Today’s question comes from Steve and Steve is basically asking, should I stay, or should I go? And for those of you old enough, like I am you’ll remember that was a song by The Clash. Anyway, it was an interesting band, but, Steve writes in and he says, Marco, we have spoken a few times on the phone and I have sincerely appreciated your time. The genius-ness that I feel when listening to the podcast was ever-present during our conversation and I appreciate the fact that you are sincerely trying to help others achieve some of the success you have enjoyed.
Thank you, Steve.
I have a question that I have been struggling with for some time and hoping for a little friendly advice. Here’s the situation, my family and I live in a nice neighborhood on what is referred to as the North shore of Chicago. Our home is average for the neighborhood and has a market value of around $400,000. When we purchased eight years ago, we put down 20% and have been aggressively paying off the house after refinancing to a 15-year loan back in 2017 for three and a quarter percent. Our current loan balance is around $245,000. We would like to move whether in or out of state in the near future, I have been contemplating refinancing my mortgage to a new 15 year because the rate has dropped over 75 basis points. Then turning it into a rental and moving elsewhere. My conundrum is this number one. Should I even consider turning this home into a rental? When the taxes remember we’re in Illinois are around $12,000 a year for a 2200 square foot home. Ouch. And number two, if I were to go the rental route, should I wait to do a cash-out refinance after getting renters in place to recapitalize the estimated $120,000 into other rental properties.
Any light or wisdom you can shed would be greatly appreciated. You’re your loyal listener – Steve
Well, Steve, first of all, thank you for being a loyal listener. And thank you for your question. It is a good question. So the real question here is, should you turn your primary residence into a rental? Well, I have to make one assumption before I can answer your two questions here, and that is whether or not you have the down payment for the next purchase, which will be your principal residence. So I’m just going to assume for the moment that you do have the down payment for another property, giving you the option to keep your current home, the principal residence as a rental or potentially being a rental. So that’s really the big question. First and foremost, do you have a down payment for another home regardless of where it is? And then the question becomes, is it worth keeping this home as a rental, you have over $120,000 of equity in this property. What do you do with it?
All right. So as is true for every single episode, I am not an attorney or a CPA, and I cannot give you specific financial or legal advice consult with qualified professionals. And all I can give you is just my thoughts and opinions. And by no means, is this giving you specific advice or direction, but I will share my feedback. So I guess the first thing I’m going to say regarding your second question is if you’re planning to refinance this property, the tenant or future tenant does not need to be in the property for you to do a refinance. It really doesn’t matter. However, if you do refinance this property and you are living in the property and therefore it is your first home, your principal residence, you will get the best rate and terms on a mortgage refinance because you are claiming it as your principal residence. And those have the most favorable terms and the lowest rates. So regardless of what you plan to do, and regardless of what your intentions are, emphasis on the word intention, if you are living there and it is your principal residence, then you will not be lying on a loan application and you will get the best rates. After you move out you can claim it as a second home, as long as you live far enough away, because the lender is going to ask you where your principal and second home are located. And if they happen to be down the street from each other, no boy, no, that’s not gonna work. Uh, but if you live in another state, well, then you could easily make the argument that this is a second home and you’ll still qualify for some of the most favorable terms and rates out there. But if you are claiming it as a rental property, you’ll still get a great loan, whether it’s a refinance or a new loan, whatever it may be, but it won’t be as good as a principal residence. So just keep that in mind, there are slight differences between principal residence, second home, and investment property, or what they call NOO, Non-Owner-Occupied loans.
All right, with that out of the way, this is really we’re going to come down to the numbers. I assume that you’re not emotionally attached to this property. You’re looking at the numbers clearly. Yes, $12,000 a year in property taxes is very high. I mean, I thought it was pretty high where I live here in Southern California and it is high. It’s just, we have this interesting thing called proposition 13, where the property taxes are artificially capped at about 1% of the purchase price from the day you buy it. And it can go up every year incrementally by a tiny amount. So on average, it works out to be about 1.25% of the purchase price, which is an artificial property tax. Anyway, that’s a conversation for another day. The point here is that you have to look at the numbers. So if you run the numbers on this property, now, I don’t know your address, but I just went to Zillow and I did a search for your area. And I picked a property that was roughly in the same price range. And here’s what I’m determining from what I see. If you’ve got a $400,000 property, you’re probably going to be able to rent it out for about no more than $3,000 a month. I’m looking at this and I’m seeing about $2,500. Let’s be optimistic, let’s say your $400,000 property rents for $3,000 a month. When you look at this from an RV ratio, a rent to value ratio, it’s 0.75%. So it’s less than that. 1%, that ideal number, it’s not mandatory, but it’s just a nice target. And you’ve got a 0.75% RV ratio. So right off the bat, I can tell you that this is not going to be great on paper, and it may be in a great area and you’ll have great tenants and it’ll be stable. You’re not going to have the most favorable returns. So with that, you are essentially looking at a flat cash flow and I did some quick numbers. And I basically made this estimate. If you have a $400,000 property, your monthly mortgage payment is going to be somewhere around 2000, maybe just a little over $2,000 a month. So let’s call it 2000. Again, we’re being generous here. Your property taxes are a thousand dollars a month. You already told me that your home insurance is probably going to be a hundred to $150 a month. So right there, you can see that without adding anything else, maintenance and repairs or any HOA fees, if you have them or utilities, if you plan to cover something there you’re already negative. So you have a negative cash flow.
