Maximizing Returns on Your Paid-Off House: Should You Rent or Sell?
Recently, the question has emerged on whether it’s better to rent out or sell a paid-off house. Assuming a 150k equity in your property, you can consider the capital gains and rental income as potential sources of return on investment (ROI). But how do these figures stack up against the costs of managing a rental property and the capital gains from a potential sale?
Contemplating Your ROI: Renting Versus Selling
From the outset, if you own a property with a pre-tax annual rental income of 15360, your return on capital (ROC) is about 10 percent. However, this figure does not include maintenance, insurance, and an agent to manage the property. Factoring in these costs, your ROC might drop to 6-8 percent, but considering capital growth of 3 percent per year, your total ROC can reach up to 14 percent.
On the other hand, if you sell your house for 400k, you might get 12k in capital gains annually. This can boost your ROC to 7-9 percent before taxes. Moreover, the depreciation of your property can also save you taxes, potentially allowing you to reinvest the savings without additional tax impacts. In this way, your overall ROI can be even higher than renting the property.
Calculating the ROI: Pros and Cons of Renting
While renting seems lucrative, let’s break down the numbers. You currently have 150k in equity in your property, generating around 15k per year, or about 1300 per month, which gives you a 10 percent ROC. However, there are additional expenses such as repairs, maintenance, and taxes.
In a year, you can expect to spend about 7.5k on these expenses and likely report a small loss of 2.5k to 7.5k for tax purposes. Assuming a combined tax rate of around 30 percent, you can save between 700 to 2500 in taxes. Thus, your net profit for the first year is 15k - 7.5k - 0.7k 8.2k, or a 5.5 percent ROC.
In the second year, with a 5% increase in rent, your net income can be 9.5k, while you might further reduce your mortgage principal, potentially owe little or no taxes, and even get a tax refund. Assuming no change in the property’s value, your return in year two is 10.5k on 151k, which is 6.9 percent.
Continuing this pattern over 10 years, the power of compound growth becomes evident. This doesn’t even factor in potential appreciation, the ability to borrow against your growing equity, or other tax advantages of owning real estate. Similar to the rental option, real estate often outperforms because of the leverage over long-term investing.
Should You Consider Selling Instead?
If you decide to sell your property, after selling costs you can expect to receive about 120k in proceeds. Subtracting the capital gains taxes and other fees, you might be left with about 100k. To match the returns from renting, you would need to find another investment that returns 5.5 percent after accounting for taxes and fees each year. This requirement poses a significant challenge, especially if you need to maintain a consistent 5.5 percent return year over year without any down years.
Apart from the capital gains, property appreciation can also increase your investment. For instance, if you bought a property today for 420k with 20% down and paid 6k in closing costs, your initial investment would be 90k. Assuming a 10% appreciation in three years, your investment would be worth 132k, a 46% gain. Considering a 3% inflation, it might take three years to appreciate another 10%. Therefore, if the property appreciated and you continue earning 8-12 percent in rent annually, you could see substantial returns. Over the next three years, you could see a 42% appreciation and roughly 30k in tax-free income for an overall return of 80% on a 90k investment, about 25% annualized.
Furthermore, if you need the liquidity, taking out a Home Equity Line of Credit (HELOC) against the home while it is still your primary residence might be a viable option. While this will slightly reduce your net profit due to the higher interest payments, it can improve your rate of return by reducing the amount of money tied up in the property.
Real Estate vs. Alternative Investments
While real estate investment might seem appealing, it’s important to remember that it’s not suitable for everyone. Managing a rental property can involve responsibilities such as dealing with difficult tenants, but these challenges can be managed. If you are considering an alternative investment that offers a 50% growth over three years while also paying 6-10% dividends, the potential for real estate still stands out.
In conclusion, shifting investments comes with costs, and taxes can significantly impact your capital when you move it around. If you’re not planning to go back to school or start a business, and maximizing your income is a priority, selling your home might be an option. However, few investments outperform real estate over the long term, especially with the benefits of capital gains, appreciation, and tax advantages.