Oh, how I hate physical mail (don’t worry… I didn’t click bait you, the home sale exclusion stuff is coming!). I hate it so much I let it build until my office is drowning in a sea of white envelopes. For the most part, this approach is okay because I’ve automated all of our expenses, and if I do say so myself I’ve gotten pretty damn good at identifying important mail just by looking at the envelope. If I was a superhero I’m pretty sure this would be my superpower. That said, when you let it build as long as I do, one or two pieces of important mail still usually sneaks through. But it’s fun. It’s like an easter egg hunt. You never know what you’re going to find.
Today, I found a real gem. Stuck within all my mail was a letter from my mortgage provider that they were transferring my mortgage to another company. This certainly isn’t typical but I wasn’t surprised. I used a company called Guaranteed Rate to refinance my mortgage last year and they’re in the business of underwriting loans, not really in the business of loaning money. So what they do is offer a mortgage, generally at rates below what you’ll find at traditional banks, fund the loan, and then go out and use their size to sell a large block of their loans to the highest bidder. As a consumer, it’s a little annoying having providers changed up on you part way through the loan but it’s a small price to pay for the better rate.
Anyway, this letter reminded me of why I did the refinance and the inspiration for this post.
We bought our home back in 2014. At the time, my wife was pregnant with our first child and we apparently needed more space but we weren’t quite ready to make the trek out to the suburbs yet either. This made buying a home a little tricky. If we were planning on moving to the suburbs in 2020 or so, then that doesn’t give the property much time to build equity. For us to break even we would need to experience outsized appreciation. This seemed highly risky so I’ll admit that I had no desire to move. Mrs. Woodstock, on the other hand, was a bit more motivated.
And as it turns out, “needing more space” may have turned into the best financial decision of our lives. In the four years, we’ve lived in this home, it’s appreciated a little over 50% (based on the closest comp which is 800 sq feet smaller)!
But now we have a new problem!
Rent or Sell
Once the area began appreciating we decided to line up our finances so that we can afford a down payment on the next home without selling our current residence. Our logic was, we’ve locked in a low-cost and rents continue appreciating. This property could serve as an annuity and help offset our new mortgage. Our version of Linus’ house hacking strategy. To make the best decision we would have to run the numbers.
First was determining if the rent was appreciating at the same pace as the property value to cover the 1% rule of thumb for rent based on the property value. The mistake some people make is that they look at the purchase price of their home when they convert it into a rental property when the better number to look at would be the property value to account for opportunity cost.
Second was looking at the tax consequences of not selling. Long-term capital gains are taxed at either 15% or 20% depending on your marginal tax bracket. At 50% appreciation, we’re looking at a bill exceeding $60k! It is hard to account for that regardless of your preferred real estate valuation method and suddenly the numbers may not look as favorable as they otherwise would have.
Now for those of you paying attention, you’re probably wondering why the tax matters on the sale of a property if we’re looking at keep? The answer is Home Sale Exclusion.
What is the Home Sale Exclusion?
The Home Sale Exclusion is an IRS rule that allows you to exclude up to $250,000/single or $500,000/joint of the profit from the sale of a primary residence if you have owned and used the home as your primary residence for two of the last five years.
If I rent the property for more than 3 years then I forgo the opportunity to exclude the gains from the sale of my home from my income. By selling the property, I can not only pocket the gains tax-free, but I can reposition them into a new property with a higher basis. Based on the home sale exclusion and the possibility that rent cannot keep up with the 1% rule, the better choice will be to sell rather than hold on to it for a long-term investment.
Now that I know I am more likely to sell within the next five years, perhaps I can sweeten the pot by incorporating a refinance? Last year I was looking at refinancing options and decided to refinance into a variable term loan. I was locked in 30-year fixed at a rate of 4% and refinanced to a 5 year ARM at a rate of 3.375%. This has saved me over $300 a month and $4,000 annually. The 5 years is key because even if I move out today, I can still rent the property for the next three years and still qualify for the home sale exclusion! What this means is, the variability of the 5 years never comes into play. Given the ages of our children, our timeline to move into the suburbs, and the home sale exclusion rules, the variable part of the loan after 5 years is not going to be a factor.
By determining the value of the capital gains taxes today, I was able to see that selling made more sense than renting which allowed me to refinance and net another $4,000 annually or $20,000 in savings over the course of five years. What’s more, if rents and property values continue to increase, my capital gains savings do as well!
So the point I’m making here is…even if you have superpowers, always check your mail!