What to Do WIth the Old Homestead
Kevin J. Daum

This article was originally published in a 2006 edition of Log Homes Illustrated magazine.

Almost all of my clients begin our conversations waxing on endlessly about the glory and beauty of their log home to be.  After all, when starting a log home project, all the focus goes toward the new house.  The fun is in picking the plan and company, shopping for finish items and the endless daydreaming of the log home they wish they had.  The subject of their current home is usually treated like the forgotten child in these conversations but eventually the decision of what to do with that home comes to the discussion table.

The behavior is certainly understandable.  Plenty of attention is required just dealing with all the stuff involved with building a new log home but the old home subject can’t be ignored.  It is usually an integral part of the financial process for funding the new home and may have to provide temporary lodging until the new home is completed.

Questions run through the mind in abundance. What do I do with the old home? Should I keep it and rent it?  Should I sell it now?  Should I wait and sell it after the build?  Should I rent a place to live while I build?  Will I qualify with both houses?  How can I afford double payments?

Many people are motivated to sell the old house before starting to build the new one for the following reasons.

• Concerns over the need of cash for the build.
• Concerns over affording payments on both houses.
• Concerns over qualifying with both houses.
• Concerns over the housing market.

While each of these concerns may have validity, there are many options in how one can restructure finances to use the house in a financially beneficial manner.  But first you need to address all the issues so you can maximize the financial benefit.  Here are my 5 steps to setting an effective strategy for the old domicile.

Step 1 - Assess your cash needs 

You will need lots of cash for your log home project starting with the down payment for your lot.  Even with a construction loan you will likely have to put out the initial deposit for your log package and pay for permits and fees out of pocket.  You will also need cash reserves to qualify for your loan which can be as much as twelve months’ payments.  On top of that you will need cash to run the project while you are waiting fro draws from the bank. 

If you have lots of cash in the bank then your old house may not be a factor but if most of your money is in retirement or you are cash poor then your existing house will need to provide you with the necessary funds.  This can be handled through use of a credit line or refinance if there is sufficient equity in the house.

Step 2 - Figure out how you will manage your cash flow

The good news here is that many construction lenders anticipate cash flow issues and have created ways to solve the problem before it starts.  Most national construction lenders today require or at least offer the option of an interest reserve.  This is a portion of the construction loan that makes the interest payments for you.  That allows you to manage only the payment on your existing home. 

Additionally, many of the same lenders don’t calculate your existing home payment in their qualification numbers.  By working with these lenders you can adjust your existing financing by taking out cash to manage the project without impact to your qualification for the construction loan.  Ask your loan officer for loans where these features exist.

Step 3 - Consider your living situation

Not all the issues in this assessment are financial.  Moves can be traumatic.  Your new home project will likely take anywhere from nine to fifteen months from the time you break ground.  That is a long time to be living out of boxes.  If you have kids you may be disrupting school issues and just the stress of a double move can be taxing.

On the financial side a double move can cost thousands of dollars and increases the likelihood of damage to your property.   In addition you will have the added challenge of finding an interim place to rent.  Lastly, unless the real estate market takes an unlikely dive in values you will lose out on any appreciation during the year you are building. 

Step 4 -Take into account tax deductions

There are lots of tax factors regarding the interest on your existing home.  If you refinance to take cash out of the existing home some of it may not be tax deductible.  The IRS and most states with income tax limit interest deductibility to the amount of your original or smallest loan amount plus the cost of any capital improvements made over the years plus $100,000.  So for example if you now only owe $50,000 and you have made another $50,000 fixing up the place you will only be able to deduct interest on $200,000 even if you borrow $300,000. 

Even if you have high loan balances you can only deduct interest on a maximum of $1,000,000 combined between the new project and the old house.  This should be taken into account in how you structure the debts long term and may play a role in how much you borrow on the old house versus the new project.   If you sell the old house early you will lose the tax deduction benefit from your payment and will get zero deduction for any rent you pay.  Be sure to consult with your CPA to run all the numbers.

