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After booming for several years, real estate sales slowed to a crawl in 2023, for good reason. The combination of a run-up in housing prices, low inventory, and 20-year-high mortgage rates has left many potential buyers feeling priced out and sellers feeling trapped in their current homes.

But if you’ve made the decision to move, you may be wondering about keeping your former home as an investment property rather than selling it. After all, rental prices remain near their 2023 all-time high. If your home is paid off or you have a low-interest mortgage, it can be an attractive concept, offering a passive income stream and the potential for ongoing price appreciation.

Remember that real estate isn’t an “investment” in the same way that your portfolio is. It’s more like owning a business, with costs, risks, tax implications and demands on your time and attention.

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Of course, there’s nothing wrong with opening a new business and it could be lucrative for you. But you’ll want to make sure you fully understand the potential downsides and opportunity costs before you commit.

See what you should keep in mind, and make sure to talk to your planner before making a decision.

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A note about short-term rentals

The considerations below generally apply to both long-term rentals as well as short-term ones. In addition, if you’re thinking about turning your home into a short-term rental, through companies like Airbnb or VRBO, make sure you’ve researched local laws and rental trends. Many communities now ban them, and markets where they’re legal are often saturated with inventory.

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Mortgages

For your primary home, we generally believe in carrying a big, long mortgage, given – among other reasons – the tax benefits, additional liquidity and comparatively low interest rates. However, mortgages for second homes may be a different story because the purpose of the second home is not the same as your primary home.��

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Taxes

Most states offer a “homestead exemption” that reduces property taxes on your primary residence. Once you move, your former home will no longer qualify, effectively raising your property taxes. See your property tax bill to determine how much you can potentially expect it to increase.

Your home may not qualify for the capital gains exemption either, and if not, any price appreciation when you ultimately sell will generally be taxable. To qualify for the exemption ($250,000 for single filers and $500,000 for married couples), you need to have owned and used the home as your primary residence for at least two out of the last five years before you sell (the years don’t necessarily need to be consecutive).

In general, owning an investment property can make your tax situation much more complicated. Any rental income is just that – taxable income – but you can deduct costs associated with the home, including property taxes, insurance, depreciation, maintenance, management and legal costs (more on those below). Even if you’ve always done your own taxes, you may find that you need to bring in a professional, just like any other business owner.

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Insurance

Once your property becomes a rental, it most likely won’t be covered by your homeowner’s insurance policy. Instead, you’ll need a landlord policy. According to the Insurance Information Institute, landlord policies typically cost about 25% more than comparable homeowner’s insurance policies.

Unless you’re renting your home fully furnished, you won’t need much coverage for personal property (generally just enough for appliances). When you change to a landlord policy, the “loss of use” coverage on your homeowner policy will be converted to “loss of rental income.” This way, if you can’t rent the home for a period of time as a result of a covered loss (a fire, for example), your policy will help compensate you for the loss of rent.

It's also a best practice to require your tenant to purchase a renter’s insurance policy that could provide some coverage if their negligence causes a loss. Ideally, that renter’s policy should list you as an additional insured party.

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Legal costs and implications

Your legal costs may be minimal and simply consist of help preparing leases. But there are other scenarios that could require expensive legal assistance, like evictions or tenant disputes. Landlords are generally subject to a host of local laws and regulations, and resolving issues is rarely simple and straightforward.

And remember that as the property owner, you can be held liable for events that happen there. For example, depending on the situation and where you live, you could be responsible for things like:

• Injuries to a tenant because of something you should have addressed, like a slippery walkway
• Injuries to a neighbor from a dog owned by your tenant
• Criminal activity that occurs on the property

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Property management and maintenance costs

You probably have a good sense of what your maintenance and repair costs have been in the past, but they could be higher on an investment property. Tenants aren’t likely to take the same care with a home as the owners would, which means issues can go unnoticed or unreported until they’re significant. And you should expect the home to need cosmetic refreshes between tenants as well.

You may decide to hire a property management company to reduce your time finding tenants, collecting rent and making repairs – especially if you’re moving out of the area. This will also increase your costs.

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Vacancies

While a vacancy isn’t a “cost,” you’ll need to account for lost income in your plan as well. Vacancies are inevitable now and then, and they can last longer than you’d expect. (They also raise the risk of squatters, which are an increasing concern and can be even more difficult to deal with than evictions.)

As we said above, you can get a landlord insurance policy that covers vacancies due to natural disasters or other periods when the house is uninhabitable, but it won’t cover vacancies when you’re looking for a new renter. If you anticipate your rental to be vacant for more than 30 days, contact your insurer.

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Opportunity costs

Any money you spend on your investment property could have been used in other ways. Some of the tradeoffs include:

• Holding excess cash. Because you need to be prepared for unexpected costs on two properties, your emergency fund will need to be much larger. In today’s environment, cash yields look pretty good, but over the long term, they’re not much higher than inflation (and sometimes less).
• Having less money available to put toward your new home. Holding onto your current home means you’ll have less liquidity for things like your down payment, moving costs and updates to your new home.
• Having less available for other financial goals. You may have to cut back on saving for retirement, college or other major life goals.
• Risking the loss of the capital gains exemption we discussed above.

And don’t forget the cost of time and energy that you could dedicate toward other things. Even if you outsource most of the heavy lifting, you’ll still likely need to make ongoing decisions and meet with lawyers, accountants and property managers. If you have a bad experience with a tenant, that can mean a lot of heartache and stress – or even a drawn-out court battle.

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Is an investment property really worth it?

If your income from the property would simply be offset by all the costs we’ve discussed above, you’ll be counting on housing price appreciation to make it a good investment. And while home prices have soared recently, that’s not always the case. In fact, over the long term, they’ve risen slower than bonds, let alone a diversified portfolio.

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Average annual gains since 1980

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Sources: Bloomberg, FHFA, Morningstar Direct. Figures as of Dec. 31, 2023, except housing prices, which are reported quarterly and are as of Sept. 30, 2023. "60/40 balanced portfolio" consists of 45% U.S. large-cap stocks/15% international stocks/40% U.S. bonds. Benchmarks: For large-cap stocks, the IA SBBI US Large Stock Total Return Index; for bonds, the Bloomberg US Aggregate Bond Index; for international stocks, the MSCI EAFE Index; for housing prices, the FHFA House Price Index.��

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Does that mean you shouldn’t consider it? For most people, it’s unlikely to be the best use of your money, but it depends. For example, if your home is in a desirable vacation area, you may be considering turning it into a short-term rental that could have high income potential compared with the carrying costs.

Or, if you’re a contractor or a real estate agent, you may have specialized knowledge and skills that increase your ROI – and you may enjoy the day-to-day management more than most people would.

But if you’re considering it simply because the numbers look good to you, make sure you have a full picture of the risks, costs and opportunities. Your planner can help you think through your financial planning options and help find one that’s right for you.

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