It's said to be one of the biggest questions that many older Americans face, when embarking on an international remote working or digital nomad lifestyle: What should they do with their single most valuable asset: their home – keep it, or sell it?
Here, in an article reprinted with permission from InternationalLiving.com,
Paul J. Carlino, a former tax attorney for the Internal Revenue Service (IRS), explains how he and his wife, Rebecca, addressed what he calls "this rent vs. sell predicament" back in 2018, when they decided to move from the U.S. to Mexico...
In general, when older Americans decide to move abroad, they have two options, when it comes to their U.S. home, if they happen to own it: They can either rent it out, for the time they'll be away, or sell it.
While the best option will vary from person to person (or couple to couple), depending on their financial circumstances, the location of the property, and a host of other factors, there are a number of issues that everyone should be aware of, especially on the tax front.
My wife, Rebecca, and I faced this Rent vs. Sell question three years ago, ahead of moving to Mexico from Virginia in 2018.
As a former tax attorney for the Internal Revenue Service (IRS), I was aware of many of the relevant laws, but I still learned some important, and surprising, lessons during this process, which I'd like to share here, with others who may be facing a similar dilemma right now.
An investment in our financial future
Real estate is, of course, a critical element of any well-balanced investment portfolio. But 20 years ago, when Rebecca and I were looking to purchase our first home, we were more concerned with whether we would be able to afford a house than we were about how it might one day stack up next to our stock holdings.
At the time, housing in the trendy Virginia neighborhoods just across the Potomac River from our jobs in Washington, D.C. was so in demand that would-be buyers were routinely forced to bid more than asking price, and even to forgo home and safety inspections.
This made us nervous. Moreover, the amount of money the bank wanted to lend us (back in those madcap, pre-global financial meltdown days) was more than either of us could ever imagine paying back.
Because we were adverse to being "house poor" – that is, we didn’t want to spend the majority of our incomes on a mortgage – Rebecca and I went with our gut, and decided on a cheaper option.
We purchased a 1940s townhouse on the proverbial “wrong side of the tracks” for half of what we would have spent on a slightly larger, single-family house in a more popular neighborhood. But we felt safe in the new house, and planned to use the money we were not paying to the bank for the travel that we both loved to do.
It turned out that luck was with us. As our realtor had predicted, we found ourselves in the vanguard of our new neighborhood’s gentrification. Modern housing developments were soon built on either side of us, more shops and restaurants moved in, and our area became known as that "quaint, colonial neighborhood." Then housing prices in the entire city began to rise.
When we purchased our home in 2000, the city assessed our land and house at US$127,900. Ten years later the assessment was US$378,420. And by the time Rebecca and I decided to move our family to Mexico in January 2018, it was US$516,168.
Choosing between two attractive options
After we decided to move overseas, Rebecca and I therefore had a difficult choice to make. Should we rent it out, and use the monthly rental income to help pay our expenses in Mexico, or should we cash out, and take advantage of a federal law that would eliminate all tax on the substantial gain that we would realize by selling?
Renting had advantages. The monthly rent would provide a steady stream of income to partially replace the salaries we were leaving behind, and thereby reduce the amount we would need to draw on from our savings, in order to meet our daily living expenses.
The income would cover our rent in Mexico; tuition for our children’s schooling; and, as I liked to joke, even leave us with a few dollars for tacos.
As fiscal conservatives (at least when it comes to spending our own money), Rebecca and I liked that rental income would provide a financial cushion, until we could develop several business ideas we wanted to pursue.
Another point to consider when moving overseas is that rental income can help you secure a residence visa in your new country. While this wasn’t relevant to our situation, some countries – Uruguay, for instance – require a provable stream of income to gain permanent residence. Rental income can help you to meet this requirement.
There are downsides to renting as well, however, as we learned in researching our options.
First, the costs involved in hiring a management company to look after the property in Virginia, and keep it occupied, would bite into our income.
These companies often charge a fee equal to one month’s rent to find a renter, and then 8% to 10% of the monthly rent to maintain the property, and respond to issues raised by the tenant.
While such online sites as Craigslist do exist as free platforms to help landlords and tenants connect, such sites, obviously, can’t manage the property.
Second, we would have to report the rental income as taxable, further reducing the amount that would finally make it into our pockets.
Rebecca and I also found selling to be an exciting option.
Based on conversations we had had with several local realtors in Virginia, as well as our independent research using the online tool Zillow – which uses comparable properties to estimate a home’s market value – we anticipated we could sell the house for roughly US$600,000.
In that case, we would make a profit of US$400,000, after subtracting our initial purchase price, and the cost of the capital improvements we had made, which totaled US$200,000.
We figured that we could invest the US$400,000 profit, and use the returns from our investment to cover our expenses in Mexico.
Further, under section 121 of the Internal Revenue Code (the Housing Exclusion), none of this US$400,000 profit would be taxable. The Housing Exclusion allows a married couple to eliminate from income up to US$500,000 in gains on the sale of a home. (A single person can exclude up to US$250,000.)