So that doesn’t make sense from a financial perspective. So why would you want a small negative cash flow? The only reason you would consider that is if you know, and know with a high degree of confidence, that the property values in this area, for whatever reasons that are driving those things fundamentally or economically, you have a high degree of confidence that the property value is going to continue to increase. So what you’re not making in cash flow, you would hope and should be making in price or appreciation gains. And I’m not saying that because you should be a speculator and investing for capital gains reasons. You don’t want to do that unless there’s a compelling reason to do that. Ideally, you want both worlds. You want price growth through appreciation, and you want cash flow. When you have both of those, it makes for a great investment and a solid return because you’re looking at the whole picture. Every facet of it, not just one thing like cashflow only, but my guess is that you’re going to have a negative cash flow. And then you’re probably not going to have much in terms of appreciation. So what I did is I have an internal tool here. I went and pulled up what I believe is your zip code, which I think is 60035. You can correct me if I’m wrong, but I’m looking at zip codes around that region as well. And in terms of price growth or what I call momentum, it’s pretty low. I mean, you’re on the weak side of the spectrum. So that just tells me for the foreseeable future, which means 12 months out. You’re probably not going to see any price appreciation just because of where you live, the property taxes, the high prices of property in that area. So my guess is that you probably won’t see appreciation for the next two years, and then even Zillow kind of validates what I’m thinking here, what I’m seeing, because according to their forecast, however, they calculate it. This area and this home that I’m looking at are essentially flat. They projected to be essentially zero price gain for the next 12 months. So let’s just assume you have no appreciation of negative cash flow, but you have this equity there. So let the numbers drive your decisions. To me, it just sounds like you may be better off moving if you want to move, or if you need to move and then sell this property and do that through a 1031 exchange. If you need to do it that way, in order to defer the taxes on the property.
My suggestion here would be to do two things. One talk to a 1031 exchange accommodator about your situation. And also talk to a tax professional about your situation, because you do have a principal residence here, and you may be able to make your move with no tax implications because it is your principal residence, and then be able to have investible capital after you’ve made the move. The alternative scenario is that you move and then you do a 1031 exchange on this property, which still allows you to defer the taxes from the equity that you pull out from this property. So essentially you’re just moving it, leveraging it up and quick math will tell you that if you’ve got $120,000 or more of equity that you can pull from this property for investment purposes, regardless of how you pull that out, that’s enough for roughly speaking for properties.
So that could be three larger, more expensive properties. It could be five, could be three, but somewhere in that range, but let’s just call it four. So if you have four properties and they’re roughly producing conservatively speaking, $250 a month in passive cash flow, I would think it’s more like 300, maybe 350. Again, it depends on the market and the location. Let’s just be conservative and call it $250 a month times four properties. That’s a thousand dollars a month net, true net cashflow. Um, whereas right now you’re getting zero. And depending on the market that you choose, you’ll probably see stronger appreciation gains. Even if it’s like 2, 3, 4%, 5%, whatever it is, it’s better than zero. The flat market that you’re in right now, the flat area.
So you stand to (A) increase your cash flow, (B) gain some appreciation potentially, and then accomplish your move all at the same time. So anyway, high-level answer, but I hope that helps. I’m not sure what else I can tell you about this, but if you have any other questions, you know, by all means, reach out to one of my investment counselors here, but certainly talk to your tax advisor. That would be the place I would start just to cover your tax questions, talk to a 1031 exchange. accommodator, we can hook you up with one of five or six that we recommend, and then talk to your investment counselor here as well about the possibilities of what you could do with 120,000 or more of equity from this property. Anyway. Good job on what you’ve done so far. I appreciate the question, Steve. So thanks for writing in.
For everybody listening If you haven’t subscribed to the show, click that subscribe button, remember to just be on notice for future episodes. And I’m just trying to push three episodes a week right now. So I hope you enjoyed the show. If you have a question about investing or real estate or finance in general, just shoot over a question to me at passiverealestateinvesting.com or the short cut is just go to AskMarco.com and it’ll send you to the same place. That’s it for now, I appreciate the question. Thank you for listening. And I will see you all on our next episode.
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