I’m genuinely excited about this post. This post should apply to everyone who has enough time left in their life to move at least one more time.
If you haven’t purchased a home yet, but you will in the future, this is for you.
If you’re currently in the market to buy a home, this is for you.
If you’re a homeowner but not planning to move, this is for you.
If you’re a homeowner who’s still underwater from the crash, or who’ve put in more than your home is worth, this is for you.
If you’re a homeowner, and you are ready to move, this is for you.
If you’re on the verge of retirement, and you’re thinking of downsizing, this is for you.
Due to a regulation change in 2016, you and everyone else in ‘Merica, can forget about this traditional idea of selling the old home in order to buy the next one. This isn’t some magical secret where the government gives you a free home, nor is this some intense investment strategy; this is just something to think about as you do what you normally would do… move. There will be some maneuvering that needs to be done each time, but in my opinion, it’s worth it, and I can help you do it, of course! I’m going to try to address all of “you” I mentioned above as I explain this, hopefully you can empathize with the others as I do. Forewarning, this post, and all the points within, are based on the idea that owning more property is a good thing. So without further cliff-hangers, let’s talk about the following:
The Traditional Route
Details and benefits
The Traditional Route
Stick with me renters and “I don’t own a home yet” readers… this is your future, so it’s important to understand what lies ahead before you take your next step towards homeownership.
Most people who buy a home use a mortgage to fund the purchase. Unless you have a lot of cash ready to throw at a house— Read my post about Down Payments— you won’t have a choice on this. With a mortgage comes a lot of scrutiny, and rightfully so. Your lender will look into your debt to income ratios, monthly bills/income ratios, bank statements, credit checks, etc. They’ll do this once at the beginning and then again right before you close. Typically what YOU think you can afford is different from what the bank thinks; spoiler alert, it’s not as much as you think.
Due to the need for a mortgage, most people cannot “afford” to buy a second home without getting rid of the first, especially by the banks’ standards. Furthermore, when you buy a second home that isn’t your personal residence, it’s designated an “investment property” and you’ll be required to put down 20% because of it’s designation. Not only can it be difficult to come up with 20% down once, but even more so to do it twice. Many of you may have equity in the home from your last down payment and/or from the increase in market value, and would need to sell your current home in order to come up with an impressive down payment for the next one.
Because of these factors, people look past the opportunity to hold onto their existing home when looking to buy the next. In years past, the only way to afford a second home, without selling the first, was to rent it out for at least 1 year, sometimes 2 years, and claim the income on your taxes. This paper trail could be presented to a bank during the approval process to eliminate the current mortgage from the debt/expense equation… in addition, whatever income you made could be factored into what you can “afford” per the bank’s standards.
This was simply not practical for people—you’d need to move back in with Mom and Dad for at least 1 year, and/or rent another place for 1-2 years while you turn your first home into an investment property. Of course none of this matters if you can actually afford to hold two mortgages at once, yay for you… I guess?
It has always been possible, but not practical.
I hate talking about bank stuff, because it can get really… ummm… boring. Bear with me because it’s actually the key to this whole thing.
Conventional loans changed a regulation early in 2016. Instead of requiring 1-2 years of rental income like I described above, now, they only require the lease. The lease needs to be for 1 year minimum and the security deposit and first month’s rent need to be deposited. With the lease, they will count the income and discount the payments/debt. Boom. Some of you are already seeing the value in this. There are some details that need to be considered though.
