The Pros & Cons of Owning Rental Property
June 11, 2018
The economics of buying rental property for current income and long-term capital appreciation have not been more favorable for a generation or more than they are right now, unless you were smart enough, or contrary enough, to buy at the bottom of the Great Recession of 2008. This is especially true with the passage of the 2017 Tax Cuts and Jobs Act, which offers a number of tax benefits for landlords, effective Jan. 1, 2018, in addition to the ones they already enjoyed.
Pros of Owning Rental Property
Below are some of the pros of owning a rental property:
1. Mortgage interest rates are expected to average 4.35% in 2018 for a 30-year fixed rate mortgage, according to Freddie Mac. This is up from an average of 3.99% in 2017 and 3.65% in 2016, but still remains historically low. While the rates represent an opportunity, it is also important to remember that mortgage rates are typically higher on investment properties than for traditional home owners.
2. Even modest inflation means that you will be paying off current debt with future, cheaper dollars. Low fixed-rate debt secured by real property is the best possible hedge against inflation, since the market value of your property and the rent you can charge can increase in concert with other prices at lease renewal time, while your major expenses can remain flat.
3. Mortgage interest, insurance and all of the other expenses of maintaining a rental property are deductible against its income.
4. In addition to other rental-related deductions, under the 2017 Tax Cuts and Jobs Act, there is a new tax deduction for owners of pass-through businesses, which you can take advantage of if you operate under a sole proprietorship, limited liability company (LLC), partnership or S corporation. An amount equal to 20% of net rental income can now be deducted annually, provided total taxable income for the year from all sources after deductions is below $157,500 for singles or $315,000 for married couples filing jointly.
5. If it’s a seasonal rental, you can use it yourself for two weeks without jeopardizing the deductibility of the expenses.
6. Depreciation, the allowed tax deduction for wear and tear, may even produce a nominal loss, which you can deduct against other income. In other words, you may achieve a net positive cash flow from the rental income less expenses and still have a net loss for tax purposes. But be aware that depreciation reduces the cost basis for purposes of calculating capital gains when you finally sell it. It is a good idea to consult a tax professional if you are considering owning a rental property, especially given the recent changes to the U.S. tax code.
7. You can even treat a unit in your own home or on your own property – a garage apartment or mother-in-law apartment, for example – as a rental and lay off a share of the mortgage interest and other expenses against its income, thus reducing your overall cost of living.
8. In a so-called 1031 Exchange, you can sell a rental property and invest in another of “like kind” without paying capital gains taxes.
Cons of Owning Rental Property
Here are some of the cons of owning a rental property:
1. The biggest caveat is that real estate is not liquid. Even in a hot seller’s market, it can easily take several months to complete a sale. If your timing is driven by unexpected need or other exigencies, you may not get the best price. For instance, in the housing market unpleasantness of 2006–2008, median new house prices sank by about 30%.
2. The interest and principal parts of your mortgage may be fixed, but there is no guarantee that taxes will not rise faster than you can increase rents, or that insurance premiums won’t spike, as they have in the wake of natural disasters, or that insurance claims in such cases will be fairly adjusted.
3. Despite your due diligence in vetting prospective renters, if you wind up with a tenant from hell – for example, one who is needy and demanding, pays late, won’t turn off the water, can’t change a light bulb, and whose friends, followers, children and pets leave a trail of destruction behind them – then the depreciation allowance in the tax code is probably sorely inadequate. (You can add a lease rider to the standard lease form spelling out rules about occupancy, pets, smoking, tenant insurance requirements, etc.)
4. Neighborhoods can change. With good research and some luck, your investment property will flourish amid other well-maintained houses and apartments, and local amenities will actually improve so your cash flow will steadily increase while your costs remain stable. But things happen. For example, municipalities can be capricious or corrupt, and you might find some undesirable development impinging on your neighborhood. You should pay attention to local politics where you invest, just as you would where you live.
5. The tax code may change by reducing or eliminating some or all of the tax benefits for home ownership and pass-through businesses.
6. Landlordhood is not for everyone. You may feel squeamish about increasing rents, even if you are a good and reasonable kind of landlord. It’s OK to be friends with your tenants, but friendship can easily be a drag on the rate at which you can raise rents. One Manhattan brownstone owner rented an apartment to old friends from the West Coast and wound up, 20 years later, with a rent that was half the fair market rent – after a period of especially high inflation in the 1970s. Her friends were better negotiators than she was.
7. Minor repairs are most economical if you can do them yourself, but you may not have the time, tools or skills. Whether or not you are handy, find a local handyman (or woman) and be very good to them so they will be inclined to respond on an emergency basis.
The Bottom Line
The economics of rental property ownership may be compelling, but the return you can achieve must be much higher than you could earn in conservative investments such as bonds and dividend-paying blue chip investments, because there are real risks, not the least of which is your own capacity to manage property and tenants.
By David F. Smith