Advantages/Disadvantages of rental property?

[tryan]

Ended up selling both units in '05 for less than I bought them for and accumulated massive neg cash flow during hold period. Haven't calculated entire damage, but probably lost at least 100K. Ouch.

Yup the down side of the boom is/will-be brutal ... my partner and I lost 500k in the slide from the late 80's into the early 90's recession. Took 12 years for the properties (9 units) to flip right side-up. Then - of course - we became motivated sellers.

Put your seat belts on!

 

[Slarty]

I like owning some rental units because they have such a low correlation to other assets. That's one of the big benefits for me to have some. :

My rental investments are kind of a hybrid between apartments and homes. They are duplexes which I rent. Since some people buy duplexes to live in one side they appreciate somewhere between SFR's and apartments. Anybody who can buy a residence in the US has probably done it during the boom. That means its probably the most difficult time to be a landlord now. In years to come there will be more renters and probably higher rents, if you believe inflation will get serious again. This is also why I see rentals as an inflation hedge. If you can find a property that doesn't have negative cash flow now then it might be a good long term investment since the rental should just get better from here. 8)

My plan is to hold onto my rental properties forever and to let them totally depreciate. Due to my income level and the fact that I don't work in the real estate industry, I am not permitted to take the depreciation now. But, that depreciation continues to accumulate every year over one's lifetime so you don't lose it unless you sell the property. It's like a bank account that I will use to offset profits during my FIRE years in the near future. That's when I will harvest the benefits of all that depreciation. Cash flow should also increase then and provide a nice non-correlated cash flow. It's currently the worst time to be landlord in the Denver, CO area since 1964.

The key for me was to find a neighborhood with duplexes where people tend to rent for long periods of time (greater than 5 years), but has not appreciated at radical rates during the boom. Instead, this area appreciates at a more sustainable 4% annual rate. In case you're wondering, I'm talking about some select suburbs of Denver in beautiful Colorado. People are so focused on the coastal areas that some gems are still out there.

I treat rental units like running a business instead just an investment. It does take more work and effort, but if you are a manager of people then you'll probably be able to manage tenants. I find a lot of similarities between the two.

The other thing this provides is an interesting fall back position. If something happens to my job before my planned FIRE date, then I could move into a side of one of my duplexes and really minimize my expenses while still living very well. This is also a good option to minimze expenses at the time of FIRE if I want to live where my duplexes are. I like options and flexibility since the world is so unpredictable and fun.

 

[Nords]

That's when I will harvest the benefits of all that depreciation.

Can you expound on that statement? I thought the main reason for 1031 exchanges was to avoid having to pay the depreciation-recapture 25% tax rate, and I don't see much benefit to depreciation. Not that we have a choice!

 

[Slarty]

Nords,

You are correct, if your strategy is to agressively build equity at increased risk. You can roll property equity into something larger, which probably means you're getting bigger loans to achieve larger leverage. But, I'm betting that we're coming off a record real estate boom with record low interest rates and appreciation is going to be very difficult for decades. I still remember 1991 - 1993 where some properties lost 20% of their value.

I've chosen a more conservative strategy to hold the properties and to bank the depreciation to off set taxes on income in the future since I'm not permitted to apply it against today's income. I will continue to pay off the properties and turn them into cash flow machines with banked depreciation for off setting taxes on that income. It's definitely more conservative that rolling equity into bigger properties.

 

[Nords]

Nords,

You are correct, if your strategy is to agressively build equity at increased risk.  You can roll property equity into something larger, which probably means you're getting bigger loans to achieve larger leverage.  But, I'm betting that we're coming off a record real estate boom with record low interest rates and appreciation is going to be very difficult for decades.  I still remember 1991 - 1993 where some properties lost 20% of their value.

I've chosen a more conservative strategy to hold the properties and to bank the depreciation to off set taxes on income in the future since I'm not permitted to apply it against today's income.  I will continue to pay off the properties and turn them into cash flow machines with banked depreciation for off setting taxes on that income.  It's definitely more conservative that rolling equity into bigger properties.

I understand using depreciation to reduce the taxes on the rental income, although I wouldn't necessarily use the words "aggressively" or "increased risk".

