Your Home - Sell it, Rent it, or Keep it?
Up to the 1980s, home values were reasonably priced and were not generally considered financial investments – they were a place to live. However, from March 1984 to March 2024, the average home price in California increased by 664%¹. Combine the built-up equity and fewer individuals receiving employer pensions and relying on social security, and more people facing retirement are considering how to efficiently access the equity of their homes to help achieve financial goals.
¹Freddie Mac House Price Index
The largest component of many people’s net worth is the value of their homes. However, the accumulated equity in home values does not directly translate into increased income. A person’s net worth may appear substantial compared to other parts of the country because of higher property values, but unless the equity is converted into liquid assets, no significant cash flow is generated to fund retirement expenses.
Why Are You Moving?
There are various reasons why people want or need to move from their existing homes: Some of the more common are:
a) Downsizing
Moving to a smaller home from a two-story or larger home may be more manageable for you. Health and medical concerns can play a significant role in this decision.
b) Move to a Retirement Community
Living in a retirement community enables older adults to connect and socialize with individuals at a similar life stage.
c) Moving Closer to Family
Ironically, appreciating home values in various parts of California has left younger generations with limited choices but to move out of the area to more affordable locations. Now that you are retired, you desire to live closer to children and grandchildren.
Here are some available opportunities regarding your residence. Other strategies may be available, such as 1031 exchanges (See Publication 444) and transfers to trusts, but I will address the basic choices of selling, renting, or keeping your residence throughout retirement.
Option: Selling
Things to Consider:
Capital Gain Exclusion. If you have lived in your home as a personal residence for at least two out of the past five years, you may be eligible to exclude $250,000 of capital gains ($500,000 for couples) on the sale of your home. (See Publication
Possible Large After-Tax Cash Sum. Selling your home can provide a sizable sum of cash after deducting various expenses, including selling costs, debt, and income taxes. Of course, you must live somewhere and cost of new home may leave little cash, but if you have qualified retirement accounts (IRA’s) which tax withdrawals as ordinary income, tax management can play a key role in your retirement since withdrawals from taxable accounts can be taxed at lower capital gain rates or not taxed at all (loss positions or capital gain exclusion for incomes below certain levels).
Diversify Assets. Selling your home can help reduce your overall financial risk by transferring a portion of your home sale proceeds to diversified investments, such as stocks, bonds, cash instruments, real estate investment trusts, commodities, annuities, etc.
Option: Renting
There are no immediate tax consequences on the decision to convert to a rental. Net rental income is taxed as ordinary income. Net rental income is the gross rent minus deductions associated with the rental, such as taxes, insurance, interest, property management, landscaping, etc. Renting your residence can provide monthly income during retirement, a depreciation deduction for tax purposes, tax write-offs for income and expenses losses (passive loss rules), and a possible “Step-Up” from adjusted cost to fair market value at the time of the owner’s death (or first spouse to pass).
Stream of Income
Rental income during retirement can be a steady source of income to help fund your expenses and goals. The current average rent in the Tri-Valley area for an average-size single-family home is approximately $4,000 to $4,500 per month ($48K to $54K per year). The average home value in the area is roughly $1.4 million. The pre-tax return is between 3% and 4% ($48K/$1.4m) before deductions are made for ordinary rental expenses, property management fees, interest payments on a loan, and taxes. Of course, no mortgage on the rental would maximize the net income, but even low mortgage payments can still create positive cash flow from the rental.
Depreciation Deductions:
A tax deduction (no cash outlay, though) is allowed for the depreciation of your home when it is used as a rental property. The basis of depreciation will be the lower of the home’s adjusted cost basis (cost plus improvements) or the residence's fair market value at the time of conversion.
Step-Up Basis:
If you live in a community property state (California), the step-up of cost to the fair market value at the time of death is available for individuals and couples (first spouse’s death). Depending on the equity build-up at the owner's death, this feature can save your beneficiaries hundreds of thousands of dollars in taxes.
Things to Consider:
Lack of Diversification. Renting in one geographical area in a single type of property (residential) increases the overall risk of owning real estate.
Risk of no tenants: There is always the risk that tenants cannot pay for unforeseen reasons or the rental remains vacant for long periods.
Landlord responsibilities. Being a landlord can add many additional duties to your plate during retirement. You can hire property managers to assist you, but this incurs an additional expense.
Property Management. If you decide to rent your former residence and plan to move out of the area or are not physically able to manage the property, you may need to hire a property manager at an additional cost. Property managers can:
* Advertise and market your properties
* Fill vacancies
* Screening tenants
*Dealing with evictions and bad tenants
Regulation. Many states, including California, have laws regarding tenant and landlord rights. Some laws restrict rental income increases, so you must familiarize yourself with local laws before deciding to convert to a rental.
Option: Keep it
Of course, many retirees would like to stay in their homes for their lifetimes and receive the necessary medical attention when needed. The benefits of keeping your residence include:
Step-Up Basis. A way to save possibly hundreds of thousands of dollars.
The federal tax code contains a special provision that real and personal property receive a “step-up” in basis. This can be a significant factor in your decision to sell or rent. A step-up in basis resets the cost basis of an inherited asset from its purchase (or prior inheritance) price to the asset's higher market value on the date of the owner's death. Since California is a community property state, the death of one spouse will cause the whole property to receive a step-up instead of just half of the property (as in non-community property states).
Transfer of Property Tax Basis to Children. Allows transfers of a family home or family farm between parents and their children (and possibly grandchildren) without causing a change in ownership for property tax purposes. See the Prop 19 Fact Sheet (issued by the California State Board of Equalization).
Tax-deductible improvements for Medical Purposes. Home improvements can be deductible as a medical expense if their main purpose is medical care for you, your spouse, or your dependents.
Borrowing is an Option. If large amounts of cash are needed for any purpose, it should be possible to issue a mortgage or a reverse mortgage. Many things to consider include the cost of the loan, fees, payments, collateral, etc.
A thorough financial plan will explore several options regarding your financial goals, including various scenarios involving your residence. Please review our website for more information on our planning and investment management services. If you have a question or want to schedule a no-charge consultation, please call us at (925) 484-1671 or email us at your earliest convenience.
