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It was just eight months ago that we made a dramatic housing change – selling our big house in a beautiful location to move into a home less than half the size. We cut our monthly housing costs in half, improved our quality of life, and accelerated our financial independence plan.
We’ve loved everything about the change, but discovered that our current location isn’t the right long-term choice for us. We could stay here happily for a few more years, but an opportunity appeared when the tenants in our rental property gave notice.
Our first home, that has been a rental for the past ten years, was open. As I did with our downsizing decision, I’m going to share with you everything we considered before making a final choice.
I’ll share some general research, and then all the aspects about our personal situation that factored into the decision. If you’re considering moving back into your rental property, hopefully our experience helps you make the best decision.
Oh, and spoiler up front – we’ll be packing up again in a few months. We’re moving back into our rental property!
Things to Know
Can An Owner Move Back Into A Rental Property?
Yes! But, if you have a current tenant in the property it may not be quite as easy as you think. Check your local rental rules.
It’s almost certain that you have the right to move back into the property you own. Yet, the requirements to do so vary quite a bit from state to state.
In some cases, you simply have to give notice – and that notice might be as short as 30 days. In other places, the notice could be longer and you may be required to pay some compensation to the tenant.
You also may be required to live in the property for a minimum period of time after reclaiming possession. Or, to offer it back to the same tenants if you move out again before a certain period of time.
Check your local rules. Just know it isn’t as simple as you might think.
Tax Benefits of Moving Back Into A Rental Property
Can You Avoid Depreciation Recapture? No.
An acquaintance tried to tell me that moving back into our rental property would wipe out the depreciation deductions we had taken. This is false! Do not believe it.
Should we sell, we will pay taxes as part of depreciation recapture. That means any depreciation you’ve taken will be taxed on sale.
As far as I can tell, there is no way to avoid this if you are going to sell your rental property whether you are occupying it or not.
Capital Gains Exclusion (2 out of 5). Yes – partially.
The capital gains benefit is real! Homeowners who live in a property as their primary residence for at least 2 of the 5 years preceding sale are entitled to tax-free gains on the sale of the property up to $250,000 for a single owner or $500,000 for a married couple.
The rules are different for a rental, and there is still a lot of misinformation out there. The important concept to understand is “qualified use.” You need to pay attention to the amount of time you’ve occupied it as an owner and the amount it has been a rental.
If we were to live in the property for two years, it would give us the ability to avoid taxes on some of the appreciation at sale – but not the full amount.
Instead, it’s a combination of the time we’ve occupied it as our primary residence and the time we’ve rented it out.
In our case, that looks like this:
If we sold the house now we would pay full capital gains on the amount the house has appreciated since we have not occupied it for two of the past 5 years.
However, if we live in it for 2 years and choose to sell in 2022, we would be entitled to 50% of the benefit. How do we go from 0 to 50% in two years? Because we occupied it before and those years count.
10 years of primary residence (2002-2010, 2020-2022) + 10 years rental (2010-2020) = 20
10 years of primary residence / 20 years total ownership = 50%.
We’ll enjoy half of the deduction. Maybe not enough to make us move back in by itself, but not a bad benefit for a choice we’d make anyway.
Why We Are Moving Back Into Our Rental Property
Those are things every owner needs to consider when thinking about moving back. There are also a number of things specific (but not unique) to our situation. Here is everything that factored into our decision.
Sure, it’s important to optimize a financial decision as much as possible. We aren’t robots though, and personal considerations should factor in as much – or more. Especially into a quality of life decision like housing.
Long-Term Housing Plan
We’ve realized some things after our current one-year downsizing adventure.
We are perfectly happy in a smaller home. We know exactly what we need in our living space.
We like our current area, but don’t love our current home. There will be environmental noise from nearby construction for several years. We now know we won’t share walls in our final home. A detached single-family home is our future.
We’ve realized that we may want to move out of our current metro area once we step away from work. That opens up a number of options in the future.
In short, the current home we are renting is not our long-term home. We’ve paid attention to opportunities around us, but haven’t found anything that is ideal.
Moving back into our rental meets our short-term needs while giving us satisfactory housing. In short, it buys us time to make the best long-term decision.
Proximity to Work
Speaking of short-term: TFI (my wife, Teacher FI for new readers) is certain (or at least as certain as one can ever be in employment situations) she’s going to work in her current school for at least 5 more years.
Any long-term options would require us to move farther away. Unfortunately, in our area traffic continues to worsen and there are no great public transportation options.
We can’t make our final move without significantly impacting TFI’s commute and thereby her quality of life.
Our rental is actually slightly closer to her work than our current house.
Closer to Aging Parents
As members of generation X, we are at that age where the needs of our parents are becoming a significant factor in life plans.
In particular, TFI’s parents are requiring more support and attention. She needs to be closer to them. As with her work, our rental house is closer to her parents than both our current home and any potential long-term options.
We aren’t sure we want to continue being landlords.
I’ll go into the financial aspects of operating a rental a bit more below. This part is less number oriented and more an emotional reaction.
For eight years, we had zero problems with our rental. It’s always been occupied (no vacancy lasted longer than the amount of time we needed to turn it over.) The tenants have been great and relatively low-effort.
