A few times a year, a client will ask whether he or she should invest in a residential rental property. The conversation usually starts out like this, “My neighbor said he has a rental property and is able to write off all kinds of expenses.” The client is usually an employee receiving a regular paycheck, maxing out their retirement plan contributions each year, very little in the way of investment accounts, and looking for a way to invest their money while reducing their tax burden as much as possible. I don’t own any rental property myself, but I have worked with many clients who own rentals and I’ve learned a lot about them over the years. The first thing I know is, being a landlord is not for everyone. If it’s always been a dream of yours to chase down rent checks and get calls about clogged toilets at 3 AM, then by all means, buy a rental. But make sure you know what you’re getting into first.
Owning a Rental Doesn’t Mean You Get to Expense All The Things
Yes, when you own a rental property there are certain expenses you can deduct for tax purposes that you can’t deduct on your personal residence, such as utilities, maintenance, and association fees. You won’t be able to take a deduction for the principal portion of the mortgage payment or allocate a bunch of your personal expenses to the rental property. The IRS is not going to buy that you drove 20,000 miles last year maintaining a rental property that is a mile away from your home. You do get a deduction for depreciation on the building itself (but not the land). Depreciation often works in your favor since you’re able to take a deduction for the decrease in the value of the building when in fact real estate (typically) appreciates in value. However, when you eventually sell the property, your basis in the property will be reduced by the depreciation you claimed over years, and you’ll pay tax on the difference between the sales price and the adjusted basis of the property.
You Might Not Get a Tax Benefit at All . . . This Year
The IRS has certain pesky rules about passive losses. Rental income is considered passive, meaning you are not directly earning the income as you do at your job. Passive losses may be deducted from your non-passive income (such as wages), but there are limits. Passive loss limits max out at $25,000, and that number decreases as your income increases. For a married couple with an Adjusted Gross Income of $150,000, the passive loss that can offset non-passive income is zero. If you are a real estate professional your passive losses are not limited. To qualify as a real estate professional, you’ll have to materially participate more than 50% of your time in real estate and spend at least 750 hours per year managing each rental activity. Again, the IRS is not going to believe that you logged 750 hours last year managing one rental property while also holding down a full-time job. The good news is that when you sell the property later on, you’ll get to deduct all of the passive losses that you weren’t able to use in the year you incurred them. That can be a pretty hefty deduction if you’ve been losing money on the property for years, but if you’re looking for big rental losses to offset your ordinary income this year, you’ll probably be disappointed.
Finding a Good Rental Property Isn’t Easy . . . Neither is Getting a Loan to Buy It
When the housing market was in the tank a few years back, investors were paying cash for properties at unbelievably low prices. Now that real estate prices have recovered, you’re probably not going to find a good property at a bargain. If you find an inexpensive property, it will most likely be a fixer-upper and you’ll need the resources and time to get it into rentable shape.
If that elusive perfect property does exist, chances are it will never be listed. Many realtors purchase those gems themselves or know investors they can call that will pay cash for the property with a minimum of effort on the realtor’s part. Unless you have connections, you’ll never hear about the best investment properties.
If you do find a property you want to buy, be prepared to come up with at least a 20% down payment. While banks may be willing to work with buyers with as little as 3% to 5% down on their primary residence, you won’t find terms that generous when purchasing an investment property. Banks know that if things go south, you’re more likely to walk away from an investment property than you are to walk away from the home you live in, so they require more money up front. You’ll also need to have very good credit to get the best terms.
Do You Enjoy Babysitting?
Finding decent tenants can be a challenge in itself. Investing in credit checks and background checks to make sure they are trustworthy will save you time and money in the long term. Responsible tenants pay the rent on time, will take care of your property, and won’t require you to go through the costly and time-consuming eviction process.
Even good tenants come with their share of headaches. Friends of mine rented out their home while attending grad school in another state. They’d put a lot of time and money into the landscaping and stressed to the tenant how important it was to water the lawn and trees. Although the tenant paid his rent on time and didn’t cause any trouble, lawn care was not one of his skills. By my friends’ first visit back to check on the property, the grass and trees were dead and will cost several thousand dollars to replace.
Even if your tenants are perfect, rental properties come with hassles. Broken pipes, clogged drains, leaky skylights, and malfunctioning appliances are a part of life. You may be used to dealing with them in your own home but when they happen at your rental property, they are your responsibility and your renter probably won’t be okay with waiting until you have time to get around to fixing it two weeks from now.
Is owning rental property worth it? Only you can decide, but as with any investment decision, it’s best to know as much as you can – good and bad – before you make the leap.
Author – Janet Berry-Johnson