Live in second home or first home?

Question

Long-time listener, first-time, um, writer. I've searched all over the place, and I'm having a hard time finding whether it's generally better to purchase a second home as an investment property, or move into the second home, and rent out the primary residence. I just refinanced into a 15-year fixed conventional (40ish% equity right now), so I have to live in my current home for at least 2 years, which is fine, because I'll need that time to save up the down payment either way, and I have a hunch the market in my area will dip by then. I would be fine with moving into something much smaller (4000 SF is just too much for one girl and some dogs), but would also be fine with just staying put and buying something small to rent out. Is one method more tax-advantaged than the other? Does anyone have any general advice that I wouldn't have considered? I'm squeamish about using a HELOC or anything like that, and wouldn't be comfortable with the purchase unless I thought I could handle both mortgages with no tenants if need be, so I wouldn't want to put less than 20% down either way.

Katie Hendrixson · Answer

Thank you Dave and Stephen! I completely hadn't considered the 121 exemption. That definitely seems like something to pay close attention to when I'm in a position to start liquidating in 20 or 30 years.

Dave Foster · Answer

@Katie Hendrixson, In general really broad terms primary residences converted to rentals do not perform as well.    One off customization and improvements, the general demographics of the home buying public vs the renting public and desired characteristics and size that are purchased when the option is available all contribute to this.  Confirm by looking at the rents/dollar value of property for an entry level rental property vs the rent on a high end property.  I can rent a $1 mil property on the beach for $3K/month easy.  For a $300K property I'd be hard pressed to get $2000.  But I can buy three $100K properties and get 1100 for each.  It's a function of affordability and available market in a range.

The other bigger consideration is that if you buy a second property as an investment you do nothing to dilute or jeopardize your primary residence exclusion.  And that's a big deal.  Converting a primary to a rental for a couple of years still qualifies you but once you pass the three year mark you lose the 121 exemption.

Less disruption to the family??

I'm rapidly moving to conversion to the rent to live - buy to invest crowd!!

Katie Hendrixson · Answer

Thank you for your reply, Christopher!

I suppose that's why I couldn't find the generic answer online. With anticipated CapExs, I'd probably about break even on my current home until the mortgage is paid off, which would honestly be fine with me. If the only real generic difference is the extra half% or so an investment property mortgage would cost, it probably makes sense to plan to downsize and move. (It's big, but definitely not nice. But then what can you ask for for $45 a SF?)

Looks like I have a lot to learn, thanks again for your insight!

Christopher Brainard · Answer

Hi @Katie Hendrixson and Welcome to BP

Without any hard numbers, its difficult to really tell you which is better, because it all comes down to cash on cash return. Figure out how much your primary residence could rent for and see if it cash flows and what your cash on cash return is. Once you know the return on your current house, pick some potential targets for investments and run the numbers on those properties. See what the cash on cash return is there. This should tell you numerically what makes more sense investment wise........

With that said, in most cases, all that really matters is that you live in the house that makes you happy and that you can sleep well at night. If your current house is too much for you to handle or you have no need for it, downsizing may be the right choice. Larger, nicer homes often do not make sense to rent out because the rent to value ratios are lower than that of smaller properties. It may also make sense to sell and use your equity to purchase rentals instead. It all really comes down to what you want to do and how to make the most effective use of your capital/equity.

-Christopher