God forbid you have to live with Mom and Dad
The Deets and Benefits
Leasing your property will likely cost you a month’s rent in commission, and potentially some property management costs per month/year if you don’t want to play the part of landlord; no worries though, none of those expenses will go against you. Shameless plug… you’ll likely need an agent to help you with the terms of the lease and the timing of your purchase since it’s going to be contingent on you finding your next house; you don’t want to have a signed lease without a way out, and no place to live… God forbid you have to live with Mom and Dad (seems so terrible doesn’t it? There could be worse, but still). It doesn’t really matter what you do first if it’s all contingent on itself; you can get the lease signed then find a home to buy, or you could get a home under contract, then find a tenant. Having an agent will help you manage this process, and help your stress levels too 🙂
Admittedly the income piece is not as great as it seems initially. The bank will consider a vacancy factor on the new rental property you just created, formally known as your ‘primary residence.’ The vacancy factor is 25%… which is a little high, but per usual, the banks are better safe than sorry. Only 75% of the gross rental income you’re receiving from the lease is counted–both toward negating your mortgage and towards your income numbers. This is sort of frustrating, but a small price to pay. Take 25% of the total rent (not the income), then subtract your monthly payment from the remainder. Sometimes there’s a couple additional pieces to the equation, but here’s an example:
Monthly Payment: $2000/mo
Rental Price: $2400/mo
2400 x 0.75 = 1800
1800 – 2000 = -200/mo
Okay, so I used this example to prove a point. On paper, according to your lender approving you for a mortgage on your next home, you will not be making money on your current home, so you can’t count on an increase in income; however, you can count on a decrease in liability. Instead of having to hold both the old mortgage and the new mortgage, you only have to hold $200/mo of the old mortgage. Within your monthly allotment of what you can afford, the bank will factor $200 from the old house into that number. If you are able to afford $2500/mo on the new home, then you need to find a home with a payment of 2300/mo or less, because there’s an additional $200/mo that will be factored into that equation by the bank. Hopefully you won’t experience 3 months of vacancy like the bank anticipated, and you’ll make some money on your home as planned.
Let’s talk taxes. Still with me!? I know it’s confusing at first. There are positives and one potentially big negative in regards to taxes. The positives are the deductions from a now investment property. Disclaimer: I’m not a tax consultant, so be sure to seek out professional tax advice. You should be able to deduct costs of repairs and maintenance, along with any improvements you make to your new investment property (your old home). You can also deduct the mortgage interest and the property taxes for both the old home, and the new home. If, in the above scenario, you DO end up collecting $2400/mo for all 12 months of the year and you need to “claim” it as income, usually the deductions will outweigh the rent (at least in IL they will).
The one potentially big negative is the loss of potential income made on the value of the old home. This will only affect you if you have a large amount of true equity in your home. If you were to sell your primary residence instead of renting it, there would be NO capital gains or any income tax up to $500,000 profit for married couples, $250,000 for non-married. However! In order to qualify for this tax exemption, you must have lived in the home for 2 years within the 5 years leading up to the sale. So if you decide to lease the home like we’ve been talking about, you could live in the new home for up to 3 years and still sell the old one without having to pay income/capital gains tax on the profit. You also cannot take advantage of this tax exemption more than once every 2 years. If you have a lot of true equity in your home, it might be a good idea to sell it after you buy the next one… at least after a couple of years. Feel free to contact me to talk more about this, because it can get a little tricky.
***Side note: I say “true equity” to mean the increase in value of the home less the expenses. For example, if you bought a home for $100,000 and put $20,000 down, the bank would tell you that you have 20% equity in your home. But you bought and paid for that equity, which is not true equity. If the home is now worth $110,000, then you have $10,000 in true equity, make sense? Same goes for the improvements you make on your home. If you spent $50,000 on a kitchen remodel, and your home’s value went up $50,000… you did not gain any true equity, bought and paid for equity helps with Loan To Value (LTV) but doesn’t truly make you money.
You only have to put down 5% on the next home
Another great thing about this scenario is the down payment, or lack thereof. If you did this the traditional way… i.e. buy your primary residence first, then buy an investment property second… you’d need 20% down; AND you’d need to prove you can hold 2 mortgages, even if you are planning to rent the investment property. With the new way, you buy the residence first, but then turn it into the investment property later, and buy a new residence while the old is rented to someone else. The bank needs the lease to prove your mortgage will be covered, and you only have to put down 5% on the next home—which is just like it would be if it was your first home (with a conventional loan).
This whole idea is a long-term benefit. If you try to do this every 2 years, the lender may not approve you, especially if there’s not a good reason. Your lender may even put you under a microscope after you do this once. But as long as it “makes sense” per say, you’ll be able to turn every home in which you’ve lived into a rental property. If this ever becomes obvious that you are simply investing in real estate, then you’ll be treated as such. However, think of the reasons you’d move… these reasons are justification enough (in most cases) to rent out your current home and buy another. Some good reasons to move are:
- Engaged, married, pregnant/kids, mother-in-law moving in, etc.
