When Selling Your House At A Loss Is The Right Choice

Military families have unique challenges when they buy a house. The biggest challenge is what to do with the house when you receive PCS orders a few years (or months!) later. Some folks bought the house with clear plans to turn it into a rental property, but the majority planned to sell, or didn’t have a plan at all.

Whether you’ve owned your home many years, or just a few, selling can be financially tricky, especially if you’ve not made a down payment. If the market value of the property hasn’t appreciated pretty significantly, you may be underwater on your loan, or have very little equity to pay for the costs of selling. Faced with the prospect of owing thousands, or tens of thousands, of dollars just to sell the house, it may seem like a better idea to rent it for a few years until the loan balance is smaller.

There are many problems with this plan, and it is often a better choice to just go ahead, take the financial hit, and start over. But how do you know?

Note:  Many military families generously shared their stories for this piece.  I have not identified them for their privacy.

Loan Balances Go Down Slowly

The way mortgage loans work, a large majority of the early payments go to interest. Our recent low-interest rate environment makes that a little less challenging, but it is still a serious consideration.

For a three year old, $200,000 mortgage at 4% interest, the principal portion of that 37th payment is just $325, and it goes up about $1 each month. A year of payments will decrease your principal balance about $4,000. While that’s not awful, it is not a lot in the greater scheme of things. If you are underwater, or can’t cover the costs of selling, it may take many, many years of renting to get that loan balance down below the net value of the property.

The Costs of Owning A Rental

So many people think, “We can get more rent than our mortgage, so we’ll be good.” It’s pretty rare that the math works out that way. There are so many ways that a rental can cost money.

Whether you use a professional or self-manage, you will have some property management costs. Self-managers need to be able to travel to the property, have their leases cleared with an attorney, pay for advertising, etc. A professional manager may charge one-time fees for placing a property, plus a monthly fee for management, and possibly a project management fee for larger repairs and maintenance.

Both taxes and insurance can change when you convert your principal residence into a rental property. You may lose a homestead exemption on your property taxes; the details will vary by state. One military family found their taxes increased from $2700 to $7800 per year! While that is a drastic example, it can happen.

A rental insurance policy, also called a fire policy or a dwelling policy, may be more or less expensive than your homeowner’s policy. The price more often goes up, but that will depend on a wide variety of factors including the type of property, its features, and its location. You will probably also want to increase your personal liability coverage, possibly adding an umbrella liability insurance policy.

As you’ve probably noticed, owning a house is expensive. There is always something to fix. When you’re living in your own house, you can let little things slide, or easily fix them yourself. Freezer door needs to be shut just right? No problem, just make sure everyone in your family knows. Bathroom door lock broken?  Eh, no big deal, you’ll get around to replacing it when you have the time and money. It’s not so simple when you’re renting a property to someone else. It’s your responsibility to provide a property in good working condition, and it isn’t acceptable to ask your tenants to do the little extra steps to make things work, or wait until you have the time and money to make repairs.

The average home maintenance costs, spread over the lifetime of a property, run around 20% to 40% of the rent. Obviously, newer homes in good repair might have lower costs at first, but eventually all homes need work. Some years it might be just a few hundred dollars in little fixes, but then you’ll have a year where the HVAC goes out, or it needs a new roof, or tree roots get into your main sewer line. (Or all three – yikes!) If the rent you’re receiving isn’t significantly more than your fixed mortgage expenses, you won’t always have enough money from the rental to pay for all the repairs and maintenance, and that money will come out of your family’s regular budget.

Lastly, you can’t always be sure that your house will stay rented all the time. Even in a hot market, you often need a few days between tenants for necessary upkeep. In the worst cases, your house may sit empty for months at a time. Do you have enough money in your savings or monthly budget to carry that empty house? (Side note:  your insurance costs will go up if the house vacant too long – often 30 or 60 days.)

