21st-Century Landlords
The strong housing market makes renting out property look attractive. But it pays to figure the dollars and cents of being a landlord before you jump in.
By Jeffrey R. Kosnett, Senior Editor
From Kiplinger's Personal Finance magazine, December 2004
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Tally up tax breaks
Byers paid for the house by writing a check for the full amount using a 3.24% floating-rate line of credit on his residence in Pennsylvania. With taxes and insurance, his monthly payment totals about $1,000, leaving him a profit of about $900 (not counting the cost of repairs and maintenance).
Part of the income is effectively tax-free, thanks to depreciation write-offs. One of the boons to owning rental property is that you're permitted to take tax write-offs for depreciation -- that is, for the presumed wear and tear on the structure.
You can depreciate a building over 27.5 years, as explained in the box on page 51. To the extent the depreciation offsets your profit, you pocket the profit tax-free. But this is not a pure windfall. Because depreciation lowers the tax basis of your property -- the amount you'll use to figure your profit when you sell -- each dollar of depreciation claimed today will be recaptured as an extra dollar of taxable profit tomorrow. And unlike most capital gains, which are taxed at 15%, gains attributable to depreciation get hit by a 25% rate (unless your regular tax bracket is lower).
In essence, depreciation moves up some of your cash flow to the present from the unknown future. Phil Byers thinks this will put thousands of dollars in his pocket this year. He estimates that the value of his rental house itself is $227,000. That makes his depreciation deduction $8,240, protecting that much of his profit from Uncle Sam.
Convert your house
Maybe you're lukewarm about going to the trouble of hunting for a property, or you don't want to deal with unexpected repairs. Or maybe you have to move but hate to let go of a house you think will be a valuable long-term asset. You can still become a real estate investor simply by renting out the property you know best: your own home.
Because you know the house, there should be few maintenance surprises. On the downside, you can't take money from the sale to settle on a new one, so you'll need other sources of cash.
Neil Begalman, 36, an airline pilot from Liberty Lake, Wash., has used this strategy not once but twice. In 1995, he bought a 2,000-square-foot, four-bedroom house. When he later decided he wanted to be on the lakefront, he rented out the first house and bought a much smaller waterfront home in 2001. A year later, Begalman and his wife, Buppha, became parents, and their family outgrew the lake house. Begalman took money from savings and a home-equity loan to buy a 3,300-square-foot house a block from the lake, to which the family moved in August. They kept the lake house to rent. The rental houses should bring in about $1,000 per month when occupied, says Begalman, and he'll just about break even.
So far, the lake house has been slow to rent, which surprised Begalman. But he figures both houses are worth keeping because they help diversify his investments. And he also suspects that his lesser-known waterfront community will one day be discovered. He estimates that his first house, for which he paid $120,000, is now worth about $175,000, and that the waterfront place would sell for at least $350,000, about $80,000 more than he paid. So he's banking on long-term appreciation as much as current cash flow, as long as he can afford to carry both houses.