Should you rent or sell your home if you’re setting off overseas?

My wife, Rebecca, and I faced this rent vs. sell predicament back in 2018 when we decided to move from Virginia to Mexico.

As a former tax attorney for the Internal Revenue Service (IRS), I was aware of many of the relevant laws, but I still learned some important, and surprising, lessons during this process. Here, I would like to share with you the story of how we tackled the rent or sell dilemma, so that it can help inform your decision if you’re thinking of relocating overseas.

An Investment in Our Financial Future

Real estate is a critical element of a well-balanced investment portfolio. But 20 years ago, when Rebecca and I were looking to purchase our first home, we were more concerned with whether we would be able to afford a house rather than how it would look next to our stock holdings.

At the time, housing in the trendy Virginia neighborhoods just across the Potomac River from our jobs in Washington, D.C. was so in demand that would-be buyers were routinely forced to bid more than asking price and forgo home and safety inspections. This made us nervous. Moreover, the amount of money the bank wanted to lend us (back in those madcap days pre-global financial meltdown) was more than either of us could ever imagine paying back.

Because we were adverse to being house poor — that is, we didn’t want to spend the majority of our incomes on a mortgage — Rebecca and I went with our gut and decided on a cheaper option.

We purchased a 1940-built townhouse on the proverbial “wrong side of the tracks” for half of what we would have spent on a slightly larger single-family house in a more popular neighborhood. But we felt safe in the new house and planned to use the money we were not paying to the bank for the travel that we both loved to do.

It turned out that luck was with us. As our Realtor had predicted, we were on the vanguard of our new neighborhood’s gentrification. Modern housing developments were built on either side of us, more shops and restaurants moved in, and our area became known as the quaint, colonial neighborhood. Then housing prices in the entire city began to rise.

When we purchased our home in 2000, the city assessed our land and house at $127,900. Ten years later the assessment was $378,420. And by the time Rebecca and I decided to move our family to Mexico in January 2018, it was $516,168.

Choosing Between Two Attractive Options

Rebecca and I had a difficult choice to make about the house after deciding to move overseas. Should we rent it out and use the monthly rental income to help pay our expenses in Mexico, or should we cash out and take advantage of a federal law eliminating tax on the substantial gain we would realize by selling?

Renting had advantages. The monthly rent would provide a steady stream of income to partially replace the salaries we were leaving behind and thereby reduce the amount we would need to draw from savings to meet our daily living expenses. The income would cover our rent in Mexico, tuition for our children’s school, and, as I liked to joke, leave a few dollars for tacos. As fiscal conservatives (at least when it comes to spending our own money), Rebecca and I liked that rental income would provide a financial cushion until we could develop several business ideas we wanted to pursue.

Another point to consider when moving overseas is that rental income can help you secure a residence visa in your new country. While this wasn’t relevant to our situation, some nations—Uruguay, for instance—require a provable stream of income to gain permanent residence. Rental income can help you meet this requirement.

There are downsides to renting as well, however, as we learned in researching our options. First, the cost of a management company to advertise and oversee the property would bite into our profit. These companies often charge a fee equal to one month’s rent to find a renter and then 8% to 10% of the monthly rent to maintain the property and respond to issues raised by the tenant. While online sites such as Craigslist exist as free platforms to help connect landlords and tenants, those tools can’t manage the property.

Second, we would have to report the rental income as taxable, further reducing what went into our pockets.

Rebecca and I also found selling to be an exciting option. Based on conversations we had with several local Realtors, as well as our independent research using the online tool Zillow, which uses comparable properties to estimate a home’s market value, we anticipated we could sell the house for roughly $600,000.

In that case, we would make a profit of $400,000 after subtracting our initial purchase price and the cost of the capital improvements we had made, which totaled $200,000. We could invest the $400,000 profit and use the returns to cover expenses in Mexico.

Further, under section 121 of the Internal Revenue Code (the housing exclusion), none of this $400,000 profit would be taxable. The housing exclusion allows a married couple to eliminate from income up to $500,000 in gains on the sale of a home. A single person can exclude up to $250,000.

To qualify for this exclusion (and this is crucial to understand if you’re considering selling your home), married couples and single persons must meet the ownership test and the use test.

