Pros and cons of owning rental houses

by Steve Crossland, REALTOR in Austin TX on July 7, 2007 · 14 comments

I came across this article today by Robert Bruss (www.RobertBruss.com). It’s a really good overview of rental property ownership. Robert Bruss writes real estate articles that are published in newspapers around the country.

A closer look at investment purchases
Friday, July 06, 2007
By Robert J. Bruss – Inman News

What is the best investment you ever made? Common stocks? Bonds? A small business? Your house? Other real estate?

Chances are your most profitable investment has been your personal residence. If you have yet to purchase your own home, today’s “buyer’s market” is an excellent time to do so.

However, if you already own your house, why not take advantage of current market conditions to buy one or more houses as rental investments? Let your tenants buy those houses for you by using their rent payments to pay the mortgage and other expenses.

WHY BUY RENTAL HOUSES?
Realizing that profitable rental houses (and most other real estate investments) are long-term investments for at least five years, consider the advantages of such investments.

Your list of benefits will likely include probable appreciation in market value (although the home sale market is “flat” in many cities today), income tax shelter, maximum leverage to control the property with little cash, tax-free and tax-deferred sales benefits, and pride of ownership.

Yes, there are possible rental-house disadvantages unless you carefully qualify tenants before they move in to ensure they pay the rent on time and won’t “trash” your property. But sound property management techniques minimize this risk and hold repair costs down by providing tenant incentives to avoid damaging your rental houses.

HOW TO GET STARTED BUYING RENTAL HOUSES.
The easiest way to acquire a sound, well-located rental house is to buy one as your personal residence.

That might sound unusual. However, the key reason is buying your own home for owner-occupancy is the simplest way to purchase for little or no cash on the most affordable mortgage finance terms.

After owning and living in your home for a few years, perhaps fixing it up to add market value, then you can convert it to a rental house and move on to another house purchased the same way, eventually establishing a portfolio of rental houses.

Or, thanks to the tax magic of Internal Revenue Code 121, after living in the house at least 24 months and then moving out to rent it to tenants, you will have up to 36 months to decide if you want to keep the house as a rental or sell it and claim up to $250,000 (up to $500,000 for a qualified married couple) tax-free principal-residence-sale profits.

THE FORGOTTEN RENTAL-HOUSE TAX-SHELTER BENEFITS.
Most prospective rental-house investors realize these properties can provide income tax benefits, but they are often hazy as to the details.

Thanks to the unusual benefits of the depreciation tax deduction for estimated wear, tear and obsolescence, most rental houses show a paper tax loss. The reason is that depreciation is a noncash-expense tax deduction, which requires no actual payment, as is necessary for mortgage payments, property taxes, insurance and repairs.

Current tax law allows depreciation deductions for rental properties over 27.5 years. Commercial properties require a 39-year depreciable useful life.

For example, suppose you buy a $250,000 rental house, allocating $50,000 to the nondepreciable land value. Dividing the $200,000 cost of the structure, each year for 27.5 years you can deduct on Schedule E of your income tax returns about $7,300 without having to pay in cash even $1 for any actual depreciation expense.

The likely resulting tax loss from the rental house, after paying the operating expenses from the rental income, is deductible up to $25,000 annually if your adjusted gross income (AGI) from other sources is less than $100,000. Between $100,000 and $150,000 AGI, the amount of deductible rental-property loss gradually declines.

But any unused rental-property tax loss can be “suspended” and saved for use in future tax years or when the property is eventually sold.

UNLIMITED DEDUCTIONS FOR REALTY PROS.
However, “real estate professionals” can claim unlimited property-loss deductions from their other ordinary taxable income. If you spend at least 750 hours per year (about 14 hours per week) on your real estate activities, you may qualify for unlimited Schedule E deductions from your rental houses and other realty investments.

A real estate sales license is not required. Full-time real estate investors, property managers, builders, contractors and leasing agents can qualify. Either spouse is eligible.

For example, suppose a married physician earns $500,000 AGI. Normally, he would not be entitled to any Schedule E tax loss deduction from his rental houses because his AGI exceeds $150,000. However, if his wife manages their properties and she spends more than 750 hours annually supervising those investments, making management decisions, inspecting properties for possible purchase, and supervising sales and exchanges of their properties, they can qualify for unlimited “real estate professional” deductions on their joint income tax returns.

AVOID TAX WHEN SELLING YOUR RENTAL HOUSES.
If you quickly buy and sell rental houses or other real estate after fewer than 12 months of ownership (called “flippers”), your capital gains will be taxed at ordinary income tax rates up to 35 percent plus state taxes.

However, if you own the property more than 12 months, then the maximum federal capital gain tax rate is currently only 15 percent, plus state taxes.