That changed with the last set of tenants. We had a number of issues, ranging from neighbor complaints to poor treatment of the property.
As we worked through those, we realized how few options landlords have in such situations. I’m not necessarily complaining about it because bad landlords (and profit-seeking actions that harm renters) have made increasing tenant protection a necessity. Yet, in the moment it was frustrating.
All this has led us to question whether we want to continue doing it in the future. In this case, it’s not a financial slam dunk.
Moving back in gives us options. Perhaps after a few years pass, the frustration of the recent situation will be behind us and we’ll be ready to operate it as a rental again. If not, we’ll have options.
Bringing Clarity to FI Plan
Finally, now that we’re within 2 years of our potential financial independence date, there is something very appealing about starting to tighten the variables in our plan.
Housing, and rental income were two of those variables that required us to make some assumptions. Moving back into our rental allows us to build a FI plan with two major variables removed.
In this scenario, we know our housing costs would be much lower: taxes (mostly known), insurance, and a maintenance fund. We’d have certain and stable housing.
In our new plan the portion of our net worth in our primary residence isn’t relevant. Our housing is covered but not income generating. The value of the house will determine any future housing changes. That is – if we choose to rent it out, it must at least cover the costs of our new home. Or, if we choose to sell, the proceeds will be our budget for our long-term home.
This allows us to create a FI target for just non-housing expenses, and with our rental removed from our income-generating net worth calculation.
In short, we know our FI number with greater clarity. Our potential post-FI expenses are more concrete. In reality, our financial picture hasn’t changed much but our FI plan seems much tighter. I’m even more confident we’ll get there by 2022.
It’s not a purely emotional choice – far from it. There are a number of financial reasons it might make sense.
Not An Ideal Rental
We live in an area where the economics of single-family rentals don’t really work. It’s very hard to find something even approaching the 1% rule.
We converted our first home to a rental without really running the numbers. We wanted to buy a new home, and banks weren’t eager to lend at the bottom of the housing crisis.
Our mortgage wasn’t quite upside down, but it would be close. It was easier to convert to a rental to get it all done.
Fortunately, the house cash flowed immediately. Also, since that decision, appreciation has made it a wise choice. The home has doubled in value.
Yet, virtually all of the gains have come from the appreciation. We recently had to make two major repairs – replacing the roof and the deck. Those costs wiped out most of the cash flow from the previous years. Of course, they won’t need to be done again for at least twenty years – which is a positive.
However, even with rent increases the property isn’t anywhere near the 1% rule. It’s never hit it. Right now, it hits about .5%.
Of course, it’s nearing 1% of the original purchase price from 18 years ago. So, it’s not a disaster. But the money could potentially be deployed more efficiently elsewhere.
I mentioned our most recent tenants were very hard on the place. It’s also been in operation as a rental for a decade.
The major known repairs have mostly been taken care of. Now, it just needs a lot of cosmetic rehab and general upkeep. I can do most of that, but not in a short time frame due to my day job.
But…if we move in, I can do them over time. It will eventually be in the best shape its ever been under our ownership. New deck, new roof, replaced floors, rehabbed bathrooms, and new paint throughout.
We aren’t sentimental about the house so we’ll make all decisions with resale value and rental durability in mind. We don’t need luxury while we live there.
Then, the house will be ready for sale or to go back up for rent once we identify our long-term housing solution.
The repairs will cost significantly less if I do them myself over time.
This is both financially and psychologically appealing.
It might not be financially optimal (depending on your assumptions) but it’s not a loser by any stretch.
We’ve held more than $100,000 in cash equivalents (CD, high yield savings, money market) from downsizing last year. We wanted the cash available until we decided on our long-term housing plan. Well, we can use it for our short-term housing plan and do better than cash returns.
We owe about $70,000 on the rental at 4.5%.
When we move back in, we’ll pay that off and live mortgage free. We’ll also no longer have to pay our current rent of ~$2000. We’ll lose the cash flow from the rental. The utilities will be a wash. We’ll still have about $6000/year ($500/month) in housing expenses due to property tax and insurance.
Yet, in the end we’ll have mortgage freedom AND a gain of almost $1500/month in our current cash flow that can go into extra investments. Any left over cash after the mortgage pay down and repairs can be deployed in other investments.
Lifestyle Inflation? Crushed.
I considered listing this under non-financial benefits because it fits well there too.
After this choice, our annual expenses will be lower than they were early in our teaching career. We’ll be living on less than we did as two broke teachers during our debt payoff phase.
Our housing costs will be a fraction of what they were then. We have no car payments. Some but not all, of the benefit is balanced out by our increased travel costs.
Still, since lifestyle inflation was our biggest financial mistake it’s huge to have it reversed entirely.
We screwed up letting our expenses grow with our income. We’ve now fixed it and all of our income growth is going towards savings/investments. We will put more away this year than ever before.
Potential Tax Advantages
We plan to live in the home for at least two years. That will allow us to capture some of the capital gains benefit of a primary house should we decide to sell.
