If buyers can manage the financial risks, it could be a good time to capitalize on flat-to-falling prices in order to upgrade your residence or relocate to take advantage of career opportunities. Property owners should fully analyze all options involved in the decision- the sell vs. rent and buy components.

Example:

A buyer owns a three-bedroom house with a 30-year fixed rate mortgage at 3% could sell for $1.5 million, netting a gain of $300,000 before considering if the gain would qualify for exclusion. The buyer wants to upgrade to a four-bedroom.

A suitable property with a motivated seller is available for $2 million. If we also assume the buyer has good credit and $5 million in taxable investments including stock, what questions should they ask before deciding? Let’s look at a few potential scenarios for how this could play out below and the subsequent risks that should be considered.

Sell Now and Purchase with a Mortgage Scenario

The traditional approach in a normal housing and interest rate environment might be to sell the current home and buy the new home, taking out a new mortgage. A buyer who owns a home and used it as a primary residence for at least two years of the previous five years could exclude up to $500,000 of gain from their federal income taxes for a married taxpayer.

This would make the sale federal income tax free, given the above assumptions. Since the new mortgage rate would be much higher, the monthly mortgage payment would increase significantly.

This might be worth it if the new home is selling at a nice discount from normal market conditions. The sale of the old house might not sell for as much as hoped for, but since the new house is more expensive, the purchase discount could exceed the sales discount.

Sell Now and Purchase with Cash Scenario

The person in the scenario above could sell their current home and some stock to pay cash for the new one. They may be able to avoid tax on the sale of the home if they qualify to exclude the gain under Section 121 of the Internal Revenue Code. Similarly, taxes may be owed if there’s a taxable gain in the stock position sold, so they may look to sell stock that hasn’t appreciated or offset the gain with losses from other investments.

The homeowner could explore non-mortgage short-term financing options to pay in cash.

Rent Now and Purchase with Cash Scenario

Going back to the original scenario, assume the homeowner wants a new home at a good price but doesn’t want to sell the current home at a discount.

They could rent out the existing home at least until the market recovers. To qualify for up to $500,000 of federal income tax-free gain on the sale of the property, sell within three years of moving out.

At the time of sale, the homeowner owned the property and used it as a primary residence for two of the past five years. Keeping it longer than the three years would lose the primary residence gain exclusion, but they could still potentially exchange the rental for other business property to help avoid those taxes.