife and I were/are in your shoes. My gut instinct is to tell you to hold onto the home. Nashville is set to continue appreciating over the next couple years. Rents will follow.

You're exactly right that owning that property has given you great momentum in a somewhat short time frame. If you sell the house, you're removing the reason you have this momentum. You have the ability to stretch out that momentum by doing a cash out refinance on the property. The cash out refinance is also not taxed and is just as green as cash from a sale, except you get to keep the appreciating asset! It seems like you have enough equity in that home that you could comfortably pull out enough cash for a downpayment on the next home all while keeping tons of equity in your original home and STILL being able to make a small cashflow on top of it. At that point you will have 2 properties in this market that will continue to cash flow, which means you have 2 properties that can continue to appreciate to give you more momentum!

I understand the concern about capital gains, but when you are ready to sell that home, will you not put at least some of those gains toward another/multiple other investment properties? If you do, capital gains won't be an issue because you can do a 1031 exchange into more properties!

Don't get me wrong, I'm a realtor, so I love to list and sell houses. And if you'd end up going that route, I'd certainly help with that! :P

But if you guys end up choosing to hold onto it, let's connect. I'll can get you hooked up with a lender that can do the cash refinance and finance your next home at the same time.

Kallie Cornett · Answer

One follow-up question:  In terms of calculating the number of years of rental income it would take to "make up" for what you'd get if you took the alternate route to sell now and avoid capital gains.... does it make sense to say, for example's sake, we sell after the 2-out-of-5-year period and profit $280,000 ($700k sale price minus $420k purchase price), and at a 20% capital gains tax rate, we'd pay roughly $56,000 in taxes on the profit. If we're netting after expenses (accounting for annual operating AND capital expenses) a monthly cash flow of $700 or $8,400 annually, it would take 6-7 years of rental income to neutralize the capital gains taxes? So instead of comparing to the total profit, you're comparing to just the total amount you owe to IRS for taxes. If this way of thinking makes any sense (?)... you have to rent for 6-7 years to even out the taxes paid when you go to sell (doesn't really account for increased rental rate over the years), but you'd STILL have the appreciation profit on the home, and you could have also taken a cash out refi on the home at some point if needed to put into other profit-producing investments (I do realize the refi impacts the overall model of course).  THANKS again for any input!

Captial Gains - Primary residence/rental property - Sell or Refi?

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