Owning a rental property can be financially rewarding. If you're exploring this type of real estate as an investment, be aware of the risks and responsibilities.
Rental Properties: An Overview
The idea of buying a home or apartment to rent out for profit may sound alluring. But buying a rental property for income and long-term capital appreciation can have its ups and downs. For example, the housing market can fluctuate depending on location, supply and demand, and the economy.
Financially speaking, in order for the rental property to be really profitable, the return you reap should be greater than what you could earn in conservative investments, such as bonds and dividend-paying blue-chip stocks, because of the real risks involved. And on the human side, not everyone has the ability to manage property and tenants.
- Rental properties can be financially rewarding and have numerous tax benefits, including the ability to deduct insurance, the interest on your mortgage, and maintenance costs.
- The drawbacks of having rental properties include a lack of liquidity, the cost of upkeep, and the potential for difficult tenants and for the neighborhood's appeal to decline.
- It's key for investors in any type of real estate to stay on top of interest rates and consult a tax professional, particularly with the recent changes to the tax code.
Pros of Rental Properties
There are several benefits to owning a rental property. They include:
The Internal Revenue Service allows you to deduct many expenses connected with rental property in the categories of:
- Ordinary and necessary expenses
This means that you can deduct your insurance, interest on your mortgage, maintenance costs, and physical wear-and-tear on your property.
Depreciation may produce a nominal loss, which in turn you may deduct against other income. In other words, you may achieve net positive cash flow from the rental income minus expenses and still have a net loss for tax purposes. But be aware that depreciation also reduces the cost basis of a property for calculating capital gains when you sell your property.
In addition, the 2017 Tax Cuts and Jobs Act offers a number of tax benefits for landlords. If you own a flow-through entity (also known as a pass-through business) and operate it as a sole proprietorship, limited liability company, partnership, or S corporation, you now may deduct an amount equal to 20% of your net rental income—as long as your total taxable annual income from all sources after deductions is less than $157,500 for singles or $315,000 for married couples who file jointly.
Being a landlord is not everyone's cup of tea. Before jumping in, make sure you're willing to deal with everything from late or unpaid rent to tenants who damage your property.
If you rent your property seasonally, you may use it yourself for 14 days per year—or 10% of the number of days that you rent to others at a fair market price—and still be able to deduct your expenses.
In a 1031 exchange, you can sell a rental property and invest in another of “like kind” without paying capital gains taxes.
Renting Extra Space
You can also treat a room or area of your home—such as a garage, basement, or accessory dwelling unit—like a rental, writing off a percentage of the mortgage interest and other expenses against its income, although you should be aware of the potential pitfalls of renting out extra space, including local zoning rules.
The Pros And Cons Of Owning Rental Property
Cons of Rental Properties
There are also drawbacks to owning a rental property. They include:
Lack of Liquidity
Real estate is not a liquid asset. Even in the hottest market, it can easily take several months to complete a sale. And if your timing is driven by an emergency or other unexpected event, your need to sell fast might not garner the best price.
Rising Taxes and Insurance Premiums
The interest and principal of your mortgage may be fixed, but there is no guarantee that taxes will not rise faster than you can increase rents. Insurance premiums may also spike, as they have in the wake of natural disasters.
Despite your due diligence in vetting prospective renters, you could wind up with tenants who are not ideal. For example, they could be needy or demanding, pay late, forget to turn off the water, and so on. Or they could be destructive, in which case the depreciation allowance in the tax code may be sorely inadequate. You can, however, always add a rider to the standard lease form that spells out rules about occupancy, pets, smoking, tenant insurance, and the like. A security deposit can also be helpful here.
In an ideal scenario, your investment property will flourish amid other well-maintained dwellings and local amenities will improve. As a result, your cash flow will increase steadily and your costs remain stable. However, neighborhoods can change and your investment could depreciate over time. You should pay attention to the local politics where you invest, just as you would where you live. With some due diligence, you can minimize this exposure.
Unfavorable Changes to Tax Code
The tax code is not immune to change. It could change in ways that would either reduce or eliminate some or all of the tax benefits for homeownership and flow-through businesses.
Being a landlord is not for everyone. You may feel shy about increasing rents or be protective of the way others treat your property, which can lead to conflicts. You may even become friends with your tenants or they already may be family or friends. If you cannot be firm about rent increases or property care, for example, you could wind up collecting rent that is well below market price, or with a property that is undervalued.
In maintaining a property, minor and major repairs arise. Some property owners can save money by doing the work themselves. However, most lack the time, tools, or skills for home repair. Expect to shell out periodic contractor fees.
Whether you are buying a primary home or a rental property, it is important to consider what's happening with mortgage interest rates. Low fixed-rate mortgage debt is generally a good hedge against inflation. If you are a landlord, periodic rent increases are one way of offsetting inflationary rises in property upkeep expenses.
Interest rates in June 2020 are hovering near an all-time low of 3.13%, with the impact of the COVID-19 pandemic taking its toll. Rates are expected to continue to decline through the summer. This compares with mortgage rates in the 4% to 4.5% range between 2017 and 2019. Mortgage rates have averaged around 8% over the last 50 years. While these rates represent an opportunity, it is also important to remember that mortgage rates are typically higher for investment properties than for traditional homes.