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If you're looking to start building a real estate portfolio or want to expand beyond your current home, you may be wondering how to finance your acquisitions. One method is by tapping into the equity you've built in your personal residence. A home equity line of credit (HELOC) is a popular way to do this, but another viable way to utilize equity and reduce your cost of living is by downsizing your home. It's a wonderful strategy for real estate investing, but there's more to it than just selling your current home and buying a smaller house. This article covers not only why an investor may want to downsize but also includes a complete step-by-step list to downsizing your larger home.
What is downsizing?
In its most basic definition, to downsize means moving from a large home to a smaller home. It will involve selling your current residence, which presumably is larger and more expensive (or at least has more equity in it) and moving into a new home with less square footage. As long as there is adequate equity in the property, you can purchase the new place for less than you made selling your current one, leaving a fair amount of cash in your pocket when all is said and done.
You might want to consider downsizing if you have paid down a significant portion of your mortgage, your existing home has appreciated significantly since your originally purchased it, or you think the offset in monthly or yearly expenses associated with your current home could be enough to cover purchasing an investment property.
There are additional benefits beyond the profit difference you made downsizing that you will be able to pocket down the line. Depending on what you purchase as your new place, it's likely you'll also see a reduction in your monthly mortgage payment, property taxes, homeowners insurance, utility bills, and general maintenance of the property. That can potentially be counted on for "extra" money each month, which you can redistribute and utilize as you see fit.
If the goal is to achieve financial freedom through your real estate investments, you now need to earn less from your investment properties in order to replace or exceed your current expenses.
What are the investor benefits of downsizing your home?
Downsizing isn't just for a retiree moving to a senior living community or an empty nester who wants to buy a condo so they can start traveling. There are many great reasons to consider downsizing at any stage of life, especially for an investor. When looking to finance investment properties, you will likely need a bare minimum of 20% down to obtain a conventional mortgage.
This can be a huge hurdle to overcome, especially if you're just starting out. The median sales price of a residence as of February 2021 was $313,000, according to the National Association of Realtors. That means you would need nearly $63,000 to purchase a secondary investment property.
Obviously, this will depend on your particular market, but for many people, this amount of cash is not readily available or on hand outside of a retirement account. By choosing to downsize your personal residence, you can take the profits from the sale of the home and use them as a down payment on your next property, using the remaining balance for an investment property.
Thankfully, homeowners have exemptions up to a certain amount from having to pay capital gains on the profit from a personal residence, meaning equity earned isn't subject to the same taxation as an investment property. This gives you more money for your next home and investment property.
How to downsize your home (step-by-step list)
The downsizing process may seem a bit intimidating. Below is an easy step-by-step list that works well for most homeowners who are ready to downsize their home.
- Do any necessary home repairs, then have a Realtor give you a proposal for listing your family home, making sure to include factors like closing costs so you know exactly how much you should walk away with.
- Have your real estate agent also run a search for a smaller place you would be happy living in. That way, you know what you'll need cost-wise for your new home. You can also start a secondary search for the investment property you have in mind, although this can wait until after you are settled into the new place if you prefer.
- Make sure to have a garage sale or yard sale to eliminate the clutter prior to listing. Be ruthless -- not only are you moving your stuff from one home to another, you'll also be moving into a smaller space. Furniture that worked in your current home may not work with a smaller floor plan. Only keep belongings with sentimental value or functionality that will actually work in a smaller space; otherwise, you'll end up paying for a storage unit, which will eat away at the housing costs you're looking to save.
- Once you're comfortable with the difference in list price between your existing home and the cost of your new space, you can get your house on the market. Keep in mind that you can look for your new real estate at the same time. If you find a home you love, you can always put in an offer contingent on the sale of your current residence.
- Close on your two pieces of real estate, and notify your tax accountant about the sale so they can assist you with the proper setup for future taxation. Once you're settled in the new space, it's time to start the search for your investment real estate with the difference from downsizing your home.
The Millionacres bottom line
The downsizing concept is not a new one for homeowners or investors, and the downsizing process doesn't have to be difficult. Just follow the steps above, and carefully consider the true costs of the transactions so you have plenty of capital left over to purchase a real estate investment. You don't want to be living in a tiny home for no reason. Seeking the help of professionals like a Realtor and an accountant will go a long way toward making sure you catch anything you might have otherwise missed when downsizing.
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