What I don't understand is the comment about "bank the depreciation to offset taxes on income in the future since I'm not permitted to apply it against today's income".

When I fill out Schedule E I can use the depreciation as an expense against the rental income. To me that seems to be applying it against today's income. In fact we participate significantly & materially (whatever the specific wording is) in the rental's management and have a low adjusted gross income, so we actually take a four-figure loss on our rental income that reduces the rest of our taxable income.

My "not that we have a choice" comment is regarding the IRS' assumption that the property is being depreciated, whether it actually is or is not. Unless a landlord sells rental property with a 1031 exchange, the sale of the property makes it subject to the depreciation recapture tax at the 25% rate. I know you're not selling it, but unless you're deeding it to your heirs you're eventually going to have to confront the depreciation recapture.

So if you're not applying depreciation against today's income, then how are you "banking the depreciation"?

 

[Martha]

Nords, if he has more rental losses (which would include depreciation) than rental income, then there are limits on the passive losses he can take. If I recall, if a single taxpayer's income is $100,000 or less, the taxpayer can deduct up to $25,000 tax loss from rental passive activity. But any rental tax loss exceeding $25,000, or if the taxpayer's income is too great to take the loss, the loss must be "suspended" for use in a future year, or when the property is sold to offset capital gains.

I might not be quite right on my numbers--too lazy to look at the IRS publication.

EDIT: From the IRS publication 527: if you or your spouse actively participated in a passive rental real estate activity, you can deduct up to $25,000 of loss from the activity from your nonpassive income. This special allowance is an exception to the general rule disallowing losses in excess of income from passive activities. Similarly, you can offset credits from the activity against the tax on up to $25,000 of nonpassive income after taking into account any losses allowed under this exception.

If you are married, filing a separate return, and lived apart from your spouse for the entire tax year, your special allowance cannot be more than $12,500. If you lived with your spouse at any time during the year and are filing a separate return, you cannot use the special allowance to reduce your nonpassive income or tax on nonpassive income.

The maximum amount of the special allowance is reduced if your modified adjusted gross income is more than $100,000 ($50,000 if married filing separately).

If your modified adjusted gross income is $100,000 or less ($50,000 or less if married filing separately), you can deduct your loss up to $25,000 ($12,500 if married filing separately). If your modified adjusted gross income is more than $100,000 (more than $50,000 if married filing separately), this special allowance is limited to 50% of the difference between $150,000 ($75,000 if married filing separately) and your modified adjusted gross income. If your modified adjusted gross income is $150,000 or more ($75,000 or more if you are married filing separately), you generally cannot use the special allowance.

 

[Slarty]

Martha,

yes, that is my situation exactly. The depreciation amount accumulates each year in a suspention until I am permitted to take it per IRS rules. If I made less income or if my income was substantially from real estate then I could apply the depreciation now.

Nords,

Regarding risk....there are a lot of ways to measure it and they are all imperfect. One way I use is to monitor my debt-to-equity ratio. If I roll 80%equity from a property into a larger property where it only represents 20% equity then I've increased leverage and I have more debt to equity, which means I have more risk of a loan call if the value of the property were to drop. As I get closer to FIRE, I'm getting more interested in a lower debt-to-equity ratio.

I do plan to hold on to the properties for the rest of my life so I don't have to worry about confronting the depreciation recapture. I'd appreciate your thoughts on any different strategies that might be more lucrative. The assumptions behind my strategy is that appreciation will be very low for very long and interest rates will go up and inflation will go up and drive up rents. Also, the rental market is at a 40+ year low and will only go up from here and make it easier to find lower risk tenants as new generations cannot afford to buy homes due to inflated prices and increased interest rates.

 

[Craig]

We would agree real estate rentals are worth the trouble.

It is a business, and you have to treat it as such. Screen potential renters carefully ... they are not just your tenants ... they are caretakers of your property.

But you can get others to carry your real estate investments, eventually they cash flow, and all the while you can have very nice appreciation. We now consider this a very important leg in our retirement stool.

Also, one unique tax feature to real estate is the section 1031 / like-kind exchange ... you can sell real estate, realize the gain, plow the cash directly back into other real estate investments, and defer the taxes ... perhaps forever. And, if careful, you can later borrow out some of that equity without tax consequences. See your own tax advisor, as individual results may vary ...