Step 5 - Determine the viability of keeping the house long term

Often people think they might keep their existing house as a rental property.  With real estate appreciating at record rates it certainly bears consideration.  Two issues need examination to make a good decision.  First is the issue of capital gains.  If you have lived in this house for more than two years you are entitled to take your gains tax free up to $125,000 per person or $250,000 for a couple.  This could save you as much as $62,500 in taxes in some states.  But you can only take the savings if you sell the property.  Otherwise turning the property into an investment will eliminate the savings after three more years since you had to have lived there for three of the last five years.

The second consideration is whether or not your current home makes for a good rental investment.  The best rental properties are lower priced simple homes.  Houses on the lower end get higher rent versus value and tend to appreciate better than higher end properties.  So if you are moving out of a “McMansion” you may be better off selling it, taking the tax free gain and reinvesting the cash into cracker box houses in the city.  It may take a little work but could result in tens of thousands of dollars in benefit.

Once you have done your homework and developed a strategy, in most cases you will determine it is probably worth saving the hassle and moving costs to keep the existing home at least until the new house is built and you are ready to move in.

Here are three basic options available to you to make your strategy effective.

Option 1 - refinance to take cash

There are plenty of programs out there to tap into your equity.  Whether you get a Home Equity Line Of Credit (HELOC) or a simple refinance you should be able to get as much as 90 percent of the existing value of your home without paying exorbitant rates and fees.  To determine which type of loan is best have your loan officer set out several options on a spreadsheet or a piece of paper to show you the mathematical differences.  There is no right or wrong here, only cheaper and more expensive.  Make sure you figure in the costs and payments as well as the tax deduction factors when analyzing the difference.

Option 2 - refinance to lower payment

If you are considering the first option you should already be addressing this issue.  But even if you don’t need the extra cash you have the option of saving money here.  You now can assume you will not have this house for more than 2 more years.  For those of you paying on 15 or 30 year fixed loans you are now making unnecessarily high monthly payments.

Have your loan officer show you 3 year fixed Interest Only loans that are sure to bring down your payments for the next couple of years until you sell, or maybe even option ARMs.  You could save thousands of dollars. Loans with low points and fees are desirable here but beware of pre-payment penalties.  Ask for 1 year prepayment penalties or “soft” penalties that prohibit refinancing but allow you to sell the house without a problem.  Make sure you analyze the math to make sure you make up for any closing costs with payment savings.

Option 3 - Sell and buy an interim house

For those of you who don’t mind the double move and know that you are at least two years from moving in to the new place, you have a chance to make a little more money.  The government allows you to take the capital gains benefit discussed earlier every two years.  This means you could sell today to release your cash tax free.  Then find a house to buy and live in while building the new house.

When two years have passed you can sell the interim house with a brand new tax free gain and move to your log home.  Or find the perfect little rental and move in there for two years before renting it out for another three years.  Either way you can take advantage of the tax savings not to mention the appreciation.

If you are going to try to time the sale of your house with your move in you should keep a steady eye on the market conditions in your neighborhood.  Your real estate agent should be able to give you a fair assessment of timing and the needs for selling your home.  You have the time to make small adjustments that may improve your price so go for it.

Whichever options work for you it is best to address this old home issue and act on it early in the process.  Cash availability and payment management are big issues in a construction project.  The sooner your strategy is set the sooner you can get back to focusing on your log home heaven.

About the Author...
Kevin Daum is the Founder and CEO of Stratford Financial Services, a Real Estate finance and education company, founded in 1989. Stratford specializes in Purchase loans, Refinance loans and Custom Home Construction finance and has successfully financed thousands of clients. He is the author of "Building Your Own Home for Dummies" (Wiley), as well as "What the Banks Won’t Tell You." Mr. Daum was an Underwriter for Plaza Savings and Loan and Key Bank of New York. He is an INC 500 CEO and has been listed as one the 40 Most Influential People Under 40 in the San Francisco Bay Area. He is the Global Chair for the Edison Innovation Program with the Young Entrepreneurs' Organization (YEO) and is a founding Board member of the Bay Area Chapter of YEO.

Mr. Daum is a frequent contributor to numerous business publications on the subjects of Real Estate and Small Business leadership and speaks regularly on both subjects. He can be contacted at kevin@stratfordfinancial.com.