- Job change, closer to work, specific region, change in major clients, etc.
- Desired school district, school population, school specific strengths (i.e. sports, band, etc.) etc.
- No more kids, avoiding upkeep, desire an HOA, etc.
- Any proximity-type reasoning—Being closer to lake, City, Country, a place of interest, family, etc.
We’re discussing what to do with the old house when you change your residence; instead of selling it, lease it. The bank/lender ultimately has control of whether or not you’ll be approved for the second mortgage, but they are looking to be sure it makes sense, and that someone isn’t taking advantage of the rules they have in place. The above list is not an official list of any kind, and it does NOT guarantee your lender will approve you. However, they are examples of legitimate reasons that a person may change their residence, which would be hard for a lender to argue against so long as they’re true. Will you be able to do this 10 times? Probably not, but it’s possible… it is all up to the lender.
All this being said, let me conclude by running you through what “you” should do, IMO, considering the reasons for moving that “make sense” so you can hang on to as much real estate as possible over your lifetime of moving. And as a reminder to all, look into the requirements for the tax exemptions when selling a home.
If you’re a person who hasn’t purchased a home yet:
Consider a smaller home, condo, townhouse (keep in mind HOA fees for townhouses and condos). Consider less sought-after school districts. You’ll save money due to size and less-desired schools—in most cases those places will have good rental population, making it easier for you to lease it, and buy the next one. Put as little down as possible—leverage. When you buy the second home, you’ll have the legitimate reasons of “bigger home” and “school.” Also, read my post You can probably buy a home, and you didn’t even know it!
If you’re a homeowner and haven’t really thought about moving:
Consider finding a similar home that’s cheaper or about the same. Maybe there’s some things in your home you’re putting up with or settled on, but don’t bother you that much. Know that it’s possible to rent your current home, and then buy the home that has all of those things you want. You can be picky this time, because you don’t “have” to move. You may have moved into the “ready to move” category, so be sure read below as well.
If you’re a homeowner who’s still underwater from the crash, or who’ve put in more than your home is worth:
You probably knew that you could rent your home and cover your mortgage, but you probably didn’t know that you could buy another home. If you’re underwater, then hang on to the property until you can sell it without it being a short sale. If you’ve over invested on your home with updates and you want to make some of your money back, then you can rent your beautiful home (hopefully it’s beautiful if you “over” invested) and buy another that has that couple extra things you’re looking for. Save up 5%… call me… and we’ll get you outta there.
If you’re a homeowner, and you are ready to move:
If you have a lot of money tied up in the home; save some money, so you have at least 5% for the down payment on the next one. If you think you’re pretty safe on what you owe, and with the margin between you’re monthly payment and what you’ll be getting for rent, then you might be able to take out an equity line of credit on the current home. If you’re income will support that, and you can cover most of or all of the monthly payment with the new renter, then you can use the equity line for the down payment on the next one. Oh, and contact me so I can help with this. 😉
If you’re on the verge of retirement, and you’re thinking of downsizing:
I know it’s hard to get rid of your current home and think about moving in general. It can be especially hard if you have lived there for many many years, all of the memories come flying back. This plan would be a way for you to hold on to your beloved home. Whether you rent it to family or strangers, you’ll still own it, and it can be passed down to your family for generations. See the above scenarios, because you are in the same boat, but for different reasons.
I don’t think this is for everyone…again, this assumes that owning more real estate is a good thing. You may not believe in real estate wealth or you may be skeptical about having multiple properties. I would bet that most people like the idea of an income generating property, but find it difficult to acquire them and/or wrap their head around being a landlord. This idea lightens the upfront cost, and makes it a little easier to establish your real estate portfolio and generate a long-term retirement plan or family wealth plan. The landlord-ing is something you can’t avoid, but property management can alleviate some of the headache.
Thank you for reading. What kind of reservations do you have? Comments and questions are welcomed!