Paying off current Mortgage or invest in new rental?

Question

I currently live in what will become a rental property and vehicle for retirement. I am contemplating whether or not to buy another property that cash flows in a high priced market or payoff the mortgage of the property where I currently live in and want to rent out. I max out 401k, IRA, and HSA contributions. I carry no debt other than current mortgage on property I live.

Dave Foster · Answer

@Jedd Storoshenko, Is that property you're living in a top shelf rental waiting to happen?? If not you might be better served to sell that and take the profits tax free and transition to another property to use for investment. Doing that you get profit tax free, and you get to reset the depreciation clock and buy what might be a much better rental.

Dave Toelkes · Answer

First I would ask how close you are to retirement. If you are less than 10 years away from retirement, you may want to pay off the mortgage on your current primary residence. A free and clear primary residence in your retirement years won't strain your income in retirement should you decide to stay in your current home.

A second option, would be to sell your current residence, and buy the property where you will eventually live. Assuming that you are downsizing, you may be able to buy your replacement home free and clear and use whatever is left from your tax free sale profit to purchase a rental property. With interest rates only rising in the future, it may be a good idea to buy your future home and your future rental home now, especially if the resale market is still active for homes at your price point.

If you have more than ten years to retirement, and no plans to move or sell your current residence in the near future, then I suggest you pay off any home equity loan on your primary residence and then pay down your primary mortgage to the point where your home mortgage interest and home equity loan interest deductions are not affected by the new Tax Cuts and Jobs Act limitations for 2018-2025. If this is not an issue for you, than I would suggest you consider buying your future home now and put it in service as your rental property. Let your tenants pay the mortgage on your future primary residence now while you expense all the repair costs and take a depreciation expense for all the major improvements. At some future point in time, when you do retire and want to convert your rental to your primary residence, you have the option of converting your current primary to a rental and letting your new tenants pay off the rest of your mortgage balance, or, you can sell and use your tax-free profit to buy two or more (perhaps several) smaller investment properties.

For future tax planning purposes, note that the tax basis for your primary residence will become the lower of the current market value or your actual cost basis at the time you convert to a rental. If the current market value for your home is less than you paid for it, you won't be able to take a tax loss if you sell.

Before taking any action, sugggest you explore all your options with your financial planner, your tax advisor, your estate planner, and your lawyer.

Clayton Mobley · Answer

@Jedd Storoshenko I think you've gotten all the right advice from @Richard Sherman (promise I'm not BP stalking you today lol) and @Dave Foster , although the option to combine the Sec 121 exemption and the 1031 does still exist if you convert to a rental and sell within three years.

However, I think Dave's question about the condition of the prop is still the most important one here. You have rental numbers based on...what? Has it been a rental before, have you looked at comps? What would your expenses be and would you be self-managing or hiring a PM? Is this a brand new(ish) prop or would you need to put work in to rent it out for those numbers? Richard is spot on, most folks think their primaries would make great rentals because we love them, that's home, who wouldn't want to live there? But when you start looking at all the nitty-gritty details that are easy to overlook as a homeowner, but really turn tenants off, you start to see bills adding up. How old are your capex items (water heater, flooring, roof, appliances)? Do they need to be replaced or repaired, what about five years from now? Look at your property as you would if you were looking to move there for the first time, it may open your eyes.

Esp if you would need to put work into the prop to rent it at the top of the market, or if you have a lot of appreciation built up, I would strongly consider selling, taking the 121 exemption on that profit and then deploying it elsewhere. If your mortgage is still at $300k AND you have some equity/appreciation already built up, you could definitely be putting that capital to work elsewhere.

Just as an example based on numbers I know first hand, assuming you have just $100k in equity but are willing to maintain some amount of debt in future investments, You could take that $100k and put 20% down payments on 5 B/B+ cash flow props in Birmingham that rent for $995 on average. Gross income is just under $5k, running those figures through our ROI spreadsheet to account for expenses, you net over $1350 per month plus you have a more diversified portfolio that your tenants are paying for.

The point is that you appear to have a lot of capital (debt and equity) tied up in a single property, when you could get the same or better returns from a more diversified portfolio in other markets (Birmingham and others in the south and midwest). And those are turnkey numbers, so if you wanted to be more hands-on and DIY distressed props, you could potentially see higher returns.

Unless your property is really top of the line, tenant-ready, I think your best bet is to take the tax-free profit and deploy it elsewhere. If you're really attached to the idea of holding it as a rental and you think it will do well, convert it, rent it for 12-18 months and see how it goes. If it's a great money maker, awesome, hold it until you don't want to anymore and then 1031 into bigger/better/more doors. If it doesn't perform and you've rented it for more than 1 year but less than 3, you can still take the profit tax-free under Sec 121 and then use the 1031 exchange to move the rest of the value tax-free into other investments.

