Selling - Should You Rent Your Home or Sell It?

Six months ago, David Miller, a 39-year-old hotel office manager from Washington, D.C., was laid off. Now, after unsuccessfully searching for a new position in Washington, he's decided to relocate to Florida. He found a new position in Florida with a major hotel and is excited about the more affordable standard of living and - let's face it - better weather.

But he's struggling with one decision: Should he sell the two-family colonial home or rent it out?

"I don't know which is better money-wise," he says. "Is it better to put the house on the market and take the profit and run? What if I want to come back? I won't have a home. I've heard of people who sell their home when they move, then come back and can't even afford an apartment."

In Miller's case, the stakes are high: The home he purchased just four years ago for $247,000 is now worth an estimated $456,000. Selling now will bring sizeable gains, but may price him out of the market if he returns in a year or two.

Miller's situation isn't unique. Nearly 5,500 Americans change homes every day, according to the U.S. Census Bureau. And these days, many are willing to move to find better jobs. Americans are becoming more flexible. Almost half of U.S. job seekers are willing to relocate for employment, according to a survey by the career web site Monster.com.

It is usually necessary to sell one's home in order to afford a new home. Most people do so when relocating. However, some people choose to rent out their homes instead especially if they plan to return. In some cases, people know that they'll be back in a year or two - possibly when they complete a graduate degree or finish a specific project at work. There are also times when a would-be seller wants to hang on until the market picks up in order to sell at a price deemed acceptable. A more likely scenario lately, however, is that the owner wants to maximize his or her gains and is inclined to hang on while property values continue to soar. Others, like Miller, don't feel confident in changing jobs and want to keep their old home until they're certain they won't be coming back.

Whatever the reason, there are important financial issues at play when weighing this decision and it's helpful to have a clear idea what issues come into play. Below are a few things to consider:

It's a taxing issue

As you probably know, if you have lived in your home for a least two of the past five years you qualify for a generous tax break from Uncle Sam. The unmarried can earn up to $250,000 in tax-free gains while married couples who file jointly can enjoy up to $500,000 in capital gains tax-free.

Here's the good news: Those who plan to rent out their home for a year or two will still qualify for these breaks (provided they've lived in their home for at least two of the past five years). Be careful though, should a person sell more than three years later, they will forfeit the tax exemption, meaning their gain would be taxed as a capital gain. Once you move out of you home, the clock starts ticking on these two out of five years.

Thus, for those whose renting plans would turn a tax-free gain into a taxable one, consider selling. The guideline is, if you have a large gain on your personal residence, you don't want to rent it out and risk losing your tax-free gain. That's a very bad idea.

Don't take a house that you're not going to have to pay tax on and convert it into rental property if you know you'll never live in the home again. It's like taking money and throwing it in the fireplace. One solution to this problem: Move back into the house and live there for two years before you sell, you'll requalify for the exemption.

The tax benefits of renting

On the other side of the fence, becoming a landlord also offers some attractive tax perks. While rental income is taxed as ordinary income, the numerous deductions on expenses and depreciation could easily be eliminate your tax bill. But there is always a catch. If you eventually sell the house and qualify for the capital-gains tax exemption discussed earlier, you'll be taxed on the amount you depreciate. This little exemption could make renting out your home considerably less attractive.

Let's talk about deducting expenses first. Nearly every out-of-pocket expense relation to owning and managing the property can be deducted. For example, you can deduct your mortgage interest payment and property taxes just like you deduct them on your primary residence. You can also deduct any advertising or broker fees, cost of repairs to the property, utilities and management company fees, maintenance expenses such as cleaning services, the cost of fire and liability insurance, and even travel or transportation expenses incurred for the maintenance of the property and collection of rent.

Then factor in the "phantom deduction," better known as depreciation. To find your depreciation, divide the fair market value of the property at the time you start renting it out (minus any land around the property) by its recovery period - which is 27.5 years for residential rental property. Voila! You now have your annual depreciation. For example, if the home is worth $300,000, you divide that by 27.5 and get a $10,909 annual deduction. Deducting depreciation will cover a lot of the income you're receiving from renting your home, so it's a nice tax shelter. If you have another $15,000 in out-of-pocket expenses, which are also deductible, you can get over $25,000 in rent tax-free.

While you cannot deduct improvements, you will recover their cost by depreciation. You may also want to look into deducting the depreciation on the cost of any appliances, carpeting, furniture or plumbing. You can do this over five years. So if you purchased a new $1,000 refrigerator for your rental, you can deduct $200 a year from your rental income for five years.