Monday, November 11, 2019

Inherited a House - Sell or Rent?

When you inherit a house from your parents, it is usually tax-free.  Should you keep it and rent it out, or sell it?   Turns out there are good arguments for both - assuming you don't go for option #3 and live in it.

Another neighbor has died, at the ripe old age of 98.  She was a sweet lady and left one son as an heir.  And of course, all the neighbors are on pins and needles, asking, "Is he going to sell the house or rent it out?"   Older people are nervous that if rented out, a family of rednecks or gypsies will move in, park cars on the lawn, have loud parties, steal and vandalize everything, and bring down property values.  And their fears are realized, on occasion - it has happened more than once - so they worry.

Of course, 95% of the time, if rented out, such homes are rented to old people like themselves, often for many years at a time.   But the other 5%, well that could include long-term gypsies, or worse yet, weekly rentals, where six families decide to "split the cost" of a vacation and have a hootin' hollar blow-out in the back yard.   And sadly, as a neighbor, you have no control over this.

But getting back to the main point, is it better to rent the place out or sell it?   And of course, it pays to address the third option - living in it.   On old people's island, the issue is often moot.  Heirs often live several States away, and have no interest in living here, as they are still working.   Keeping the house as a vacation getaway is a pricey proposition - As I noted before, it can cost well over $1000 a month just to cover taxes, insurance, and utilities - as well as maintenance and upkeep.

It is funny to me, but I have seen situations - in many parts of the country - where heirs will unload a house for half its retail value, just to be rid of it quickly.   And to some extent, this makes sense.  In a situation where there are a half-dozen heirs, the additional amount of income to be had by holding out for a higher price is marginal - and to get that higher price, you'd have to put some money into the house to fix it up.   The executor of the estate, still working, has no time for this, and no incentive to do other than the minimum.  So the house is unloaded and everyone moves on with life.

In other situations, some children move here and occupy their parents' former home, as they too, are near or at retirement age.   Sometimes this works out, other times, not.   It only works out if you wanted to live here in the first place.   If your dream retirement home was elsewhere, there is little point in moving here on the basis that the house is "free" as you can sell the house here and buy elsewhere, if that is where your heart takes you.

So, selling the house makes a lot of sense for many.   If someone came to you with a suitcase with nearly a half-million dollars in it - tax-free - you'd take it, right?   Yet, you'd be surprised how many heirs act like inheriting a half-million dollar home is a burden.   But if sold, that money is tax free and could be used for any purpose.  You could pay off the mortgage on your own home (a good idea, if you are approaching retirement yourself).  You could invest in stocks, bonds, mutual funds.  You could buy an annuity.  You could just leave it in the bank.  Or you could spend it all in an orgy of new cars and fancy vacations and designer clothes.

Oddly enough, a lot of people chose that last option, particularly if they are under 50 years old.  Retirement, to them, seems like a far-off thing, and besides, "I'll just work until I'm 70!" - right?  Lump-sum payouts like this can be very dangerous.

But what about renting the place out?   This has its upsides and downsides.   The biggest downside is that you are a landlord, and if you don't live here, a remote landlord.   I've been both, and both are stressful, but at least the former is more profitable.   If you are a remote landlord, you generally have to hire a local real estate agent to manage the place, and they take a pretty big cut - about 10% or more - and moreover, if repairs are needed to the house (and they will be needed, like clockwork) the real estate agent will hire a friend of his to do the repairs, and they will be expensive, or at least cost more than you would have paid hiring your own people or doing the work yourself.

Unless you can rent the place long-term to a friend or acquaintance, you'll need some boots-on-the-ground to manage the place.  And renting to friends can be problematic, as if they stop paying rent, they stop being friends in short order.  Friendship and business relationships don't go hand-in-hand.   It's like lending money to family members - another bad idea.

But what about the upsides?   Well, assuming you have other investments, maybe having some real estate in your portfolio might be a good way to diversify.    After all, the house represents nearly a half-million dollar asset, and who knows?  It may go up in value.   Real Estate, like stocks, can be profitable in two ways.  First, the value (stock price or sales price) can go up over time.  Second, the asset can produce income (dividends, rental income).   Real Estate has a third advantage - the depreciation deduction.

The depreciation deduction confuses people, because they think something is depreciating in value, when in fact, the house may be neutral or appreciating in value.  It is just a deduction, like any other.  So let's call it "Big D" and forget about depreciation.

The reason it exists is that if you own a rental property, your rental income may just barely cover the mortgage, insurance, taxes, and repairs.   You own a rental property and your net income is zero.  However, since your mortgage payment pays down the balance in part, every month, you owe less and less on the property over time.   This paid-down debt represents income to you, as your net worth is increasing every year, even if your cash-flow is neutral.

So, in theory, you could owe taxes on thousand of dollars in income, for a property that produces no real cash income to pay those taxes.  How unfair to greedy landlords!   The depreciation deduction basically allows you to take the value of the property (what you paid for it, or your "basis") and divide by a number of years (e.g., 10 - consult your accountant for current numbers, please!) and then deduct this from your overall income.

