Determining whether selling your home now or using it as an investment property will create more generational wealth depends on a variety of factors, including your financial goals, current market conditions, the potential rental income of the property, and your long-term investment strategy.
If you sell your home now, you may be able to realize a significant profit, especially if you purchased the property at a lower price and the local real estate market has appreciated since then. However, you will need to consider the costs associated with selling, such as real estate agent commissions and closing costs, which can eat into your profits. Additionally, if you don't have a plan for reinvesting the proceeds, you may miss out on potential investment gains.
On the other hand, using your home as an investment property and renting it out can provide ongoing income and potential tax benefits. You may be able to deduct expenses such as mortgage interest, property taxes, and repairs, which can reduce your taxable rental income. However, being a landlord also requires time, effort, and resources to maintain the property, find tenants, and manage rental payments and maintenance requests.
Selling Your Home Now
When you sell your home you will be subjected to tax on the profit called "capital gains tax." The capital gains tax on a home is calculated by subtracting the adjusted basis of the home from the selling price of the home. The adjusted basis is the original purchase price of the home plus any additional qualifying expenses.
Here's the basic formula for calculating capital gains tax on a home:
Capital Gain = Selling Price - Adjusted Basis
Once you've calculated the capital gain on your home, you can determine how much you'll owe in capital gains tax. The capital gains tax rate depends on your income and the length of time you owned the home.
If you owned the home for more than one year, your capital gains will be considered long-term, and you'll be subject to long-term capital gains tax rates. The long-term capital gains tax rates for 2023 are as follows:
Source: Internal Revenue Service
If you owned the home for one year or less, your capital gains will be considered short-term, and you'll be subject to your ordinary income tax rate.
It's important to note that there are certain exclusions and deductions that can reduce or eliminate your capital gains tax liability on a home, such as the primary residence exclusion, which allows individuals to exclude up to $250,000 in capital gains ($500,000 for married couples filing jointly) on the sale of their primary residence if they've owned and lived in the home for at least two out of the five years before the sale.
Let's say you are single and earn $60,000 per year. You bought your home over 5 years ago for $250,000, have lived in it as your primary residence the entire time, and have paid off the mortgage from the proceeds you received as a beneficiary of your parent's Revocable Living Trust (your parents had generational wealth at the forefront of their minds and made sure they had a Revocable Living Trust). You now sell your home for $550,000. For ease of example, let us assume that you are able to subtract $50,000 in qualifying deductions, making your capital gains $200,000 (this is a very simplified example and does not take into consideration other factors which could reduce your capital gains). Because you qualify for a primary residence exclusion up to $250,000, your capital gains tax liability would be $0. Please note that this exemption is only available once every two years.
You can then take your $200,000 and use it as a down payment for a new house or invest with the help of a qualified Financial Planner.
Renting Your Home Out As An Investment Property
If you are confident in your ability to manage a rental property and believe that the property will appreciate over time, using your home as an investment property could potentially create more generational wealth than selling it now.
Rental property can create generational wealth in several ways:
Cash Flow: Rental property generates income from monthly rent payments that exceed the expenses of owning and operating the property. This positive cash flow can be used to reinvest in more rental properties or other investments, creating a passive income stream that can be passed down from one generation to the next.
Appreciation: Over time, rental properties can increase in value due to market conditions, improvements made to the property, or gentrification in the surrounding area. Appreciation can create significant wealth over multiple generations, especially if the properties are held for long periods.
Equity: As tenants pay down the mortgage on the rental property, the property owner builds equity. This equity can be used to purchase additional rental properties or other investments, creating even more opportunities for wealth creation.
Tax Benefits: Rental properties offer significant tax benefits, including deductions for mortgage interest, property taxes, repairs, and maintenance expenses. These tax benefits can reduce the amount of taxes owed, increasing the net income generated by the rental property.
Inheritance: Rental properties can be passed down to heirs, providing a valuable asset that can generate income for generations to come.
Additionally, the use of a 1031 exchange, also known as a like-kind exchange or a tax-deferred exchange, is a strategy used by real estate investors to defer taxes on the capital gains earned from the sale of investment property.
Under Section 1031 of the Internal Revenue Code, if a taxpayer sells a property that has been held for investment or productive use in a trade or business, and uses the proceeds to purchase another property of like-kind within a certain timeframe, they can defer paying taxes on the capital gains from the sale. Essentially, the 1031 exchange allows investors to reinvest the profits from one investment property into another without incurring immediate tax liability. There are several rules and requirements for a 1031 exchange to be valid so it is best to consult with a qualified attorney or real estate advisor if you are considering this an option.
Overall, rental properties can create generational wealth by providing a steady stream of income, increasing in value over time, building equity, offering significant tax benefits, and being passed down to heirs as an inheritance.
The Bottom Line
Ultimately, the decision to sell your home or use it as an investment property should be based on your personal financial goals, risk tolerance, and investment strategy. It is helpful to consult with a financial advisor or real estate advisor who can provide guidance based on your specific situation.
To learn more about which opportunity for generational wealth is best for you, schedule a free 30-minute consultation and LET'S BUILD!
