With interest rates hovering at relatively low levels and many millennials choosing to rent rather than buy, the rental housing market is looking increasingly attractive for an investor interested in a rental property investment. In fact, some of these investors are encouraging everyday people to put their extra cash to work in a way outside of the market, through rental property investments. HGTV makes investment property ownership look easy, but the reality is very different from reality TV.
Let’s start with, the reason why are you considering adding rental property to your portfolio. The additional stream of income can be enticing. Do you love to mow grass weekly in the summer? Do you like 1 am calls from your tenants with a leaky sink? Yes, of course, you can hire a property manager for these things, but then that stream of income starts to look a little less appealing.
Time and money
Actively participating in the real estate market comes with a different set of benefits and challenges than traditional investing. Many of our clients participate in the real estate market, within their investment accounts rather than via investment property ownership. By including the exposure in investment accounts, you can reap the benefits of diversification without the headaches that come with being a landlord.
If you are still determined to build an investment property portfolio, you first have to decide if a rental property fits your lifestyle. Just as in traditional homeownership, you can expect the unexpected with rentals and tenants. Adding a property to your portfolio comes with stress, time commitments, and risk. Do you have room in your life for more of all of that? If you can resoundingly check that box yes, then let’s move forward.
Fitting all the pieces together
Now, how does a rental property fit into your financial plan? Assuming you are diligently saving for your retirement and have a well-diversified investment portfolio, a rental property may complement your plan. I like to think of rental properties as satellites to your core plan.
These satellites have different tax ramifications and things to keep in mind. The compensation you earn from your rental property is considered ‘passive income.’ Although this income is specifically classified, you may use the loss to deduct against your nonpassive income in certain circumstances. As a couple ‘Married Filing Jointly’ and you make signifigicant management decisions such as approving tenants, you are considered to be actively participating in rental real estate. Therefore, you may qualify for a special $25,000 allowance which is a unique strategy to use passive losses to offset nonpassive gains, dependent on your income level. If your income is less than $100,000 (Married, Filing Jointly) you may deduct up to $25,000 of losses. And if you fall in between $100,000 and $150,00o the deduction will be phased out and eliminated when your income is above $150,000.
Don’t forget about Uncle Sam
Another critical tax difference in rental property investments is how you may depreciate the value. Unlike a vacation home that you spend more than 14 days in a year, a rental property can be depreciated over 27.5 years. This depreciation figure will be a line item on your taxes that helps to reduce your tax liability of the property (but remember, this is ‘passive income’). Once you sell the property, that depreciation is recaptured at the time of the sale, and you will pay tax including depreciation and the gain.
When it comes time to begin searching, your criteria will be quite a bit different than when you purchased your first home. Not all properties are valued the same way, and you need to be aware of that before buying or selling. One to four unit buildings are considered ‘residential,’ meaning they are valued through comparable properties that have recently sold. Anything 5 units or more is considered ‘commercial’ and is valued based on the amount of income it produces annually, net of all expenses other than debt coverage. For these larger buildings, one systematic way to evaluate potential purchases is by using a ‘capitalization rate.’ This formula is designed to tell you the expected rate of return on your investment property as if it were completely paid off.
‘Capitalization Rate’ equals the ‘Net Operating Income’ divided by the ‘Current Market Value.’
The net operating income is the (expected) compensation generated by the property on an annual basis. You determine this figure by subtracting all the expenses, other than debt service, such as routine maintenance, vacancy reserves, and property taxes. The current market value is the reflection of the worth of the property in today’s dollars.
Risk and reward
The risks involved in adding a rental property (small or large) to your portfolio are three-fold. The real estate market is tightly correlated with interest rates. When you are ready to sell, people may not be prepared to buy, meaning your money is not available with just a phone call.
The taxation of rental properties is complicated. There are multiple additional tax forms or schedules that could be involved in your tax preparation once you own a rental property investment. If you are a real estate agent and make the majority of your income from real estate related activities, there are some tax benefits available. Otherwise, if you have losses from the rental, you will be limited in what you can write off on your taxes, as mentioned previously.
Vacancy is the most prominent risk. Vacancies could be due to any number of factors, the popularity of the area declining, the building itself declining, new properties increasing the competition, tenants moving out early, etc.
There is a multitude of podcasts, books, articles dedicated to creative ways to get started in a rental property investment. Many of the principles around approaching mortgages, in general, were touched on in this blog. Simply put, investment property purchases require a more substantial down payment and contribute to your overall debt to income ratio. A debt to income ratio is a way that lenders evaluate your riskiness as someone to lend funds. Many lenders do not include your potential rental income when evaluating your application, making it tricky to obtain funding.
Well, what about dipping into a retirement account to fund this venture? We would highly advise against borrowing, owning property in an IRA (this is a conversation for another day), or distributing assets from a retirement account to fund a rental property purchase.
Let’s take a look at these ‘not options’ one at a time. Borrowing against your retirement accounts is essentially leveraging yourself to increase risk in your portfolio. Anytime properties are involved, additional cost buffers are in place because of the trend to expect the unexpected. Therefore, if you are borrowing to purchase something you can’t afford off the bat, you are setting yourself up for disaster.
Next, briefly, owning property within a retirement account is questionable in terms of the IRS rulings, we encourage you to stay away from the fringes of IRS rules. When this does occur, the property is owned within what is called a self-directed IRA; many custodians do not even offer them because of the potential risks, increased recordkeeping requirements, and potential costs.
Thirdly, distributing assets from your retirement accounts to fund a rental property investment is not advisable because you are going to be paying more for your rental property than you anticipate. In other words, you will be paying tax on the money coming out of your retirement account, and very likely a 10% penalty for the money leaving the account before you reach the age of 59 and 1/2. Paying more for an investment than is required is rarely a way to set yourself up for success.
The path to a rental property investment
Therefore, saving and using non-retirement assets is the most common path to a rental property investment. Jumping ahead to once you take the plunge and have made the purchase, you will need to plan around your new cash flow. If you would like some tips on cash flow management, please check out our blog post on the topic.
You must assume you will have vacancies. Never assume you will have 100% rental income in your cash flow because again you need to expect the unexpected. You will also include maintenance costs in your analysis. Once considering all the costs involved in the ongoing ownership, your once very appealing cash flow number is going to be significantly less.
In summary, a rental property investment can be a nice complement to your portfolio only once you have saved for it. If real estate is something you would like to incorporate in your investments and rental property is not for you, we can include exposure within your investable accounts. Both paths are options we can include in your financial plan; it is a question of which is the right one for you!
Are you considering how you can put your excess cash to work? Do you have any questions or feedback you’d like to share?
I’d love to hear your thoughts, so please feel free to leave a comment below so we can continue the discussion.