But various tax-avoidance methods are available to cut or eliminate these taxes. In addition to the principal-residence-sale tax exemption of Internal Revenue Code 121 (if the house was owner-occupied to meet the statute’s requirements), tax-avoidance consideration should be given to tax-deferred exchanges and installment sales.

Also, remember that any unused annual property-tax losses from rental properties are “suspended” for use in future tax years or when a property is sold. Your tax adviser can provide full details.

Personally, I have sold several rental houses at considerable profits with no tax due because my suspended tax losses sheltered my capital gains from taxation.

More information is available in my brand-new special report, “Pros and Cons of Investing in Rental Houses and Condominiums,” available for $5 from Robert Bruss, 251 Park Road, Burlingame, Calif., 94010, or by credit card at 1-800-736-1736 or instant delivery at www.BobBruss.com.

{ 14 comments… read them below or add one }

1 Ryan Campbell July 27, 2007 at 3:43 pm

Steve,

I am a big fan of your blog and really appreciate the service you provide with it!

I wanted to know what you think of rentometer.com? Have you found it reliable for comparing rents in the Austin area? Or are there better tools available?

Thanks again,
Ryan Campbell

2 Steve Crossland July 27, 2007 at 8:49 pm

Hi Ryan,

Looks like an interesting and clever site. I don’t think the results are to be trusted though. We have a very actiave MLS for Leasing in Austin, with very good data about leased home prices. That’s where I look to price a rental home.

steve

3 Mickie August 24, 2008 at 6:19 pm

I have used turbotax for years, would that program suffice when filing taxes and claiming rental property?
thanks, lots of good info on this site

4 patricia August 10, 2010 at 6:12 pm

Wanted to know: What are the pitfalls in an owner selling and holding the paper (mortgage)? Can the owner define what can’t and can be done with the property until it is paid in full? Or by acting as a bank, I am immediately in a catagory that forces me to abide in the same way as a bank or mortgage company??

5 Steve Crossland, Austin REALTOR August 10, 2010 at 10:01 pm

Hi Patricia,

As long as you receive a large enough downpayment, owner financing is a relatively safe move. It can often bring buyers to a home that otherwise wouldn’t sell, or wouldn’t sell for as much. You just need enough dp to cover repossession costs if necessary.

Also, unless you write something in for pre-payment penalty, the buyer can refi and pay off the loan in a year or two. If that’s what you want, you write in a balloon payment. If you’d rather have extended payments for many years, you’d have to have a pre-payment penalty to discourage the buyer from paying off or reselling.

Steve

6 Julie July 13, 2011 at 9:20 am

This is such a basic question, but are the loan payments a deductible expense when owning a rental home? Is it just the interest like on a regular mortgage?
Thanks!

7 Steve Crossland, REALTOR in Austin TX July 18, 2011 at 11:39 am

Hi Julie,

Only the interest portion of your payment is deductible on your income taxes. You can also deduct insurance, property taxes, commission, management fees, repairs and maintenance, etc. though.

Steve

8 Siyanda Nyengule September 5, 2011 at 4:51 am

im a 2nd year student i want to buy a property then develop it for rental purposes what are my options as to how to attain my vision of doing this ???

9 Steve Crossland, REALTOR in Austin TX September 6, 2011 at 12:00 pm

Hi Siyanda,

Your first step is to contact a lender to find out what sort of financing you can qualify for. Then buy something as an owner-occupant and live there. maybe renting a room or two to friends. Eventually, you can move out and convert it to a full rental property and buy another property.

That’s how a lot of investors get started.

Steve

10 Roselle April 5, 2012 at 1:55 pm

We are currently in a process of buying another house. If things go as planned, we might be moving to our new house the beginning of this summer. My husband and I wanted our current home to become a rental property. Since it wont make any since selling our current home because we would lose a lot. It is a smart choice to hire a property management to manage the a residential rental property?

11 CopyKat April 10, 2012 at 9:43 pm

Thanks for this article I am determining right now if this is a good option for me or not. I am selling my first home and buying my second. I didn’t quite understand the tax implications on this. It sounds like it is a good idea to keep these for about three years, and then move on if I read this correctly.

12 Steve Crossland, REALTOR in Austin TX April 28, 2012 at 8:23 am

> It is a smart choice to hire a property management to manage the a residential rental property?

Hi Roselle,

You should strongly consider a property manager if you don’t have the time/expertise to manage the home yourself, and/or if you won’t be living near enough to the home to properly manage it.

Good luck!

Steve

13 Lorna Borger May 31, 2012 at 4:11 pm

Do you know if you need a license to manage personal rental properties in Texas? And any idea how to find general appreciation rates for a given area? Thank you!

14 Mike December 20, 2012 at 8:26 am

I’m retired military now but bought a house and lived in it for four years before moving to an overseas assignment. The house has been in a rental status since I left the states (10 years). I have no plans on returning to the house or area and would like to sell it. What kind of penalties would I expect from the sell.

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