But, it is a business, and takes dedication ... but it is a business that can prove very profitable.

Another ideas ... consider an LLC to hold the properties, to give you a little more shield from liabilities.

Best of luck.

 

[Nords]

But any rental tax loss exceeding $25,000, or if the taxpayer's  income is too great to take the loss, the loss must be "suspended" for use in a future year, or when the property is sold to offset capital gains. 

Lemme make sure I understand this.

Let's say a rental property has a house value of $100K depreciating on MACRS at a 27.5-year rate, which would depreciate the house by about $3600/year.  Let's assume that depreciation is the only "loss" (rents & other expenses are a wash).  A high-income landlord wouldn't be able to deduct that $3600 so it rolls over & piles up year after year.

After 10 years the house is depreciated to $64K for MACRS purposes.  If its value appreciated at 3% it'd also have a resale value of $134K.  That would imply a cap gain of $134K-64K of $70K, but luckily that accumulated depreciation jumps back in and knocks another $36K off the cap gain to result in a cap gain of $34K.

It's as if the home started at $100K and was sold for $134K.  In other words, the depreciation couldn't be used and didn't count.  True, depreciation capture wasn't held against the landlord as it would have been held against a lower-income landlord.  However the $34K cap gains are still taxable.  Nothing's been avoided.

I guess you're saying that after you FIRE your income will drop below the $100K limit and you'll be able to use the piled-up depreciation to wipe out your cash flow and get some losses.  That sounds great if tax brackets are higher, but if tax brackets stay the same or get lower (I know, unlikely to come from Congress) you'd have paid taxes now to avoid taxes later-- a wash at best. 

The kicker is that even without Congress, FIRE is likely to knock one's income & tax rates down into the 15% bracket or even lower.  If you're paying taxes at the 25% or higher rates now and reducing your taxes in the 15% bracket later then it's not saving you any money.  True, you weren't able to take the depreciation because of your income, but it's certainly not saving any money.

Meanwhile a lower-income landlord with an AGI of $99K would have been depreciating the property against their income at a 25% tax savings or better.  Reducing 25% taxes with depreciation now and paying a 25% recapture years down the road allows that savings to be banked in the meantime-- real money saved in a real bank.

In any case, following the rules because you're constrained by them doesn't seem to be much of a strategy.  If you never sell the homes, good on you.  Eventually (after 27.5 years) you won't have to worry about depreciation.  But then you'll be in the same situation as any other landlord, facing massive cap gains and depreciation recapture just like the rest of us.  Except that lower-income landlords been taking depreciation and reducing their taxes in a higher bracket than you have, and that's definitely the kind of savings that can be taken to the bank. 

I hope I have a detail wrong here, because if I'm right then darn.  After nine years of depreciation and no end in sight, I was hoping to find a way around the depreciation-recapture & 1031-exchange issues.

The assumptions behind my strategy is that appreciation will be very low for very long and interest rates will go up and inflation will go up and drive up rents. Also, the rental market is at a 40+ year low and will only go up from here and make it easier to find lower risk tenants as new generations cannot afford to buy homes due to inflated prices and increased interest rates.

I hope that's workin' for ya in your area. Our rents only benefited from market demand, not inflation. When new rentals were built in the area, rents dropped regardless of inflation. Rental rates have risen with demand but they certainly haven't kept up with property appreciation (e.g. property taxes).

And while the market may be at a 40-year low, again the renter is more concerned with affordability. If they can't afford to buy homes due to high prices, they probably can't afford rent increases either. As landlords like TH bail out of the rental market because of higher yields on CDs than on rentals, that reduces the available supply of rentals and drives the prices up. Hopefully there'll be tenants who can afford that. If not there's gonna be a bunch of unhappy landlords who can't raise rents and are stuck with rising expenses... but supply & demand will eventually bring that all into equilibrium.

I guess my view is that rentals depend on the neighborhood, not on the CPI or historic rents. It doesn't matter how the nation's numbers look if the local neighborhood is on the downward spiral of the cycle. Those assumptions may work for certain properties at some times but I'd be surprised if they work consistently across all properties in a landlord's portfolio.