The Stress Factor

It’s 3 am, and you’re wide awake, thinking about whether someone is going to answer your rental ad, or whether the hurricane headed toward your house is going to topple that big tree, or whether your neighbors will ever forgive you for the incident with the tenant’s dog. Owning rental property can be very, very stressful. You have to be very good at compartmentalizing the things in your life, or you’ll find yourself snapping at your kids because the dishwasher in your rental house just went out. Again.

Kay is a military spouse, and she said this, “There were many reasons why we waited to sell, but the stress it caused me over the 5 years (and continuing until we sell it) wasn’t worth it.”

Not everyone is cut out to be a landlord, and that’s OK. It’s a tough job, especially if it’s not your only job. And if you don’t have significant cash reserves, and money is tight, it will be even more stressful. Which brings us to:

Emergency Funds and Cash in the Budget

As discussed above, having a rental property can be expensive. In a perfect world, your rent is significantly more than your monthly costs, so you can build up a cash reserve to pay for those larger, infrequent expenses. In reality, it doesn’t always work that way. Do you have enough cash reserves, or cash flow in the budget, to handle a $10,000 repair in the first year of landlording? How long can you cover the mortgage (and higher insurance) on a vacant property?

If your emergency plan involves borrowing from other investments, or using credit cards, you might want to think again about whether renting is right for your situation.

Taxes On The Sale

Most families don’t pay any federal capital gains taxes on the sale of their principal residence, but both capital gains taxes and depreciation recapture taxes may apply to the sale of rental property.

There is a generous military extension for those who have Permanent Change of Station (PCS) orders away from the property, so you may never have to pay capital gains taxes on your rental. However, it only extends the 2 of 5 rule for ten years, so you may eventually run out of extension, and you can only take the capital gains exemption on one property at a time, which is problematic for those who want to buy another house in the future.

The depreciation recapture tax is one that catches many non-professional landlords by surprise. This tax is a little complicated, but you can very roughly assume that if you made money on the sale, you’ll pay up to 25% of the total depreciation you’ve taken over the years that you have owned the property. A very, very rough estimate on a $250,000 purchase, of which $50,000 of the value is land, is that it would depreciate about $7,200 per year. This might lower your tax bill each individual year, depending on all the other variables in your tax situation. When you sell, it will likely create a tax liability of around $1,800 per year times the number of years you’ve depreciated. The actual tax calculations between the purchase price, sales price, associated costs, capital gains, and depreciation recapture are pretty complex and require a better-than-average tax knowledge. I strongly suggest you get a CPA to help you with it.  But for planning purposes, you can guesstimate about 25% of the depreciation.

The Appreciation Myth

Sometimes, you can make good money on a house if it increases in value relatively quickly. These are the stories that make everyone want to be a landlord! What isn’t mentioned is that when you look at the big picture, real estate prices over time have increased at almost exactly the same rate as inflation. For every single big jump, there is a corresponding decline, either in a different period of time or in a different market. Yes, you can make a lot of money off a lucky purchase, but you can lose money with only a small market decline.

Many, many military families own homes that are worth less than the purchase price. One military family I spoke with told me they were “upside down in the home to the tune of almost 80K” at their fifth year of home ownership. Even today, in this red-hot market, I know people whose homes have only now caught up to their pre-2008 values.

Opportunity Cost

Opportunity cost is defined as “the loss of potential gain from other alternatives when one alternative is chosen.”   Rental property can have a couple of opportunity costs.

The first is what you could be doing with the equity in the house. Let’s say you could sell and come away from the transaction with $50,000. How could that $50,000 benefit you if you paid down debt, put it in your retirement accounts, or paid for more education?

The second is any monthly money that you’re putting into the property. I hear folks say, “Well, we’re $200 a month out of pocket, but it’s a good investment.” I challenge those people to run the numbers on how much they’re “making” on that investment property, and compare that with what the same money could do elsewhere.  Once again, start by considering paying off debt, funding a retirement account, or getting a better education.