Of course, always always always talk to a CPA and/or Qualified Intermediary before pulling the trigger on either option. Dave Foster is a great resource for 1031 details.

Best of luck!

Jedd Storoshenko · Answer

@Anthony Wick In answering your questions. I can sleep at night with leveraged mortgages as long as the cash flow. 34 years old. My goals are to be retired ASAP with cash flow rental income of 100k per year.

My current property has a mortgage of 295k and is costing me 1k per month to live there. If fully rented without me living in it would cash flow 1k per month with leveraging the current mortgage. If property is paid off it’ll cash flow $3500. The idea of it paid off and turned to an LLC sounds appealing for limiting liability and take tax advantages into account.

Richard Sherman · Answer

@Jedd Storoshenko listen to @Dave Foster ! If the home you live in has a lot of capital appreciation (profit) then you will almost certainly want to sell and take that tax-free (up to $250k for a single, $500k married filing jointly) . IF it has been your primary residence any 2 of the last 5 years. You can NOT 1031 a primary residence...very few exceptions and they are so complex they make no sense to try on a SFH. If you convert it to a rental and rent it for more than 3 years then you lose that exemption and any capital gains are now taxed. Also, generally, our primary homes make less than ideal rentals. People tend to keep them due to inertia and emotional attachment.

Paying them off means best cash flow and lowest risk but least amount of leverage. Just depends on your situation as everyone else says.

Diana Muresan · Answer

Ok, now I get a better picture. To make you feel better, I’ve closed on lots of properties with higher taxes, in Chicago are we can have a $250k home with $13k in taxes. Now back to your scenario, couple of options I see here, you could refi cash out, 80% LTV is max allowed, so at $336k loan you will have about $40k to invest in your next multiunit. The rent roll you have is great, though if you plan on buying lots of real estate in the future, messing with renting septa’s bedrooms is not glam, the other option is to convert the SFR into a triplex as you mentioned there is a potential for 3 units, you can do a refi renovation loan and let’s say you need $200,000 for renovation, your new loan amount will be $495k, closing costs are much lower than a purchase and you don’t need to bring any cash to the closing.

Jedd Storoshenko · Answer

@Diana Muresan the mortgage is 295k on house that was appraised last sept for 420k. It is currently a mother daughter home with the potential for 3 different units or a house sharing rental (by the room). Taxes insurance and mortgage $2595 on a 20yr fixed. The apartment attached to the home is rented for $1700 and my significant other and I put in 1k each to cover all expenses (mortgage tax ins utilities maintenance etc) $3500 all said and done give or take a few dollars depending on seasons. I’ve had the house rented before at $950 per bedroom at 3 bedrooms plus the 1700 would rent roll $4550 minus $3500 in exp = $1050 cash flow

This is suburb NY where prices and property taxes are high. So when people say “buy a couple units” or “buy this unit for 70k cash” these examples are hard to come by where median house prices are 450k and property taxes 10k per year.

I may need to learn more and diversify to other markets.

This is suburb NY where prices and property taxes are high. So when people say “buy a couple units” or “buy this unit for 70k cash” these examples are hard to come by where median house prices are 450k and property taxes 10k per year.

I may need to learn more and diversify to other markets.

Diana Muresan · Answer

Few missing pieces to the puzzle, I need to know more info before I can give my opinion.

First, your current mortgage is $295K, what it the value of the house? You mentioned your mortgage payment is $1000, what about taxes and insurance, what is your total monthly payment? $1000 PITIA sounds low for a $295K balance. What is the forecasted rental income on your current property?

I agree with the comments above, an SFR used as owner occupied might not be the ideal investment rental property. If you are ready to expand you portfolio and based on how much you want to invest yourself in real estate, I suggest either selling or cash out and purchase more, I suggest you look into multi units, only because on conventional market, they only allow 10 financed properties and if you are looking to purchase cheap condos, in few years you will get to 10, you are better to get a multiunit instead every year or two based on your purchase power.

If you decide to sell and if your income is below your county median income, then you could get a multi unit on conventional market with only 5% down and purchase a second one as investment with 25% down. After a year you can go back and purchase another multi unit FHA with 3.5% down payment, you just need show it will be owner occupied

Eamonn McElroy · Answer

@Jedd Storoshenko

Quantitative Answer = What is the ROI of the second property you're looking to buy? We know the ROI of paying down your current property's mortgage (projected interest paid less tax benefit if applicable). Usually the ROI of paying of a mortgage is LOW -- it's like buying a treasury bond.

Qualitative Answer = What do you think will allow you to sleep better at night?

Paying off current Mortgage or invest in new rental?

Paying off current Mortgage or invest in new rental?

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