 

[mathjak107]

being a landlord is great...that is until its not great!...i owned a co-op in new york city for 18 years which i leased out..for 15 years the tenants i had were good,,but then darkness fell.....a tenents husband left her..well scattered lateness fell into missed payments...6 months of court and finally 8,000 in damages to the apartment she was gone...i wouldnt be a landlord again..ever

 

[mathjak107]

its not worth being a landlord and enduring the grief when it happens...i figured in 1987 i bought a house for 169,000..i sold it 2 years ago for 375,000..sounds great until i realized that 100,000 invested in my diverse mix of funds in 87 is now worth over 1 million...and no headaches and court dates and missed rent like my properties

 

[Slarty]

Nords,

Yes, I think you have it all correct, but I'm not a tax expert. This is just what I've picked up from my accountant. I'm at a major disadvantage because of my income from non real estate sources. It's a bummer because I'd prefer to take the depreciation now while I'm paying massive taxes. I want to highlight another option for this though. Remember that I like flexibility to adjust to future conditions. If my wife or I would lose our job then we could go take an exam to become licensed as a real estate agent, and we could then repatriate some of that depreciation earlier instead of later.

I also agree with the loose connection of rents to inflation. Owning real estate is all about the local conditions, which is a real stength since its not correlated with much else. But I do believe that as inflation picks up people tend to get higher percent raises and can cover higher rents as they go up with the cost of everything else. Higher wages are a drag on Wall Street so it's great to have something that is somewhat non-correlated with stocks.

 

[Martha]

Nords, it works for nonrealestate professionals only if you never sell and have reduced income or have passive income to offset the losses against.

When we owned apartment buildings they operated at a profit. In the last couple years of ownership, the profit was significant because we had paid off debt and rents had increased substantially in our town. However, we also were invested in real estate partnerships/LLCs. We had losses from those investments which we used to shelter the income from our own rental properties. It was tax and income wonderland.

Now we have sold all our rental properties but the one we live in. In the past year, two of the real estate partnerships had their assets sold. Over the years, all most all our capital had been returned plus we used all the depreciation losses. Now it is time to pay the BIG TAX. Capital gain and recapture.

They get you in the end.

 

[TomSimpsonAZ]

The way I view it is that rental properties are great if they pay for themselves. My property was bought with 800 dollars out of my pocket and the rent covers the mortgage. There might be some occasional additional expenses, but those are fairly few and far between(knock on wood).


Basically, its a headache and it doesn't do me any good until I pay it off or sell it, but, it is like a free annuity with a really shitty return.

 

[free4now]

Anyone know of areas where small rental properties would be cash flow positive for someone getting in today? At least here in the San Francisco bay area the rents are a half or even a third of PITI payments, so it's really not at all cost effective to be a landlord.

 

[Slarty]

fireme,

That's a great question! It'd be great to hear from a bunch of people about this.

One of the ways I look at real estate is to look at the amount of down payment that will get me to break even cash flow. I look at 30 year fixed loans, but you'll need to choose your loan structure because it changes the answer to this questions. I've found that duplexes in the Denver, CO suburbs are break even cash flow at around 16% to 18% down payment with a 30 year fixed loan if you have excellent credit. I've found the break even to be closer to 40% or 50% down payment for properties in resort areas such as ski resorts and some other resourts.

 

[TomSimpsonAZ]

Anyone know of areas where small rental properties would be cash flow positive for someone getting in today?  At least here in the San Francisco bay area the rents are a half or even a third of PITI payments, so it's really not at all cost effective to be a landlord.

The midwest.....thats about it

 

[unclemick]

midwest - yep!

Not even gonna run the numbers. Gonna take a cruise instead.

Still if it's a long winter? Repeat - I am not a landlord type.

Too old, been there done that, -  quick think of more excuses!

Kansas City and greater area - seems to be a lot of that - also some 'old timers' offering rent to buy packages.

For all I know - may be a bubble relative to prior years - nothing like the media darling areas though.

 

[cute fuzzy bunny]

I guess that monthly rent = 1% of purchase price bit still works. Look up rents in the area you want to buy in. If you can get a house for $150k and rent it for ~1500 a month, thats a great place to be a landlord. If the house is $500k and you can rent it for $1200 a month, look elsewhere.