Lastly, there is the opportunity cost of the time involved to manage a property. Even if you have a property manager, you will still spend some time on house-related issues. And if you’re self-managing, and put a lot of sweat equity into your properties, then you’re definitely missing out on something else you could be doing during that time.

Should You Sell At A Loss?

There is no single right answer to whether you should sell at a loss or rent and try to make up the difference. Every single situation is different, and every family has a different ability to withstand the stress and financial turmoil of being a landlord. The important things is that you make an informed decision after looking at all the variables.

Here’s what one military spouse told me,

“It took running the numbers over and over…best case scenario (good tenants, no time between turnovers, etc) vs possible scenarios (replacing carpet, going a month or two without tenants, etc) which included losing our homestead tax deduction. It evened out at about 5 years before having it as a rental made financial sense. So it would have taken 5 years with NO adverse expenses in order to break even selling. It was not worth the risk.

Best decision we ever made, even though cutting a check at closing really stunk.”

When considering your options, be sure to include the following factors:

• property management fees
• real estate taxes
• insurance, including umbrella liability if appropriate
• potential vacancies
• maintenance and repairs
• capital improvements
• liability
• stress
• natural disasters
• taxes upon sale of the property
• your savings
• your monthly budget and its ability to absorb the costs of the property

In many cases, even a property that looks profitable at first glance turns out to be a loss when you include every single expense, especially that dratted depreciation recapture.

How To Sell When You Can’t Afford It

Deciding that it is better to sell at a loss is only half the battle – then you have to actually do it! It’s painful, but it will get the pain over with and allow you to start moving forward.

If you are underwater, or don’t have enough equity to cover your closing costs, you have a couple of options.

1. Use your savings. Make up the difference by bringing your own cash to the table. This may feel the worst up-front, but it is the best option and will allow you to move on the fastest.
2. Take out a personal loan. Interest rates won’t be great, but you’ll only be worrying about the loan and not all the other parts of owning a rental property.
3. Talk to your mortgage company about your loss mitigation options. You may be eligible for a deed-in-lieu of foreclosure or a short sale, sometimes called a compromise sale by the Department of Veterans Affairs (VA.) You will generally have to exhaust all your own resources before being eligible for a short sale, but you may have some protections if you are pursuing a short-sale due to a Permanent Change of Station (PCS) move.
4. (and I debated not even including this option, because it is almost never a good choice.) Borrow from your retirement accounts. This is not a great choice for a number of reasons, including the temptation to not pay the money back, the opportunity cost of the money being out of your retirement account, and the possibility that you’ll leave employment/the military and have to pay it all back at one time.

When You Might Not Want To Sell

Even with the knowledge that keeping a rental will cost you money, it still might be the right choice.

You may have legitimate reasons for holding on to a rental property that costs you money each month. For example, my husband once had 10-month orders to a school, and we knew that our family would return to the same area. We were unable to find a 10-month tenant at market rents, so we chipped in to the costs each month so that the house would be occupied at some level. If you have a location where you are guaranteed, or even very likely, to return, you may decide that it is worth the monthly cost to have that home available upon your return. This can be important if you have a situation that makes finding a rental harder, such as pets, a particularly large family, the need for handicap access, or if you have extended family living with you.

Also, some people may come out ahead by waiting to sell. With a solid lease, good tenant selection, and some luck, holding on to a house might make you some money. If you’re willing to gamble on that possibility, then great. Just be sure you understand that you aren’t guaranteed to have a smaller loss by waiting, and you might have a significantly greater loss.

Home ownership is always risky business, and military life increases that risk. When faced with the prospect of selling at a loss now, or renting the property in hopes that the situation will improve, be sure that you are thoroughly considering all the factors. It’s hard; no one wants to lose money, and it’s easily to become emotionally attached to a house. Sometimes, the right choice is to take the loss now and move on with your life!