Should I sell it or rent it out? How will you respond when your clients ask you that question when they’re moving out of a home? CPAs can provide a valuable service by helping clients think through this issue in a structured way. To help, we’ve created an Excel spreadsheet that compares the net present value of the cash flows from renting a house with that from selling it immediately. (Click here to download.) It is important to understand that there are qualitative as well as quantitative considerations to the decision. The spreadsheet will be most helpful in dealing with the quantitative factors, while the following section addresses a number of the qualitative factors.
The decision of whether to sell or rent a home is complex. The spreadsheet will enable CPAs to help homeowners make a more informed choice, but several of the variables that affect the rent-or-sell decision are not quantitative and thus cannot be incorporated in the decision model in the spreadsheet. CPAs should discuss them with their clients in addition to reviewing the spreadsheet results. Some of these nonfinancial factors are:
Adequate funds . Can your client afford two homes? The homeowner may be able to refinance or borrow against the equity of the old home for the purchase of the new one. Generally, there will be periods during which the rental is vacant, thus generating no income. CPAs should make sure their clients have sufficient funds to cover both homes for several months.
Rental market . Investigate the local supply and demand for rental housing. There must be sufficient demand for rental properties in your client’s area. Determine the rents charged for similar residences. Real estate agents, rental management companies, local newspaper classifieds and inquiry of local renters offer this information. Research zoning restrictions to prevent unpleasant surprises.
Problem tenants . A vacant rental is better than a bad tenant—but neither is desirable. It can take months to evict someone. In the meantime, tenants can cause severe damage to the property. Check local laws regarding eviction and deadbeat tenants. Advise clients to consult an attorney about how to handle deadbeat tenants before renting. Run a credit check on the applicants and call previous landlords and other references. CPAs should prepare their clients for the possibility of bad tenants and the associated difficulties. An estimate of post-rental repairs can be factored into the spreadsheet’s outcome.
Managing the property . If the client is busy or lives more than an hour away from the rental property, it may be best to pay a professional manager to collect the rents and arrange repairs. Managers usually charge 8% to 10% of the rental income. Discuss the advantages and costs of a rental management company with your clients. If they would like to have the property managed, you can enter a percentage into the variables section of the spreadsheet.
Taxes . Current tax law gives homeowners a great deal of flexibility when dealing with a former residence. If the taxpayer has lived in the home as a primary residence for any two of the previous five years, any gain on the sale of the house is excluded from taxation up to $500,000 for married taxpayers filing a joint return and $250,000 for single taxpayers. And so, with careful planning, your client can avoid taxation on the sale of a former residence, even after converting it into an income-producing property. See “T ax Implications of Renting Your Home,” below, for a more detailed discussion of the factors the CPA must consider in helping the client make those plans.
WORKING WITH THE SPREADSHEET
The spreadsheet provides a structure for obtaining the information needed to help CPAs formulate a recommendation to the client. You can download the spreadsheet by clicking here. The lead worksheet of the spreadsheet contains a section into which CPAs must enter a number of variables marked in red. The black numbers are intermediate calculations used in the recommendation (click here to see exhibit 1). A separate section of the lead worksheet is the outcome section that will show which alternative provides the greater net present value of the calculated cash flows (click here to see exhibit 2).
Begin by obtaining some basic information about the client’s former residence, such as its cost, portion of the cost allocated to the land, the size of the down payment that was made, the mortgage rate, how many years the client is into that mortgage and how many years the client envisions renting the property (Decision horizon – Years). This basic information can be entered into the spreadsheet in the appropriate cells.
Another important set of variables is the status of the local residential housing sales and rental markets. Your experience may be sufficient to answer these questions, or you may need to consult with a real estate professional in the area. Are houses in the local market selling at fair value or at some discounted amount (market depression factor)? At what percentage of fair value are houses currently being rented?
CPAs also will have to provide some guidance in the determination of the return-on-alternate-investment variable used to compare the returns the client can expect from renting vs. selling. Take into consideration the client’s investment position and risk-return preferences. For a simple solution, assume the proceeds will be used to reduce the mortgage on the new home and use the interest rate on the new mortgage for this variable.
When all the variables are filled in, the spreadsheet will show which alternative provides the greater net present value of the cash flows. In addition to providing a recommendation, CPAs can perform some sensitivity analysis by modifying some of the softer assumptions to see the effect on the recommendation.
PHILIP R. WITMER, CPA, PhD, and CLAUDIA L. KELLEY, CPA, PhD, are associate professors at the Walker College of Business at Appalachian State University in Boone, North Carolina. Their e-mail addresses are email@example.com and firstname.lastname@example.org , respectively.
Tax Implications of Renting Your Home
IRC section 121 has increased homeowners’ flexibility tremendously. Owners can rent their prior residences for up to three years of the past five years and still take advantage of the $500,000 ($250,000 single) exclusion of gain on the sale of a personal residence as long as the home was their personal residence for two of those five years. In this context, owners can move back into a former home and make it once again their principal residence. After two years as a principal residence, the property qualifies for the exclusion for the gain on a sale. It should be noted, however, that any portion of the gain attributable to depreciation taken while the home was rented is taxed at a rate of 25% under section 121(d)(6) and section 1(b)(7). Any gain not covered by the exclusion may be eligible for the reduced long-term capital gain rate of 15% (5% for taxpayers in the 10% and 15% brackets). The American Jobs Creation Act of 2004 provides that the exclusion for gain on the sale of a principal residence does not apply if the residence was acquired in a like-kind exchange in which any gain was not recognized within the previous five years. A detailed discussion of the tax issues is beyond the scope of this article. For more information see “The Home Sale Exclusion” in the JofA (Oct.02, page 85).
Unrealized gain on a rental home also may be deferred by exchanging the property for other like-kind property under section 1031. Any gain on the sale of a rental home in excess of the amount of depreciation deductions taken is eligible for capital gain treatment. Losses on the sale of a rental home are deductible whereas a loss from the sale of a personal residence is not deductible.
Mention to your clients that rental homes are subject to the tax law’s passive loss rules. Thus, a rental loss may not be deductible against their nonpassive income. Fortunately, there is an exception from the passive loss limitations for taxpayers with adjusted gross income less than $150,000. Section 469(i) allows someone who actively participates in the rental of real estate to deduct up to $25,000 of net passive losses from rental real estate. Active participation requires that the owner make management decisions such as approving tenants, repairs and establishing the rent charge.