 

[Slarty]

(),

Be careful applying those rules of thumb. You have to look at things like taxes too. For example, in Weatern New York property taxes are about 3%.

But property taxes in Colorado are closer to 0.7%. Both of these are on the assessed values of the homes. In California I believe property taxes are 1% of the purchase price and they are not based on re-assessed values of the house.

It's amazing how each housing deal can be so unique. That's why I prefer to hear from landlords who own properties in a given area. I'd love to find out about a good way to access rental market conditions and costs in a wide array of areas. If anyone knows some good sources for this kind of information then it would be great to hear from you.

 

[Martha]

Prices for rentals also will differ substantially based on condition. For example, the four unit place that we live in is in excellent condition (except for the dirty windows). New roof, new garage, new exterior staircase, new appliances, newer carpet, etc. This means that maintenance is lower hence the price for the building will be higher than dictated by the 1% formula. In contrast, we sold a property a few years ago which was a cash cow, but had a lot of condition issues (shabby kitchens and baths, flat roof requiring lots of repairs, leaky skylights, old plumbing and electric). We sold it "as is" for less than the 1% formula would dictate.

 

[Slarty]

Martha,

Your situation highlights another opportunity on how to make this work well. It sounds like you live in a building that you rent. If you buy a building with 4 units or less, and you live in one of the units then you can get a regular residential loan rate, which is about 1 percentage point lower than an investment loan rate. That's very significant on the impact to one's expenses and cash flows.

In addition, if you are in a job where you move or if you plan to move a few years after living in one of your properties then you could potentially do this deal where ever you go, and then turn the properties into total investment properties after you move out. You'll still have the low interest rate if you locked into a 30 year loan.

 

[Arif]

Be careful applying those rules of thumb.  You have to look at things like taxes too.  For example, in Weatern New York property taxes are about 3%.  

Yep, that's why I am selling our properties in TX. The taxes have gotten to a point that it is just not worth owning the rentals that I have there. Instead we are shifting our portfolio to GA where taxes are roughly half of that in TX and the rental income is the same (comparing two Army towns). I also have equity in these properties that aren't doing a thing for me other than sitting there unemployed. So you do have to look at the whole picture (taxes, labor pool, and rental prices).

I think what gets people in trouble with rentals is they don't treat it as a business. Instead they cut corners and bend over backwards for the tenants. When I was managing our rentals I was firm but fair. No rent equals eviction so save the sob stories for your next landlord.
I am amazed of how few calls I get for references when an old tenant moves out. I evicted a girl whose boyfriend was dealing drugs in the apartment which I evicted. I never got a call from the new landlord to verify their last tenant history. Guess the new landlord will be in for a very rude awakening and then swear off rentals as too many headaches.  

 

[Martha]

Martha,

Your situation highlights another opportunity on how to make this work well. It sounds like you live in a building that you rent. If you buy a building with 4 units or less, and you live in one of the units then you can get a regular residential loan rate, which is about 1 percentage point lower than an investment loan rate. That's very significant on the impact to one's expenses and cash flows.

That is what we did when we bought the building some years ago. We ended up paying off the loan instead of refinancing when rates dropped.

In addition, if you are in a job where you move or if you plan to move a few years after living in one of your properties then you could potentially do this deal where ever you go, and then turn the properties into total investment properties after you move out. You'll still have the low interest rate if you locked into a 30 year loan.

Well, maybe. If you look at the mortgage you signed, it may very well require you to use the property as your principal residence.

We are likely to sell our building either this summer or next summer. One thing we did think about was doing a 1031 exchange into a single family home in another city. Rent out the new house for a while and then move in and convert it to our home.

 

[haha]

My parents owned, lived  in and managed a tri-plex near a a university and hospitals complex. They gradually settled on renting to female medical residents. Lots of good experiences, including some lifetime friends. They almost never had to advertise, becaue they would get word of mouth applicants.

They were always having "open house". They would have hated living in a suburban single family. In fact, they didn't leave until we pried them out in their mid 80s. Too much upkeep was beginning to fall on my brother, and he got tired of it.

Ha