To qualify for this exclusion (and this is crucial to understand if you’re considering selling your home), married couples and single persons must meet the ownership test and the use test.
You’re eligible for the exclusion if you have owned and used the property as your main home for a period aggregating at least two years out of the five years prior to the sale.
You can meet the ownership and use tests during different two-year periods, but you must meet both tests during the five-year period ending on the date of the sale.
If we sold our house, we would meet both the ownership and use tests and be able to exclude all of our profit, resulting in zero tax.
Without the benefit of the Housing Exclusion, the 10% capital gains tax rate meant we would pay tax of US$40,000 on the US$400,000 profit.
Forty thousand dollars is more than we anticipated it would cost our family of four to live in Mexico for one year. That, we thought, was a lot of money to pay in taxes.
The reasons we decided to rent
So we opted to rent, and keep the house in Virginia.
Several factors contributed to our making that decision. For one thing, we immediately found a reliable renter on our own, whom we could trust to take care of the house and yard.
We provided her with contact information for various local repair people we had previously used ourselves, thus eliminating the need for a management company.
The rent we collect is taxed as ordinary income (Rebecca and I pay in the 12% tax bracket, but rates vary from 10% to 37% based on income and filing status).
Still, not incurring the cost of a third-party management company meant more money in our pocket.
Second, given the nature of the Washington, D.C. metro area – highly transient, with close-in housing such as ours in high demand – we expected the value of the property to continue to rise.
Further, because the Housing Exclusion Use Test provides a two-out-of-five-year window, we didn’t immediately have to sell to gain the tax benefit.
In the simplest application of the test, we had up to three years after moving out to sell. If our date of sale was in January 2021, the five-year lookback period would run from January 2016 to January 2021, and we would have lived in the house as our primary residence from January 2016 to January 2018, and would be able to exclude the gain.
The final reason we decided to initially rent rather than sell was that we wanted a place to come back to, in case things in Mexico didn’t work out.
Decision Time, Again
In June 2020, our tenant informed us that she would be moving out in August. By this time, we were two-and-a-half years into our Mexico experiment, and committed to our lives there, with no plans to move back to the U.S. As a result, we began to re-explore our options with regard to the house.
My first reaction was to sell. We were still within the two-out-of-five-year window to meet the Use Test, and exclude our gain from taxation. Realtors we spoke with (and the online platform Zillow) predicted we could now sell the house for US$100,000 more than two years previously, meaning we would save about US$50,000 in taxes, and have the entire US$500,000 profit in hand to invest.
But Rebecca wanted to continue to rent. A kombucha business we had started, and the Spanish-language courses she had been running since we arrived in Mexico, were intermittently profitable, but she liked having the steady rental income. (Kombucha is a fermented, tea-based beverage.)
Another reason Rebecca wanted to hang onto the house was to realize additional appreciation that several local realtors had forecast, after Amazon announced it would be building its second headquarters in the area.
Then, while we were still debating what to do, fate intervened. I was discussing our dilemma with a friend, who has investment expertise, and he offered something that Rebecca and I hadn’t fully understood. He explained that the rate of return we earned from renting was more than we would likely get if we sold the house and invested the gain.
At that time, we were clearing approximately US$25,000 per year in rental income after paying property taxes, homeowners insurance, and maintenance expenses. (We had paid off the remaining mortgage before moving.)
If we were to sell the house and invest the US$500,000 gain, we would have to find an investment that delivered a 5% return to realize as much as we were getting in rental income.
While we might be able to find that rate of return in a corporate bond or publicly traded stock, those asset types are typically riskier investments than real estate.
Around the same time that I had this conversation with my friend, Rebecca and I found, through word-of-mouth, a family with good careers, who were willing to pay a slightly higher monthly rent than we had previously been receiving. This made the decision to rent again easy.
Plus, I knew the Housing Exclusion wasn’t completely off the table. Under the law, we could reset the five-year period critical to the use test if we decided to move back into the house as our primary residence and stayed there for two years—or longer, if that suited us.
Although it’s not in our minds to move back now, it’s not out of the realm of possibility. And why not? The house has been good to us.
Ultimately, the decision as to whether one should rent or sell one's home prior to going abroad is a personal one. There is no one-size-fits-all solution.
However, as our story shows, a crucial financial consideration that every homeowner should keep in mind is that Housing Exclusion. If you end up selling your home outside of the two-out-of-five-year window, you may have to hand over a big chunk of the sales price to Uncle Sam.
So: if you decide to hold onto your home for some years after moving overseas, be aware of how this tax could impact your finances down the road.
Paul J. Carlino is a former tax attorney for the Internal Revenue Service, who currently lives in San Miguel de Allende, Mexico, with his wife and children, and writes about expat issues for International Living.
International Living is a magazine and website dedicated to exploring Expatland, which is written by contributors who are expats themselves. It was founded more than 40 years ago, and today is based in Ireland. To see Carlino's article as it appeared on the International Living website, click here.
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