Turning Your Home into a Rental Property

We're going to talk a little bit about mortgages, particularly when you want to turn the place you're living in into a rental. Now, this happens to lots of people. It happens to lots of people who buy a house during residency, because I can't talk you guys out of buying a house in residency. And it doesn't help the last five years when housing just went through the roof. So even those of you who bought a house for a year and a half sometimes are coming out financially ahead, even though historically you come out ahead only about a third of the time after a three year residency and about half the time after a five year residency. But in the last five, six, seven years, everybody's come out ahead. Nobody's had the experience I had with the house I bought in 2006 and couldn't sell when I got out of the military in 2010 until 2015, at which point I sold it at a loss. Now, what happens sometimes if you can't sell the place or just because you think it might be a good idea, is people think about turning that first place they bought, they lived in for a while into a rental property. They start thinking, oh, I want to build a rental property empire. And that's fine if that's what you want to do, if that's one of the ways in which you're going to build wealth. I'm a big fan of real estate. I like real estate. I like direct real estate. I don't want to do it myself, I'm too busy doing wci. But I don't think it's a bad way to build wealth. You need to be deliberate about it and you need to be smart about it. And you got to put in a little bit of work to do it. But it certainly can work out very well. But what you need to ask yourself is, do I want to do that? Because if you don't want to have direct real estate investments in your portfolio, then no, you shouldn't keep the place you've been living in the last few years as a rental property. You should sell it and move on. Whether you're selling it with no gain, with a significant gain, with a loss, hopefully you've got cash to be able to sell at a loss and move on. Okay, so that's question number one is, do you actually want to have direct real estate investments? Okay, question number two is assuming yes, you do, do you want this to be your first one? Would you buy this place as an investment? If you were looking at all the places in your city, is this the one you want? There's a good chance it's not right. Because when we buy a place to live in, we use different eyes. And when we buy a place to rent out, we're looking at the location and how close it is to our job and where we want our kids to go to school and whether we like the colors or not and whether it's got a place to store our rock climbing gear or whatever. I don't know. You just don't think like that when you're buying a rental property. It's all about the numbers. It's like, well, what's it cost? What's it going to rent for? How much do I have to put into it? Are people moving to this area? Am I likely to be able to raise rents? And it's the numbers game, right? You're running numbers on the place. You don't could really care less, you know, if it's like the most beautiful interior paint job ever, you know, the paint isn't that nice. Well, you rent it for a little less than if you fix it up and put some new paint in there. And you can paint it whatever color you want and so on and so forth. So that's the question is, are you going to buy this place? Is this the place you want? And the answer to that's yes. Great. Rent it out. Right? Perfect. Getting started. If it's not, I want you to ask yourself a couple of additional questions. And the main one is, does that change if you don't have to pay closing costs on this place? Because this is the benefit of renting out the place you already own. There's no closing costs. You already own it. So that might be as much as, you know, 5% to buy a new place. You know, it's usually 10% or so of its value to sell a place, especially once you pay off realtors. And so there's some additional profit there if you can turn a place you already own into a rental. The other thing is you might get to keep the mortgage. Okay? And a lot of people right now especially have mortgages that are 2.5%, 3.5%, right? You go out to get a new mortgage, now it's 6.5%, 7.5%, whatever. You're not getting a 3% mortgage. So people are like, well, this could work out really well for me, it's appreciated. While I've been here, I don't have to pay closing costs and I've got this 3.5% mortgage. Maybe I should keep it As a rental. Well, again, do you want to be in the business of renting houses? If the answer is no, that is not enough to change your mind. Right. But that might take you from going, I'd rather have a different property to let's use this property. So what do you do about the mortgage? Well, the first thing you do is you go back and read your contract that you have with the mortgage company. It might have a requirement that you tell them if it is no longer owner occupied, if it's become a rental. You might have to tell them and you might have to, you know, pay off the mortgage or refinance it or whatever. But read that carefully. They may not require that or they may be okay with you, you know, putting in a renter. A lot of people operate on the don't ask, don't tell policy. Right. They're like, and they probably won't find out. Well, they might, then you might be in a little bit of trouble. But the truth is, I think people do this a lot. Even though their contract says they're supposed to, they don't tell anybody when it's no longer owner occupied. Some of the contracts also say it only has to be owner occupied for a year and then it's whatever. And so it might work out fine for you to keep that same mortgage on it. You know, you bought some physician mortgage with nothing down on it for three and a half percent four years ago. You, you might be able to keep that for the next 26 years while you use it as a rental property. So you just got to read the contract and see what it says on that. Now, if it turns out you're supposed to refinance it and it doesn't make sense as a rental property if you refinance it and you want to do the right thing according to your contract, well, I guess you're going to have to sell the property. The alternative, of course, is to break the contract. You told them you were going to tell them and you don't tell them. Well, okay, well, what's the penalty? It may not be much of a penalty. You might be surprised how level the penalty is, and you might be willing to take that if that's the case. I mean, the bottom line is lenders are most interested in lending to people who pay them back as agreed. And so long as you do that, there's a good chance they won't be asking a lot of questions about it. Hope that's helpful. As you decide what to do with a house that you're thinking about renting out after living in it. One other thing to keep in mind about it, of course, is the property tax or not the property tax. The capital gains tax exclusion on owner operated homes. Now, if you've lived in the house for at least two of the last five years, when you sell it, you can exclude up to a quarter million dollars of gains. If you're married, it's twice that. So if you live in it for three or four or five years as a resident, now you're renting it out. Well, how long can you rent it out for before you lose that? You can rent it out for three years and then you've got to sell it if you want to take advantage of that exclusion. Otherwise, when you sell it, you don't get any exclusion. Right? Even though you lived in 13 years ago, the IRS doesn't care. You're going to pay capital gains on the whole value. And of course anything you depreciated on it is going to be recaptured as well. Now you can avoid that by exchanging the property instead of selling it, but that's a whole other level of hassle that it adds in hope that's helpful to you.

The hosts of the White Coat Investor are not licensed accountants, attorneys or financial advisors. This podcast is for your entertainment and information only. It should not be considered professional or personalized financial advice. You should consult the appropriate professional for specific advice relating to your situation.