When a House is Not a Home
Play the video above to listen to Wendy tell her story.
Wendy’s problem can be summarized as follows:
- Wendy needs more income to cover her expenses now that her husband has passed.
- Wendy needs more income to cover her home’s constant upkeep.
- Wendy has a reverse mortgage with a growing debt balance as she keeps tapping into her home equity.
Her relatives offered her some solutions:
- Her daughter suggests she move out and live with her and her family.
- Her son suggests that he move in with her and pay her rent.
- Her brother suggests she sell the house, pay off the reverse mortgage, and use the balance of the sale of the house to buy a small condo for herself.
When Wendy came to see me, we analyzed these various solutions together so that she could make a reasoned decision about what to do.
OPTION 1: Rent out the house. Be careful what you ask for….
I told Wendy that I get this all the time from clients and especially from their heirs; the ones who stand to inherit the house. Renting on its face sounds like a no-brainer in providing income. This stems primarily from deep beliefs by all clients that real estate is God’s gift of wealth because of the increased value built up over time. Most heirs anxiously anticipate inheriting real estate as they feel it will automatically give them financial credibility.
Well, it can also provide for a lot of unnecessary headaches without getting any income. If a house is rented the tenant only pays for rent, they do not pay for any expenses. Wendy would still have to pay for maintenance, insurance, and property taxes. If the plumbing goes out, as it does with tenants since they have no pride of ownership, who is going to pay for the plumber? What about the Roof? The yard work? Damages due to dogs and other animals? A house has many parts that require maintenance.
The First Issue
The first issue of renting the house is crunching the numbers and building a budget. The most important issue is to be disciplined in reserving funds from the rental to pay for the maintenance, taxes, insurance, and unexpected costs. What about vacancies? There is no guarantee that whomever rents will end up staying a long time. This means having to clean and paint again and hiring an agent to rent the house one more time. And maybe again and again. The future of each tenant is not something Wendy can control. It is a variable which contains financial consequences that must be planned for, especially in this situation where Wendy is critically relying on the rental income for her own needs. Any appreciable period of time that passes with no income puts Wendy right back in the position she was in to begin with. Here Wendy is facing a risk that the expected income stream may not be constant or sufficient at any given point in time.
The Second Issue
The second issue is that the house is now deemed to be Income Property and is no longer considered by the IRS as a primary residence for which the tax laws give preferential tax treatment when sold. Instead, Wendy now has to file along with her yearly Form 1040 a Schedule “E” which details all the income and expenses of the house as it is being used to produce income. In other words it is now a “Capital Asset” under the IRS and must be depreciated along with the filing of the Schedule “E.”
With a primary residence an owner receives an exemption from capital gains tax when the property is sold. However, this exemption does not apply to income-producing property. The clock starts ticking now and Wendy must sell the house within 5 years to still be able to take her $250,000 exemption from capital gains tax. otherwise this exemption goes away. Wendy would have to move back into the house and live in it for at least two years as her primary residence before she could re-instate this important tax exemption.
If the house is sold after this 5 year period, there is a tax on the difference between the sale price and the cost basis. The cost basis is how much money has been put into the house from the time it was purchased, including the purchase price.
- A house bought 40 years ago for $75,000 required improvements over the years totaling $100k. The cost basis is $175k.
- The house sells for $800k net of all fees and expenses of sale. That means a gain of $625k. (800k minus 175k).
- If the house is a primary residence when selling, the IRS allows Wendy an exemption from gain in the sum of $250k.
- As income property, the capital gains tax to be paid would equal approximately 30% of $625k or about $180k.
- As a primary residence, the gain would equal $375k after deducting the exemption, and the tax would be around $90,000. A difference of $100k.
So I showed Wendy that this tax calculation alone, not counting the property taxes, insurance, and maintenance costs, actually reduced her net income from renting. In fact, that a difference of $100k that would be due in capital gains tax when the house is sold actually eats away at all or most of the rental income received in that same 5 year period.
Oh, and then there is something called “recapture of depreciation” which creates more tax liability now that the property is no longer an income property and has been sold. Here the risk is that of increased taxes when the house is sold after Wendy passes.
The Third Issue
A third issue for Wendy is that the insurance on the house now has to be changed from owner-occupied to income-producing-property. Typically, insurance companies charge higher rates for rental property because insurers know that renters are not as careful as owners. There is no pride of ownership.
Renting may also create a need to file multiple insurance claims if the tenant you pick ends up being a bad one and you evict and now have to fix the house to get a new tenant. Besides, how do you get a bad tenant out when they have small children? It might not be that easy. Attorney fees. Court costs.
Most people that become landlords cannot deal effectively with tenants. How will you be able to monitor the condition of the house? The longer the tenant is there the less likely you are to check on the house because that tenant keeps paying the rent on time, and so it is easy to become lax. Here the risk is of increased costs that could affect the expected income stream.
A fourth issue is not so much for Wendy but for her two children, and it falls into two sub-categories. First, assuming the rental goes well, what happens if Wendy needs long-term care at the cost of $4k–7k per month? The second is, what happens when Wendy passes?
Long-term care is expensive and would likely put Wendy back into a financial hole if the income is not enough to cover the costs of maintaining the house and provide enough to pay for Wendy’s care, especially if there are extended periods of vacancy, and periods when money is needed to spruce up the house for the next tenant.