I listed the numbers out above. The result for us is 50% of the appreciation exclusion benefit just by living in the house for two years. The benefit would climb slightly for every year after that.
We’ll still need to pay the depreciation recapture though.
By 2022, the house will likely have appreciated about $200,000 since we originally bought it. Having half of that excluded from taxes is substantial.
Greater Future Flexibility
Of course, we don’t necessarily need to sell it. We’ll have a locked-in housing plan and the option to sell, rent, or remain in place.
This means when we decide on a long-term housing strategy we have the advantage of time and financial flexibility to maximize our choices and financial options.
We could buy and build without worrying about housing in the meantime. We could rent and then spend only what we cash flow. We could sell and pay off a new primary residence.
Or, we could do a combination of those things! A 1031 exchange with part of the equity to a more financially efficient rental and take the remainder for a smaller house in a cheaper area.
We won’t be forced into a quick choice by a landlord, pressing financial needs, or housing instability. Having time leads to better decision-making and negotiations.
It’s a great financial AND psychological benefit to having housing costs covered and total flexibility.
Potential Downsides (And Our Solutions)
All the reasons I’ve listed above led us to moving back into our rental property. It wasn’t a slam dunk decision, though. We considered several downsides. Ultimately, we decided to move ahead despite the concerns.
Your decision may be different. For us, the pros outweigh the cons, and we believe we can mitigate most of the potential downsides.
Are We Going Backward?
This is largely an ego consideration. Yet, those have real psychological impacts and it’s important to name and recognize them.
It can feel like a loss to go backwards. In this case, we’d moved out of our starter home into a larger beautiful home. In the process we emotionally divested ourselves from the home (you have to if it’s a rental) and considered it all progress.
When downsizing, we intentionally chose not to return to the area where our rental home is. For a variety of reasons, we prefer living in other parts of the city. Our downsizing process told us exactly how we preferred to live. The neighborhood where our rental is, and the house itself, don’t meet all of those needs.
Ultimately though, we’ve decided rather than taking a step backward the move is an evolution of our plans.
We have the opportunity to make the house fit our needs. It’s larger than our current space. (Yes, we moved from an almost 2000 sq ft house to an almost 3000 sq ft house during our lifestyle inflation phase. Yikes.)
Had we stayed in the home originally, we’d be at least $100,000 ahead of where we are now. We can never regain that lost opportunity, but we can capture one now.
As outlined above it gives us flexibility. It is the final step in our unwinding of lifestyle inflation.
This is a move based in financial empowerment, because we understand our needs and have a plan. It’s not a backwards slide, it’s an aggressive move forward.
Falling Into Old Routines
Speaking of lifestyle inflation – a good portion of it happened in the latter years of living in this house.
Our behaviors in this house and in the surrounding community were based on mindless consumption. We had our regular restaurants, bars where we spent money, and lots of retail choices. Environment impacts behavior in a massive way.
A real concern is that we move back and fall into those old routines, both financially and behaviorally. That would be a slide backward.
James Clear explains in Atomic Habits that so much of self-control is really about creating the optimal environment. We already know the environment is suboptimal for our spending choices.
We’ve agreed to intentionally disrupt past behaviors by going to a nearby community instead of using the closest one where all our old habits lie. It’s a bit more travel, but friction is a good thing when it comes to consumption. It won’t add significant transportation cost, but will help us avoid falling into old patterns.
We’ll intentionally create better life routines.
Once we’ve established new routines that better fit our current approach to life and money, we can add back in more local options.
Narrowing Our Assets
By pulling the rental out of income-producing assets we are narrowing our holdings.
We still own and operate a short-term rental, but it isn’t a significant portion of our holdings.
Real estate was previously about 25% of our net worth. We targeted holding 80% stocks, 20% bonds in addition to the rental property.
Now, the vast majority of our assets will be non-real estate. Excluding our primary residence (formerly the rental) means 95% of our net worth will be in stocks and bonds.
Our plan is to learn more about REITs (real estate investment trusts). We’ll move to about 10% REITs in our holdings – likely in a REIT fund/ETF. Our new total allocation (non-pension assets) will break down like this:
|ASSET ALLOCATION PLAN|
The Result of Moving Back Into Our Rental Property
We’ve spent a lot of time thinking about this. Now that we’ve made the decision, we’re excited.
We’ll take possession of the property later this spring. After some initial rehab while we close out the lease in our current home, we’ll move back in before summer. I plan to share some of the projects we take on and the work we do to bring the place up to par long term.
We’ve got a solid housing plan for the immediate future. It gives us options in the long-term.
There are many benefits of moving back into the rental property:
- Housing is settled (for as long as we want it to be)
- Tax benefits if we decide to sell
- Save on repair costs
- Monthly cash flow increases immediately
- Cash currently on the sidelines gets back into action
- Better ability to support TFI’s parents
- Shorter work commute for TFI
- Our annual expenses are lower than they were 15 years ago
- We’ll be mortgage free for the first time ever
It’s amazing how much our life has changed since we started pursuing financial independence. Moving back into our rental property feels like yet another positive step forward. We’re excited.
What do you think about our choice? Is this part of my optimization twitch?