You’re eligible for the exclusion if you have owned and used the property as your main home for a period aggregating at least two years out of the five years prior to the sale. You can meet the ownership and use tests during different two-year periods, but you must meet both tests during the five-year period ending on the date of the sale.

If we sold our house, we would meet both the ownership and use tests and be able to exclude all of our profit, resulting in zero tax.

Without the benefit of the housing exclusion, the 10% capital gains tax rate meant we would pay tax of $40,000 on the $400,000 profit. Forty thousand dollars is more than we anticipated it would cost our family of four to live in Mexico for one year. That’s a lot of money to pay in taxes.

The Reasons We Rented

Several factors contributed to us making the decision to rent out our home. First, we immediately found a reliable renter on our own whom we could trust to take care of the house and yard. We provided her with contact information for local repair people we had previously used, eliminating the need for a management company.

The rent we collect is taxed as ordinary income (Rebecca and I pay in the 12% tax bracket, but rates vary from 10% to 37% based on income and filing status). Still, not incurring the cost of a third-party management company meant more money in our pocket.

Second, given the nature of the Washington, D.C. metro area—highly transient with close-in housing such as ours in high demand—we expected the value of the home to continue to rise. Further, because the housing exclusion use test provides a two out of five-year window, we didn’t immediately have to sell to gain the tax benefit.

In the simplest application of the test, we had up to three years after moving out to sell. If our date of sale was in January 2021, the five-year lookback period would run from January 2016 to January 2021, and we would have lived in the house as our primary residence from January 2016 to January 2018 and would be able to exclude the gain.

The final reason we decided to initially rent rather than sell was that we wanted a place to come back to in case things in Mexico didn’t work out.

Decision Time, Again

In June 2020, our tenant informed us that she would be moving out in August. By this time, we were two-and-a-half years into our Mexico experiment and committed to our lives there, with no plans to move back to the U.S. We were ready to re-explore our options with regard to the house.

My first reaction was to sell. We were still within the two out of five-year window to meet the use test and exclude our gain from taxation. Realtors we spoke with (and the online platform Zillow) predicted we could now sell the house for $100,000 more than two years previously, meaning we would save about $50,000 in taxes and have the entire $500,000 profit in hand to invest.

Rebecca wanted to continue to rent. A kombucha business we had started and the Spanish-language courses she had been running in Mexico were intermittently profitable, but she liked having the steady rental income.

Another reason Rebecca wanted to hang onto the house was to realize additional appreciation that several local Realtors predicted after Amazon announced it would be building its second headquarters in the area.

While we were still debating what to do, fate intervened. I was discussing our dilemma with a friend who has investment expertise and he offered something that Rebecca and I hadn’t fully understood. He explained that the rate of return we earned from renting was more than we would likely get if we sold the house and invested the gain.

At that time, we were clearing approximately $25,000 per year in rental income after paying property taxes, homeowners insurance, and maintenance expenses. (We had paid off the remaining mortgage before moving.)

If we were to sell the house and invest the $500,000 gain, we would have to find an investment that delivered a 5% return to realize as much as we were getting in rental income. While we might be able to find that rate of return in a corporate bond or publicly traded stock, those asset types are typically riskier investments than real estate.

Around the same time that I had this conversation with my friend, Rebecca and I found through word of mouth a family with good careers and who would pay a slightly higher monthly rent than we had previously been receiving. This made the decision to rent again easy.

Plus, I knew the housing exclusion wasn’t completely off the table. Under the law, we could reset the five-year period critical to the use test if we decided to move back into the house as our primary residence and stayed there for two years—or more if that suited us. Although it’s not in our minds to move back now, it’s not out of the realm of possibility. And why not? The house has been good to us.

Ultimately, the decision of whether to sell or rent your home is a personal one. There is no one-size-fits-all solution. However, as our story shows, a crucial financial consideration that every homeowner should keep in mind is the housing exclusion. If you end up selling your home outside of the two out of five-year window, you may have to hand over a big chunk of the sales price to Uncle Sam.

So, if you decide to hold onto your home for some years after moving overseas, be aware of how this tax could impact your finances down the road.

This story originally ran in International Living.