|PERSONAL FINANCIAL PLANNING|
| hould 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 those from selling it immediately. 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. |
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 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 “ Tax Implications of Renting Your Home ” for a more detailed discussion of the factors CPAs must consider in helping their clients make those plans.
WORKING WITH THE SPREADSHEET
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 2 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 firstname.lastname@example.org and email@example.com , respectively.