Downsizing? Should You Sell Your House or Keep It as a Rental?
Moving to a smaller home and not sure whether to sell or keep the house as a rental? Here's how taxes, timing and California landlord rules shape the choice.
"Maybe we'll just rent it out."
I hear some version of that from a lot of people who are getting ready to downsize. It sounds like the best of both worlds: you get the smaller place, you keep the house, and someone else pays the mortgage.
Sometimes it is a great move. Sometimes it quietly costs people a tax break they've been building for decades. Here's how I'd think it through.
The tax break you don't want to lose by accident
When you sell your main home, federal tax law lets you exclude up to $250,000 of gain from income, or up to $500,000 for most married couples filing jointly. To qualify, you generally must have owned the home and lived in it as your main home for at least 24 months during the 5 years before the sale. The months don't have to be in a row.
Here's why that matters if you rent it out first. The day you move out, the five-year look-back keeps moving. Once you've been out of the house for more than three years, you can no longer show 24 months of living there within the last five. In plain terms: if you rent the house out and later decide to sell, the timing can decide whether that exclusion is still available.
Two more tax points to ask your CPA about:
- Depreciation. Once a home becomes a rental, depreciation is generally allowed. The IRS says you can't exclude the part of your gain equal to depreciation allowed or allowable after May 6, 1997, so that portion is taxed when you sell, even if the rest of the gain qualifies for the exclusion.
- Your property tax plan. If you're 55 or older and counting on Prop 19 to carry your tax base to the new home, that transfer depends on selling your original principal residence. Keeping it changes that plan. (I covered Prop 19 in an earlier post.)
What changes when you become a landlord in California
Renting out a home is a business, and California has specific rules. Under the Tenant Protection Act:
- Annual rent increases on covered rentals are capped at 5% plus the change in the cost of living, with a maximum of 10%. The California Attorney General publishes the current limits. For "all other counties" the AG lists 7.7% for increases starting 8/1/25 through 7/31/26, and 8.6% for increases starting 8/1/26 through 7/31/27.
- Once tenants have lived there 12 months (or any one tenant 24 months), you generally need a "just cause" reason to end the tenancy.
- For no-fault reasons, such as moving yourself or a family member back in, you generally owe relocation help equal to one month's rent, either as a payment or by waiving the final month.
- Many single-family homes and condos owned by individuals can be exempt from the rent cap and just-cause rules, but only if the owner gives tenants the specific written exemption notice the law requires. A text or email isn't enough.
None of that is a reason not to rent. It's a reason to go in with your eyes open, especially if you think you might want to sell or move back in a few years from now.
Questions I'd ask yourself
- Do I need the cash from this sale to buy the next home, or to feel comfortable in it?
- Would the rent cover the mortgage, taxes, insurance, repairs and vacancies, with room to spare?
- Am I up for being a landlord, or for paying someone to manage it?
- How long would I keep it, and does that timeline protect my home-sale exclusion?
- Am I counting on Prop 19 for my next property tax bill?
- What do my CPA and estate planner say about selling now versus holding?
There's no one right answer
Some downsizers sell, take the exclusion and simplify. Others hold the house for income or for family and are glad they did. What matters is choosing on purpose, with the numbers in front of you.
I help owners with both paths: selling the home, or getting it ready to rent and understanding the rules. If you'd like to compare the two side by side for your home, call or text me at (805) 400-5543, email CentralCoastLiz@gmail.com, or reach out through my contact page.
Liz Anderson, Broker/Owner, Central Coast Premier Realty | DRE #01462145
General information, not legal or tax advice. Tax and landlord-tenant rules change and depend on your situation, so confirm details with a qualified tax professional and attorney.
Equal Housing Opportunity.
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