On the list of things I hope to someday own, a rental property may just be last. My parents owned rental properties near a college campus in the early 2000s and through the global financial crisis. I still have nightmares from the maintenance calls that the world’s least handy son was tasked with handling. I’m sure my nightmares pale in comparison to my parents’. Okay, there, my biases have been stated.
This is the question I get all the time: Should I sell my rental property? More specifically, I’m retired or retiring. I don’t want to be a landlord. What should I do with this rental property? In most markets post-covid, price appreciation in the real estate market has pushed off that decision. Recently, things have started going the other way. Here’s the back-of-the-envelope math we would use if we had 15 minutes and no technology to answer this question:
1. Figure out the cap rate
Cap rate is essentially the real estate version of yield: income divided by property value. Where things get tricky is figuring out what the income is in this calculation. If you charge $5,000 per month for rent, you don’t get $5,000 per month. You have to factor in property taxes, insurance, maintenance and possibly HOAs and property managers. This assumes there is no mortgage, which is what we will assume for this column.
You take that net income value and divide it by the current market value. This is your cap rate. In high-cost markets or with safer investments, cap rates are lower. In low-cost markets, or for higher-risk properties, they are higher. You are banking on more capital appreciation if you have a lower cap rate.
I live in the DC metro area, and it is common for me to look at a Schedule E, where income and expenses are reported, and see a very large chunk of the income eaten up by property taxes and maintenance.
2. Determine what’s acceptable for you
As mentioned earlier, we rely heavily on technology to make these decisions. For any property on the balance sheet, we can select a year from the drop-down to sell it, and the success meter will go up or down. The numbers never tell the whole story, but they definitely help.
If you don’t want to build out the plan, a 5% cap rate is typically the benchmark I use. There are always going to be exceptions to rules of thumb, but numbers much north or south of 5% tend to be red flags for me. If you are far below 5%, you are essentially making a bet that the property will appreciate significantly. If the stock market has historically averaged returns of around 10% over long periods and you are comparing residential real estate with a cap rate of 5%, you would need 5% annual appreciation on top of that to match those returns. If you have a cap rate of 8%, you need only about 2% to match the returns. This addresses returns but not risk-adjusted returns, which makes the comparison imperfect but useful.
3. Determine how it will impact the rest of your plan
Yesterday I was talking to a friend who derives a large chunk of his monthly income from rental properties. There was a legislative change in Philadelphia that meant that he was losing about 40% of his rental income. He will be okay, but there is a downstream impact. He will either have to make more money elsewhere or sell those properties.
For many of our clients, these are homes they have owned for 40 years, and selling them won’t make or break their financial situation. But it will have a significant impact on their life and on their taxes.
Let’s start with the impact on the person’s life. We have the advantage that we know these people better than technology does (for now, at least). A slight reduction in a success rate that comes from selling a property may mean two different things for two different clients. For Mary, whose kids live all over the world and who has a long list of hobbies, she’d gladly take that reduction for the freedom it will give her. For Sarah, who is a tinkerer and who has always been interested in real estate, she’d rather keep it. We have more clients in the first category.
Tax impacts tend to be negative if you sell, but that’s not a good enough reason, alone, to hold onto the property. The tax computation on a rental property sale is complex, and the tax owed is never less than you expect it to be, mostly due to depreciation recapture. That big deduction you got to take for almost 30 years gets recaptured (taxed) upon sale, in addition to gains on the property. I would recommend you have a CPA or enrolled agent (EA) give you an estimate before you make any big decisions.
If you’ve read this far, odds are you don’t love being a landlord. Think of the decision as getting out of a long-term relationship you’re not happy in. The catch is that it’s not as simple as breaking up via text. Selling a property is a big decision, often with many commas. I’d run the numbers and make sure that even if you know you’ll be happier post-breakup, you’ll still be okay financially.
This article is provided for informational and educational purposes only and should not be construed as investment, tax, or legal advice, or as a recommendation regarding any particular strategy. Whether a Roth conversion is appropriate depends on an individual’s financial circumstances, tax situation, investment objectives, and applicable law. Tax laws are subject to change and their application may vary. Examples discussed are hypothetical and are intended solely to illustrate general planning concepts. They do not reflect the experience of any specific client or guarantee future results. Consult your financial, tax, and legal advisors before implementing any strategy.