Why Turning A Primary Residence Into A Rental Is A Bad Idea

If you’re thinking about or already have turned a primary residence into a rental, you might want to rethink that. Even if your property is allegedly in a “high appreciation” market, it still may not make financial sense to hold on to it. To understand why, it all comes down to a numbers game, especially taxes. In this post, I will share why I decided to sell my very 1st primary residence instead of turning it into a rental, how I determined that was the best financial decision, and the numbers to back up my decision.

Is it even legal to turn a primary home into a rental?

Before I dive into my home sale and all the numbers behind it, I first want to call out the legality behind turning a primary residence into a rental. If you purchased the home entirely with cash, then you have no loan. That means you can pretty much do what you want with the home (unless renting it out is forbidden by your HOA).

However, most people purchase a home with a loan. When you do that, the terms of your loan specifically state the intended use of the home. So if you tell the lender it’s going to be your primary residence (owner occupied), you can’t use the home as a rental immediately after purchasing it. If you do, that’s bank fraud and can result in jail time!

In most cases, people do live in it for a while and then consider turning it into a rental after several years. Is it legal to do this at that point? Well, the answer is that it depends. I strongly recommend you contact your lender to find out. You don’t want to wind up in a situation that’s potentially fraudulent.

To play it safe, I think turning a primary home into a rental can be done by simply refinancing your home and replacing your owner-occupied mortgage with an investment property mortgage. That way, the terms of your loan legally allow you to rent out the home.

Do the numbers even make sense?

Back in 2012, I purchased my 1st home for $390,000. In 2015, I sold my home for $650,000. 

Fast forward to today, and now it’s worth about $800,000. So in the past 5 years, had I kept the home, it would’ve appreciated an additional $150K. Additionally, if I turned it into a rental, how much rental income would I have brought in over those 5 years? The answer comes out to roughly $6,000 per year plus principal pay down of my mortgage, totaling about $50K of additional cash to me (forget about taxes for simplicity’s sake). 

The question I have to ask myself is, “Have I made more money from the proceeds of my home sale over the past 5 years, or would I have made more money by renting it out?” First, let’s talk about the sale of my home. Because I lived in my home for at least 2 years between 2012 and 2015, selling my home qualified for the home sale tax exclusion rule. The rule states that if you live in a home for 2 of the past 5 years, you do not have to pay capital gains taxes on the first $250,000 in profit ($500K if you’re married and you both own the home jointly!). So my $650K home sale, minus 6% in sales commissions, came out to $611,000. Subtracting my purchase price of $390K, my profit was $221,000. Therefore, using the home sale tax exclusion rule, I paid $0 in taxes and pocketed the entire profit!

Alright, so I had $221,000 in cash, plus about $100K in equity I had in the house. Therefore, I had $321K of cash to invest elsewhere. Assuming I invested that into the S&P 500 in 2015, that $321K would’ve turned into $675K, a $354K profit!

On the other hand, had I kept the home during the same 5-year timespan, I would’ve been able to sell at $800K and collected an additional $50K in profit plus principal paydown. Applying the same $250K home sale tax exclusion rule on an $800K home sale, my profit would’ve been $362K. Of that $362K, $250K of it is tax-free. That leaves $112K of the profit getting taxed at a max of 20% long-term capital gains. So my final proceeds would’ve been $339,600.

Here’s a summary of what all those numbers look like:

So instead of blindly assuming that turning a primary residence into a rental is always the right financial decision, I strongly urge you to run the numbers, factor in the home sale tax exclusion rule, and consider the full opportunity cost before deciding! I will admit that if your home has a reasonable profit margin as a rental, it’s probably not a bad choice, but is it the best? Well, that’s highly dependent on your unique property and how the numbers play out!

Converting a Primary Home to a Rental: Frequently Asked Questions

Before holding onto residential real estate, evaluate alternative wealth-building vehicles. Review our analysis of why stock market investing builds enduring wealth or test your numbers with our free Real Estate Evaluation Tool.