When Wendy passes, the issue becomes what will her children do with the house? They will inherit, assuming a 50% share each. Will they continue to own the property together? Will brother and sister get along forever and ever, or will they have a falling out? Money in the way of relationships can be straining. How can the siblings guarantee amicability? Without that they will then suffer some unforeseen financial consequences themselves.
If her son wishes to live in the house now that he is part owner, can the sister prevent that? Or vice versa? Will he consistently pay the rent? What about ongoing expenses? Does Wendy wish to put her two children in a position where they might fight over money and over the house?
Let’s assume that one of them wishes to buy the other out. If agreed, the buyer will now have two different property tax calculations: one half maintains the same property tax base as the mother because it is an inheritance from parent to child. However, the purchase from a sibling has no property tax exemption, therefore the agreed-to sales price will now cause this half of the property to have a tax base assessed on that sale price. Given today’s property values in expensive urban neighborhoods, this increased property tax may be prohibitive. Furthermore, there may even be a capital gains tax that has to be paid by the sibling who sells, depending on the value of the sale price compared to the valuation of the property at the time Wendy passes.
In the end, the house may have to be sold by someone, at some time in the near future, even if Wendy is not the one who sells it.
OPTION 2: Have her son move in and pay rent
At face value this option would seem to solve a lot of problems. Namely, Wendy gets to stay in her home, rental income is produced, and there is now someone in the house keeping an eye and taking care of Wendy. What’s not to like?
In most cases it is the child who cannot support themselves adequately who offers this option as it makes it easier for them to live because their housing needs are too expensive while their own income flow is not that great. Imagine the possible scenarios:
- A brother or sister, along with their spouse and children now live with Mom.
- They are unmarried, with no job, but they are working on it.
- They are unmarried with a job, but recently got laid off.
- Any other mutation of the above.
Whichever scenario it is, for sure it is not that the responsible, self supporting child that is the one who moves in with Mom.
At some point, mom will either need to move out to assisted living, or pass away. If an heir (brother, sister) has been living in the house for some time, how easy is it to get them to move out so the house can be sold and everyone get their share? Besides, a mother is not likely to play hard ball with a child as a tenant if they fall on hard times financially. The mother may even help them out with money, rather than collecting money from them.
When Wendy dies, that live-in child now becomes a 50% owner. How could one partial owner now evict the other partial owner from the property? Checkmate!
Here, what started out as a means of getting income into Wendy’s estate to live on, now becomes a fight between siblings with attorney fees and possible court costs.
A major issue is one I see a lot. After awhile of living with mom, Wendy decides to put that child’s name on title to the house thinking the child will then do right by their sibling after she passes. If that happens, the property now belongs entirely to that child on title, and only their good heart stands between an equal division of the property to their sibling.
OPTION 3: Sell the House and Buy a Condo
Selling the house will most certainly create the liquidity that Wendy needs to live on. Buying a smaller property or a condo will take much of that liquidity away and create a different set of ongoing expenses. Some expenses are similar to the original ones, like property taxes, insurance and utilities. But HOA dues will now be required if a condo is purchased. More importantly, the same issue remains in all the scenarios of what happens when Wendy can no longer live in the house and needs to move to assisted living or nursing care. Much money will be needed for that expense.
Additionally, if this smaller house or condo now has to be sold, what if the real estate market is soft for such a property? Will Wendy have the number of years needed left in her life to ensure that the value of this property has an opportunity to go up? Or, will the value decline in the short-term, making it likely that Wendy will no longer able to live there?
I reminded Wendy of a question from earlier in our discussion: “If you think of the house as your only investment, rather than your home, does it make sense to take a large portion of the cash from the sale, and put it into another property that does not produce any income? How does this strategy help you make ends meet?” It usually does not, unless the home is worth millions and plenty is left over to invest after buying the condo. By investing the entire amount Wendy will get the most liquidity and produce the highest income stream she possibly can under any of the scenarios. There are no renters to worry about, no house expenses, and no property taxes.
The Best Option Chosen by Wendy
Wendy took some time to consider all the options. It took Wendy and I many hours going over each option as this was not done in one sitting. Each time Wendy would come back with clarifying questions. I understood she needed time to digest each and every scenario we discussed. There were also many phone calls in between meetings.
In the end, Wendy decided to sell the house.
The cash from the sale was invested in a moderate risk, income producing investment account that is fully liquid and can be closed out any time with no handcuffs. Wendy can withdraw as much as she needs any time she needs to. We set up a regular monthly withdrawal amount after building a budget for her based on her stated goals and how much rent she would be paying since she decided to not re-purchase any other property.
Wendy’s investment account is now producing a modest 3-5% rate of return which she uses to supplement her income. After crunching the numbers, we were able to show Wendy that a small portion of her investment could safely be invested for the long-term, since there was now enough other cash to sustain her lifetime.
This budget now affords her the ability to rent a brand new apartment in a vibrant, clean environment close to transportation. She does not worry about maintenance any more. She has cash to go on vacation and pay for presents for grandkids and she continues to live independently. Should she need to move out either voluntarily or involuntarily, her children and Wendy can feel comfortable without worrying about selling a property in a soft real estate market, or about capital gains taxes and property taxes, or even about unpredictable tenants. The income-starved estate has now been injected with enough liquidity to last the distance and beyond.