Rental Properties vs. Stocks and Bonds

Q: I bought a rental property that has increased in value considerably. The cash is great, but I’m wondering if I should sell high and invest in a different asset.
– Russell in Portland, Ore.

A: “This is a situation where there really is no one-size-fits-all answer,” says David Walters, a certified public accountant and certified financial planner with Palisades Hudson Financial Group.

To tackle this question, you’ll want to first get a handle on just how well this investment is performing relative to other assets.

For a simple apples-to-apples comparison, take the property’s annual net cash flow (income minus expenses) and divide it by the equity in the home, he says. You can use this yield to see how the income generated by this property stacks up against that of other investments, such as dividend-paying stocks.

To calculate your total return, take that yield and add it to your expected annual long-term price gains. If your yield is 5%, for example, and you expect the value of the property to appreciate 2% a year on average, your annual total return would be 7%.

Next, you’ll want to figure out just how much you would have left to reinvest after you pay the real estate broker (typical commissions are 6% of the sale price) and the taxes. “In this case, taxes could be a big factor,” says Walters.

Remember, because this is an investment property, you are not eligible for the capital gains exclusions ($250,000 for individuals and $500,000 for couples) available when you sell a primary residence.

Assuming you’ve owned the house for more than a year, you’ll owe the long-term capital gains rate, which is 0% to 20% depending on your tax bracket; for most people that rate is 15% for federal taxes. Your state will also want its share, and in Oregon it’s a pretty big one – 9.9%.

There’s more to it. If you depreciated the property – odds are you did – you’ll need to “recapture” some of that write off when you sell, and at your marginal income tax rate. Here too you’ll owe both federal and state taxes.

One way to avoid paying a big tax bill now is to do a 1031 exchange, in which you effectively swap this property for another investment property in another neighborhood or a different market — though there are plenty of caveats.

Assuming you don’t want to re-invest in actual real estate, the big question is where you should invest the proceeds of the sale – and is it better than what you already have?

You could look at alternative assets that have a similar risk and reward profile — dividend-paying stocks, real estate investment trusts or master limited partnerships.

A better approach, however, may be a more holistic one. “You want to know where this fits in the big picture,” says Walters. Rather than try to pick and choose an alternative investment, you may just roll the proceeds into your overall portfolio – assuming it’s appropriately diversified. If you can max out on tax-deferred options such as an IRA or, if you’re self-employed, a SEP IRA, even better.

Depending on how much other real estate you own, you could allocate up to 10% of your overall portfolio to a real estate mutual fund, such as the T. Rowe Price Real Estate Fund (TRREX) or Cohen & Steers Realty Shares (CSRSX).

The tradeoff: “Most of these funds own commercial real estate,” says Walters. “There aren’t a lot of options to get passive exposure to residential real estate.”

Then again, investing in actual real estate takes time, lacks liquidity, and comes with some big strings attached. On paper, your investment property might seem like a better deal than any of the alternatives, says Walters, “but there are 50 other things you have to think about.”

With real property there’s always the risk that you’ll have to pay in money for, say, a new roof or heating and cooling system. That's one thing you don't have to worry about with a mutual fund.