So in the case of this house, let's assume it is worth $500,000.   You depreciate it over ten years.  This gives you a tax deduction of $50,000 a year.   Say you are a young lawyer making $150,000 a year in ordinary income.   A property like this would cut your taxable income by 1/3 and your income tax bill by more than that as it would knock you into a lower bracket, or at the very least, knock off the highest rate part of your taxes.   Pretty sweet deal for young lawyers, and now you know why people got into investing in real estate in the 2000's - and why it all blew up.

Big-D has its downsides.   Your "basis" in the property is reduced by the amount of depreciation every year.  So, if you inherit a $500,000 house, your "basis" is the market value at the time you inherit, or $500,000.  If you sell the house right away, there are no tax consequences.   On the other hand, for each year you depreciate the property, your basis drops by fifty grand, and when you sell, you will have to pay capital gains tax - unless you roll over your "basis" to a new property in a Starker deferred exchange.

But of course, capital gains rates are usually lower than your marginal rate, particularly if you are in the higher brackets.   Say... this whole system seems to favor landlords, don't it?  Oh, right, they vote consistently and donate to political campaigns and you don't.  Or even if you do, you vote for the guy who promises to outlaw abortion and gay marriage, who is of course, sponsored by your landlord.

It gets even better, though.  Say you rent the place for a decade and the tenant moves out.  You decide to move in for a few years (consult your accountant for the latest numbers, again!).  You declare this as your "primary residence" and then after fixing it up (and the repair expenses before sale may be tax deductible, consult your accountant) and then you may be able to sell the property tax-free.

Wait, what?   You can inherit a property and pay no taxes on it, rent it out and make, say ten grand a year for ten years and take a $50,000 tax deduction and move back into it, live in it, and then sell it tax-free?

Well, that's about the gist of it.  Consult your accountant - there are limits on how much is tax-free in the sale of a primary residence ($500,000 as of the time of this writing).  And in some States, there are inheritance taxes, although they may not apply to spouses.  But the system is stacked in favor of property owners.  And as a property owner, I only feel this is right and just!

But these numbers also illustrate why buying a personal residence that costs millions of dollars is just plain stupid (again, looking at you, "Financial Kung Fu" with your dream of a $5M home).   Not only are the property taxes going to be murder, but if you sold the place, you will get taxed on any gain over $500,000.   A better approach, from a financial viewpoint, is to live in less house, and use that extra money (or credit) to buy investment properties which can generate income (rent) and appreciate in value - and provide that sweet "Big-D" deduction.  No, you can't depreciate your primary residence, sorry!   Expensive houses are just expenses.  Real financial experts don't promote the idea of wasting money that way.

But getting back to the house in question, the heir has decided to sell, and that is probably for the best.  He if wanted to invest in real estate, he could use the funds to buy a house closer to where he lives and rent that out - or use it for any number of uses.  Being a remote landlord is never a Swiss picnic.   And besides, to rent out the house, they would have to clean it up, paint it, maybe put in new carpets, and so on and so forth.   So that represents a cash investment that they may be reluctant to make.

Not only that, I suspect that we are at a peak of housing prices right about now.  I could be wrong about that - we have seen some people move here from "off-island" and pay a half-million for a house and plow another half-million into it.   Either they are fools with their money, have a ton of money and don't care, or they know something we don't.    As the housing stock on the island reaches a half-century old, many of the homes are in need of serious overhaul.  And it won't be long before someone just flattens one of these ranch homes and builds something more daring.

And to some extent, that is already happening.   A beach house, built years ago on two lots, is being torn down to make way for two fancy new million-dollar homes.  Sounds familiar, eh?   But that is the exception to the rule, and to some extent, recent storms (and resulting beach erosion) may be scaring off the million-dollar beach home types.   Besides, our water is brown and because of off-shore sand bars, we have no surf to speak of.

My personal thought is that prices will remain stable (let's hope!) in the next few years, as the economy slows down (and no, it won't keep growing forever and ever amen, despite what some Wall Street guru says - hey, he has no skin in the game, right?).   With housing prices more than double the national average, and off-island homes (often brand-new, with a swimming pool!) offered for half as much, the cost of homes here, to some extent, makes no sense at all.   But then again, I could be wrong about that.

Not only that, but rents on our island are out-of-whack compared to sales prices.  There are few houses for rent, long-term (but plenty of vacation rentals).   There are plenty of older folks who want to rent a home here, full time.  But they are not prepared to pay more than, say, $2000 a month, which would barely cover the P&I on such a house, if purchased with a 20% down payment, much less the taxes, insurance, and repairs.   As I noted time and time again, when it is cheaper to rent than it is to buy, odds are, houses are overpriced.   Then again, maybe rents are just skewed.

But in my thinking, selling the place is the best option, in this instance, as being a remote landlord doesn't make much sense.   Sell it and move on, and invest the money in something else, whether it is another piece of real estate or whatever.  Hanging on to such a house would be a maintenance and tenant nightmare, might not generate much income, and there likely won't be huge gains in values over the next few years.